I set aside tax money for contracted work. I paid it, but I am now being accused of tax evasion?

Question: I am an IT project manager for an investment bank. A former colleague who has started his own investment advisory business asked me to set up his office systems for him. To simplify matters, I charged him a rate based on my pro rata salary and reserved an amount for taxes equal to the equivalent withholding from my pay check.  At the end of the year, I reported all my freelance income and paid what I thought were the appropriate taxes; however, now I am being accused of tax evasion and have to pay penalties as well additional taxes. Please advise as to what I did wrong and how I can avoid this situation in the future. Thank you—TG.

Response: Everything you did seems logical and fair; unfortunately for you, when it comes to taxes, the issue isn’t whether what you did is “logical and fair”—it’s whether you followed the rules. Based on what you wrote, it sounds like—despite your best intentions—you didn’t. Specifically, it sounds like you ran afoul of the self-employment tax and estimated tax.

• Self-employment tax: if you’re self-employed—and you were, at least on a part-time basis—you pay more in taxes than someone who works for another. The total amount of social security and Medicare taxes that are paid on income is 15.3%: 12.4% for SS, 2.9% for Medicare. You have to pay this on income up to a certain ceiling amount, $102,000 in 2008. (It goes up every year.) Normally, your employer pays half this amount, which is why you’ll only see 7.65% taken out for this on your paycheck.

However, when you’re self-employed, who’s your employer? That’s right—you. That means that you, as the (self-)employer has to kick in the balance of the tax, too. If you’d based your tax payments on what was taken out of your paycheck as employee of an investment bank, odds are you failed to take out the additional amount required under the self-employment tax. (Don’t feel too bad, though—even Secretaries of the Treasury have made this mistake.)

• Estimated tax: Income tax is a “pay as you go” (more or less) tax; even though we all think about April 15 as tax day, the fact is, you need to pay your income tax throughout the year. If you’re someone else’s employee, you probably don’t think about this normally, since the amount withheld from your paycheck pretty much takes care of it. But if there’s no withholding—such as if you were doing a project for a former colleague and probably just invoiced him for the gross amount—then you need to pay the “estimated tax” on your earnings quarterly throughout the year. And when you pay, you need to file the appropriate form (typically, the form 1040-ES). If you don’t pay and you don’t file, you can be assessed penalties—even if overall, you’d have been due a refund for the year.

To avoid this going forward, make sure to file and pay quarterly for any income you earn that’s not subject to employer withholding. And remember that when you’re working for yourself, you need to make good the extra social security and Medicare taxes—the self-employment tax—that normally is paid by the employer.

Answered by Steven Zweig

Additional Resource:  self-employment tax – IRS.gov

Disclaimer: This site does not provide legal advice and users of this site should not interpret any of the information presented here as legal advice. The information provided merely conveys general information related to commonly asked legal questions. We are not a law firm and the employees responding to questions are not acting as your legal attorney. You should ultimately consult with a Lawyer for your case.