Taxing Small Business

But if your business continues to generate losses that you write off against ordinary income, it will raise a flag. The IRS presumes that if you incur a loss in two out of five consecutive years, your business activity is probably a hobby and thus, the losses are not deductible.

Your income tax is calculated based on all your taxable income, from your W-2 and your self-employment. But your self-employment tax is calculated only on your business income. These two taxes are added together to come up with the total tax on your federal tax return.

Just like the FICA tax on your wages, the tax for self-employed people is made up of both the Social Security tax and the Medicare tax. For 2006, Social Security tax is calculated on the first $94,200 dollars of your income from all sources. Medicare tax is calculated on all of your income.

If you are an employee, you pay 6.2% of your income for Social Security tax and 1.45% for Medicare tax (these are withheld from each paycheck). Your employer pays an equal amount on your behalf. For your self-employment income you must pay both the employer and employee portions - 12.4% for Social Security tax (on your income up to $94,200) and 2.9% for Medicare tax. But you do get to deduct half of your self-employment taxes on line 27 of your 1040 form.