Small Business & Self-Employment

Are you actually in business, and when did it start?

Almost certainly the moment you first got paid for the work, and that is a conclusion drawn about you rather than a status you choose. There is nothing to register, no threshold to cross and no form that switches it on. Self-employment simply means carrying on a trade or business for yourself rather than as somebody's employee, and a side hustle alongside a full-time job counts. What makes an activity a trade or business is continuity and a genuine profit motive rather than size: the tax code borrows the test from the same provision that decides whether costs are deductible at all, which is why the hobby question and the deduction question have the same answer. A hobby's receipts are still income; what a hobby cannot do is produce a deductible loss.

Two beliefs get in the way here, and both run in the direction of a nasty surprise. The first is that a Form 1099 is what makes income taxable. It is not. A 1099 is an information return, a copy of which goes to the IRS so that it knows what you were paid; the income was taxable whether or not one arrives, and the reporting thresholds that decide whether a payer has to send one have moved repeatedly in recent years and have nothing to do with what you owe. Cash income with no paperwork behind it is exactly as taxable as an invoice. The second is that a modest amount of side income is free of tax. There is no such floor for income tax. There is a threshold below which one particular tax stops applying, and it attaches to a figure one step removed from profit: self-employment tax starts at $400 of net earnings, and because net earnings are computed at 92.35 percent of the business's profit, the profit that trips it is a little over $433 rather than $400.

The harder version of the question is not whether you are in business but whether the person paying you should have been treating you as an employee, or whether somebody you pay should be treated as yours. That is decided by tests you do not control, and the single most clarifying fact about the whole area is that there is more than one test and they can reach different answers about the same working relationship.

Why the answer depends on which law is asking

Because the tests were written by different bodies for different purposes, and one of them is prohibited by statute from being written down at all. In 1978 Congress barred the Treasury from issuing any regulation or revenue ruling on worker status for employment tax purposes, and the prohibition has never lifted. That single fact explains the landscape: there is no Treasury regulation defining an employee for payroll tax, the IRS works from publications and case law instead, and the tax answer has consequently been stable for decades while the wage-and-hour answer has been rewritten repeatedly.

For tax purposes the test is common-law control, and the most misunderstood word in it is "right". The IRS states the general rule as whether the person paying has the right to control or direct only the result of the work, in which case the worker is an independent contractor, or also the means and methods of accomplishing it, in which case they are an employee. It is the right to control that matters, not whether it is exercised, and freedom given to a worker in practice does not change the answer if the right was retained. The evidence is grouped into three categories: behavioral control, meaning instructions about how, when and where to work and what tools to use, plus training; financial control, meaning investment, unreimbursed expenses and whether the worker can make a profit or a loss; and the relationship of the parties, meaning benefits, permanence and any written contract. Two points there cut against the intuition. A written contract sits near the bottom of that hierarchy rather than the top, mattering mainly as a tiebreaker when the facts are genuinely ambiguous. And a significant investment in equipment is not required for contractor status, which is the opposite of the "real businesses own tools" instinct. There is no set number of factors that decides it.

Federal wage and hour law asks a different question and is currently in an unusual state that is worth stating precisely, because a summary in either direction would be wrong. The Department of Labor's 2024 rule setting out an economic-reality analysis with six non-exhaustive factors is still on the books and has never been vacated or enjoined; five lawsuits were filed against it and none has beaten it: four produced rulings for the Department or dismissals on standing, the fifth was stayed before decision, and all five now stayed. Since May 2025 the Department's own enforcement staff have been instructed not to apply that rule's analysis in their investigations, and to work from earlier guidance instead. The same instruction says, in the Department's own words, that the rule "remains in effect for purposes of private litigation", and that is the limb that matters most to a small business, because misclassification exposure overwhelmingly arrives through a worker's lawsuit rather than through a federal investigation. A proposal to replace the rule with an earlier analysis that elevates two factors above three others was published in February 2026 and its comment period has closed; no final rule has issued. The independent contractor entry linked above works through all three layers and the factor lists themselves.

Then there is state law, which is a third answer again. Several states apply a version of the so-called ABC test, which is generally harder to satisfy than either federal test because it typically requires that the work fall outside the usual course of the hiring business, a condition with no counterpart in the federal analyses. A state can also apply one test for unemployment insurance and a different one for wage claims, so even a single state may not produce a single answer. The practical consequence is the one to hold onto: being confident you are a contractor for tax purposes tells you very little about the wage-and-hour or state answer, and a business that pays contractors carries the exposure in all three directions at once.

Do I need an LLC, and what does it actually protect?

No. Someone who starts working for themselves and forms nothing is a sole proprietorship by default, and a legitimate business for tax purposes from the first dollar. What an LLC buys is a separation between the business's debts and your own property, which is worth having in some lines of work and close to irrelevant in others. The reason the question feels harder than that is that it is usually asked as one question with three answers, whether to be an LLC or an S corporation or a sole proprietor. It is five separate questions with five separate answers, and collapsing them is where the confusion comes from.

• What is the business, legally? A sole proprietorship by default, with no separate legal person and nothing filed to create it, or a limited liability company or a corporation if you file with a state to make one. This is state law and it decides how the liability shield works.
• How is it taxed? A separate federal question with four possible answers. Federal tax law has no category called "LLC".
• Is an S corporation election in place? That is one of those four tax answers, elected on a form, and it can sit on top of either an LLC or a corporation. An LLC that elects it remains an LLC in every respect state law cares about.
• Where does the number go? For most of the arrangements above, onto Schedule C with the owner's personal return, which turns receipts and expenses into one net profit figure.
• What do you owe on it? Income tax plus self-employment tax, and only the S election changes the second of those.

Set out that way, the answer to "do I need an LLC" stops being a tax question at all. Forming one does not reduce any tax by itself. A one-owner LLC that files no election is disregarded for income tax, so the profit lands on the same form at the same rates with the same self-employment tax as the week before. What it buys is liability separation, and it costs a state filing fee plus whatever annual report or franchise obligation the state imposes. Those state costs and obligations vary widely enough that no national figure is worth quoting.

The four federal tax treatments, so the choice is legible: one member and no election means disregarded, reported on the owner's own return; two or more members and no election means a partnership, with its own return and a schedule to each member; a Form 8832 election means a C corporation; and a Form 2553 election by an eligible entity means an S corporation. That last one has a detail worth knowing because it saves a mistake: an LLC electing S status files Form 2553 alone, and filing Form 8832 first is not merely unnecessary but starts a separate five-year clock on further classification changes. It is also worth knowing that a change of classification is treated as a deemed transaction rather than as paperwork, so an LLC holding appreciated assets or debt above basis can produce a taxable event on an election that looks administrative.

What limited liability actually reaches

The statutes carry their own boundary in three words, and reading them is more useful than any summary. LLC law is state law and there is no federal version, but the operative phrase is remarkably consistent across the statutes: the debts, obligations and liabilities of the company are solely those of the company, and no member or manager is personally obligated for them solely by reason of being a member or acting as a manager. The load-bearing words are "solely by reason of". The statute removes liability that attaches to you because you are an owner. It says nothing about liability that attaches to you because of what you personally did. Four consequences follow, and between them they cover most of what actually goes wrong.

• It does not cover your own acts. If the claim is that you were negligent, or that your professional work harmed a client, the entity is not what is standing between you and the claim. Insurance is, which is why the entity question and the insurance question are not substitutes and why professional-liability coverage exists.
• It does not survive a personal guarantee. The same statutes say so expressly: a member may agree to be obligated personally. Most small-business bank lending, many commercial leases and a surprising number of vendor accounts ask for exactly that, so the separation the filing created gets signed away one facility at a time.
• It does not reach unpaid payroll taxes, and no entity does. Federal law provides that any person required to collect, truthfully account for and pay over a tax, who willfully fails to do so, is liable for a penalty equal to the total amount of the tax. It reaches the individual as well as the business, so an LLC or a corporation simply does not stand in the way. This is the largest single crack in the shield and it is discussed in hiring someone, because withholding is what creates the exposure.
• It does not displace the case law on piercing the veil. At least one state's LLC statute imports that doctrine expressly, while separately protecting owners against the narrower argument that internal formalities were not observed. The practical version is the ordinary one: keeping business and personal money in one account undermines the separateness the entity was formed to create.

There is one more split that catches people, and it is the reason "my LLC is invisible to the IRS" is wrong in more than one direction. Disregarded status is specific to income tax. The same single-member LLC is treated as a separate entity for employment taxes and certain excise taxes, must use its own name and employer identification number, the nine-digit number the IRS uses to identify a business on its filings, on those returns, and the owner is emphatically not its employee. So a single-member LLC with staff is a non-entity for income tax and a separate entity for payroll at the same time, which is precisely the split that produces filings under the wrong number.

Three narrower traps in this area are worth naming because each has a real cost. An LLC cannot elect qualified joint venture treatment, the route that lets a married couple running an unincorporated business file two Schedule Cs and each build their own Social Security record; the Schedule C instructions carry an explicit caution saying so, and a married couple's LLC is a very common arrangement. The employer identification number trigger list is longer than the IRS's own summary page suggests, and the omitted trigger is the one this audience hits: setting up a qualified retirement plan requires an EIN, which is easy to miss because the plan is presented as a benefit of working for yourself rather than as a filing obligation. And if an LLC does elect S status, its own operating agreement can invalidate the election, because an S corporation may have only one class of stock and a preferred return or a distribution waterfall is a second economic class.

One filing obligation that reached small entities in 2024 is worth a sentence, because the position changed the following year. Beneficial ownership reporting to the Treasury's financial crimes bureau was removed for companies formed in the United States and for US persons in March 2025, and now reaches only foreign-formed entities registered to do business in a US jurisdiction. That change was made by an interim final rule, which can be revised before it is finalized, so the current position is worth checking rather than assumed from guidance written in 2024.

What most American businesses actually are

This is the fact that should discipline every decision in this section and the next one. For tax year 2023, the IRS's Statistics of Income estimates 31.1 million nonfarm sole proprietorship returns. Of those, 21,411,462 reported net income, and their aggregate profit works out to a mean of roughly $25,000 each; the other 9.7 million or so, about 31 percent of the total, reported no net income at all. Against that, about 6.2 million S corporation returns were filed in the federal fiscal year 2025.

So the typical American business is a Schedule C earning about twenty-five thousand dollars, and at that level almost every structural decision resolves the same way: there is nothing to split, the entity question is about liability rather than tax, and the money is better spent on insurance and a retirement account than on filings. The rest of this guide is written for that business, and treats the S election as the minority case it is.

What does a tax year look like when nobody withholds?

It becomes a bill you pay in installments rather than a deduction you never see, and it arrives in two parts instead of one. That is the whole shape of it, and the mechanics matter less than the shape.

The first part is the one people plan for. Income tax on the business's profit, at the household's ordinary rates, alongside everything else on the return. The second part is the one that surprises people and it is often the larger of the two at modest income: self-employment tax, which is the Social Security and Medicare tax an employer would otherwise pay half of. The rate is 15.3 percent, made up of 12.4 percent for Social Security and 2.9 percent for Medicare, and it is charged on 92.35 percent of the profit rather than on the whole of it. That factor is not a convention; it comes from a deduction inside the computation equal to half of the combined rates, which is 7.65 percent, and it exists to approximate the position of an employee whose wage was set after the employer's share had already been paid. Half of the resulting tax is then deductible against income tax whether or not you itemize. The Social Security half stops at an annual ceiling and the Medicare half never does, so a high earner's effective rate falls once the ceiling is passed, and wages from a job consume that ceiling first.

There are four payment dates, they are not evenly spaced despite everybody calling them quarterly, and the way to make underpayment impossible to stumble into is to stop trying to predict the current year. Estimated taxes have a safe harbor: pay in an amount equal to the tax shown on last year's return, or a slightly higher multiple of it if last year's income was above a statutory threshold, and no underpayment charge applies however the current year turns out. The remaining balance is simply due in April with nothing added. That figure is knowable in advance, which is what makes a volatile income manageable, and it is the reason the alternative test based on the current year is usually the fallback rather than the target. Our taxes guide covers the installment mechanics and the method for genuinely lumpy income.

One mechanic is worth knowing before anything else, because it removes the quarterly payment problem for a large share of households. Tax withheld from a job counts toward the same annual requirement, and it is treated as though an equal part of it arrived on each of the four installment dates unless you prove otherwise. So a shortfall noticed in November can be cured by raising withholding on a paycheck, which is treated as though a quarter of it had been paid in April, while a larger check with the January installment cannot reach the earlier periods at all. A household with one employed spouse and one self-employed spouse can often cover both incomes through the employed spouse's withholding and never make an estimated payment.

Deductions exist only if the records exist

Because tax attaches to the profit rather than to the receipts, the records are the mechanism by which a deduction exists rather than an administrative afterthought. That is worth stating more strongly than it usually is. The tax code computes taxable income under the method of accounting on the basis of which the taxpayer regularly computes income in keeping their books, so bookkeeping is a legal choice rather than a filing chore: whether you are on a cash or an accrual basis is decided by how you keep the books, it determines which year every item lands in, and changing it later needs the IRS's consent. There is no prescribed system, and the only test the regulation imposes is that the method clearly reflect income. What the records have to do is establish every figure on the return, and it is that sufficiency standard rather than any filing requirement that turns a missing receipt into a lost deduction.

Three items in this area are worth pointing at rather than teaching here. The home office deduction is available to a self-employed person and not to an employee working from home, and the test that returns actually fail is exclusivity rather than the existence of a separate room; there are two computation methods and the choice has a consequence years later, when the house is sold, which our real estate guide covers. Equipment and vehicle costs come with their own rules about writing off the cost at once or over time, and the annual limits on those move. And the qualified business income deduction is worth up to 20 percent of a business's qualified profit, is claimed by the owner rather than the business, and behaves in three bands: below an income threshold there is no wage or property test and no line of business is excluded; above it the deduction becomes limited by the wages the business pays and the property it owns, and certain service businesses lose it altogether. It reduces taxable income only, never adjusted gross income, and never self-employment tax.

That last point generalizes, and one sentence about the structure is worth three separate caveats. The health insurance deduction, the retirement plan deduction and the qualified business income deduction all fail to reduce self-employment tax, for the same reason: the form that computes self-employment tax takes its input from the business's profit, and all three of those deductions sit downstream of that number. Nothing further down the return can reach back and reduce it.

Two provisions run the other way, and both are easy to miss. A self-employed person with a loss or a very small profit can use the optional methods on the self-employment tax schedule to be treated as having earned a deemed amount, which buys Social Security credits at the cost of paying self-employment tax on the deemed figure; the statutory ceiling on the deemed amount is exactly the earnings needed for four credits, which is the annual maximum, and the nonfarm version is limited to five uses in a lifetime. And because the $400 floor is a cliff rather than a taper, a year under it earns no credits at all rather than fewer.

Finally, three obligations that this guide names and does not teach, because they are state and local law and genuinely unbounded: sales tax, including where selling into another state creates an obligation there; state franchise taxes and annual entity fees; and business, occupational and professional licensing. Each is decided where the business operates rather than federally, none of them is optional, and all three are worth asking about locally before the first sale rather than after.

When is an S election worth it, and what does it cost?

Once profit is well above what the owner's own work is worth, and only once that gap is expected to persist. The mechanism is narrow and the saving is real, but it is bounded on one side by a legal requirement and eaten on the other by costs that are easy to leave out of the comparison.

Start with what the election actually does, which is to change what the self-employment tax just described attaches to. A working owner of an S corporation is an employee of it, and their pay splits in two. The wage runs through payroll and carries Social Security and Medicare tax in the ordinary way. The remaining profit passes through to the owner's return and is taxed as income, but it is not self-employment income, for the simple reason that the statute defining self-employment earnings reaches a business carried on by an individual and a partner's share of a partnership and contains no S corporation limb at all. Income tax applies to the whole of it either way. The saving is confined to the payroll tax on the portion taken as a distribution.

The familiar version of that saving is "15.3 percent on everything you take as a distribution," and two features of the tax described above make the real figure smaller than that. The tax is charged on 92.35 percent of profit rather than all of it, and half of what it produces was already deductible, so part of what the election avoids was coming back at the owner's marginal rate anyway. The ceiling matters even more: once the Social Security half has stopped, the saving collapses to the Medicare component alone. So the election is worth most in a band of profit that is neither low nor very high, rather than rising steadily with income.

There is no safe percentage, and the IRS says so twice

The wage has to be reasonable compensation for the services actually performed, and the striking thing about that requirement is what does not accompany it. The Internal Revenue Code contains no percentage. The regulations contain none. The IRS's own fact sheet on the subject states that "there are no specific guidelines for reasonable compensation in the Code or the Regulations", and nothing in its current guidance on the subject supplies one. It will also not tell you in advance: "whether compensation is reasonable in amount" appears on the published annual list of subjects on which the IRS declines to issue a ruling. So the position is a mandatory standard, no definition of it, and a refusal to adjudicate it ahead of time. A split of 60 percent wages and 40 percent distributions, which is the version most people meet, appears in no statute, no regulation and no ruling.

What does exist is the framework an examiner applies, and it is more useful than a ratio because it explains the answer instead of asserting one. The question is where the company's money came from. The IRS separates three sources of gross receipts: the services of the shareholder, the services of other employees, and capital and equipment. To the extent the receipts were generated by other people and by assets, payments to the owner can properly be distributions. To the extent they were generated by the shareholder personally doing the work, they should be wages, and the owner is additionally treated as performing the administrative work behind those other employees and assets. Nine factors then inform the amount, including the owner's training and experience, their duties and the time devoted to them, what comparable businesses pay for similar work, what non-shareholder employees are paid, and the dividend history.

Read that framework carefully and it cuts against the instinct that a one-person service business can defend a low salary because it is small. A solo consultant generates essentially all of the receipts personally, so essentially all of the money is exposed to the wage characterization. A business whose profit comes from twelve employees and a warehouse is in a completely different position on identical numbers. One bright line runs in the taxpayer's favor: the IRS says reasonable compensation "will never exceed the amount received by the shareholder either directly or indirectly", so it cannot impute a salary out of money that never left the company.

Enforcement is worth being straight about, and the honest description of it is not a reassurance. Treasury's own inspector general, examining returns from 2016 to 2018, found in 2021 that the IRS was selecting under 1 percent of S corporations for field examination and that officer's compensation was examined at an average rate of about 0.1 percent, and identified 266,095 returns with a single shareholder, profit over $100,000 and no officer's compensation claimed at all. IRS management disagreed with three of the five recommendations that followed. A national compliance project on officer's compensation began in 2020, after the period those figures measure, so current coverage may look different. Those figures describe detection probability rather than legality, and a taxpayer who is not asked has not been permitted. Their real use is different: the feedback loop that would correct an indefensible number in this area barely operates, which is worth knowing when weighing any confident assertion about what is safe.

The costs, including three that are easy to miss

The visible costs are the filings: a corporate return with a schedule to each shareholder, quarterly employment tax returns, an annual federal unemployment return, a W-2, payroll processing, and in many states a separate state filing or fee. Those are private prices varying by an order of magnitude, so price your own rather than take a figure from anywhere. Two features of the federal regime bite regardless of profit: the late-filing penalty on the corporate return runs per shareholder per month, for up to twelve months, and applies even in a year when no tax is due, so a single forgotten return can cost more than a year's saving; and federal unemployment tax now applies to the owner's own wages, which a sole proprietor never pays.

Then three costs that comparison charts do not carry. The first is that a shareholder owning more than 2 percent of the stock, counting shares attributed from family members, loses the tax-free employee fringe benefits: health premiums are includible in wages rather than excluded, and such a shareholder cannot participate in a small-employer health reimbursement arrangement at all. The second is the exposure created by having a payroll where none existed, described in hiring someone: a sole proprietor with no employees withholds nothing and therefore has nothing to misapply, and an S corporation owner in a bad quarter has the government's money sitting in the account. The third is that the election is hard to unwind, since a corporation whose election terminates generally cannot elect again for five years without the IRS's consent. The election itself has to be made by the fifteenth day of the third month of the tax year to count for that year, which is March 15 for a calendar-year business.

The qualified business income deduction cuts across all of this, and because it behaves in the three bands described above, any salary rule of thumb stated without reference to taxable income will point the wrong way in at least one of them. Reasonable compensation is excluded from qualified business income by statute at every income level. So in the first band, below the threshold, every dollar moved from distribution to salary shrinks the deduction: the salary is a cost. In the second, above the threshold, the relationship inverts, because the limitation there is measured against the greater of 50 percent of the business's W-2 wages or 25 percent of those wages plus 2.5 percent of the cost of its qualified property. A profitable business with no property and no payroll has a wage limitation of zero, so the salary the owner was minimizing becomes the only thing that can lift the deduction. The same dollar is a cost below the threshold and a benefit above it.

The third band is where that inversion stops applying, and it reaches most of the businesses likely to be reading this. The statute names a list of service fields: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage, plus a catch-all for a business trading on the reputation or skill of its owners. For those, the deduction is phased out entirely above the income threshold rather than merely limited, so there is no qualified business income left for a wage limitation to be measured against. A consultant above the threshold gains no deduction at all by raising their salary: they pay the payroll tax and buy nothing. For that reader the inversion never arrives, and the wage should be set by what the work is worth and nothing else.

Two further consequences of a low wage are worth weighing because they are not tax costs at all. Social Security retirement benefits are computed from earnings on which the tax was paid, so wages set low reduce the record that eventually produces the benefit. And an owner-employee can end up paying federal unemployment tax on their own wages while being excluded by their state from ever collecting on them: some states exclude corporate officers from coverage or restrict their benefits, and because federal law contains no such exclusion, the Department of Labor states that in those states "the employers of corporate officers are liable for the full FUTA tax on wages paid to these individuals". Whether that describes your state is a question for your state.

How do I pay myself, and keep the two sides apart?

Not as a wage, and this is the structural point people most often have backwards. For a sole proprietor or a one-owner LLC that has made no election, money you take out of the business is not pay and is not a deductible expense; it is a draw, and the tax is computed on the business's profit whether or not you ever move the money. The mechanics of setting the amount belong to our cash flow guide, along with the separate-account discipline that makes the figure knowable at all and the method for turning irregular revenue into a steady draw. What follows here is what the draw is legally, and what that changes.

A draw appears nowhere on the tax return, has nothing withheld from it, and has no effect whatsoever on what you owe. What the tax is computed on is the profit, which is what the business earned after its genuine costs. The practical consequence is that the two decisions people tend to run together, how much to take out and how much tax to set aside, are answers to different questions: the second follows the profit and the first does not.

The exception is the S corporation, where the two halves genuinely are different animals. The wage is payroll, with withholding, a W-2 and employment tax. The distribution is not, and it is limited by the owner's basis in the company: a distribution above basis is treated as gain from a sale. That is also where informality becomes expensive. An owner who funds the company out of their own pocket and later takes the money back has to be able to show it was a loan rather than a capital contribution, and a court that finds no written agreement, no promissory note and repayment dependent purely on how the business does will treat it as capital. The label used on the return does not create the evidence.

The tax set-aside follows from all of that and should be treated as an obligation rather than as good practice. Because nothing is withheld, the money for two taxes on the profit has to be held back as revenue arrives, and it belongs somewhere other than the balance you look at when deciding what you can afford. Our cash flow guide owns the method for turning irregular revenue into a steady draw, including the design decision that determines whether the system holds, which is to set the draw from a bad month rather than from the average.

One more distinction is worth making explicit because it is easy to lose while looking at a bank balance. Revenue is what the business took in. Profit is what is left after its costs. Cash is what happens to be in the account on a given day, which depends on when customers paid and when bills fell due. All three can point in different directions at the same time, and it is entirely normal for a profitable business to be short of cash, which is why profitability and solvency are separate questions. Our cash flow guide is built around the second of them.

Business credit deserves a sentence here because it undoes something the entity was chosen for. A business credit card, a line of credit, a term loan or an equipment lease will usually be conditioned on a personal guarantee, and the LLC statutes expressly permit an owner to agree to be obligated personally. So the liability separation an entity created gets given back one facility at a time, and the honest way to think about a guarantee is as a personal debt that happens to be documented as a business one. That is not a reason to avoid borrowing. It is a reason to know which of your obligations the entity is actually standing behind, which is a question worth answering while the facilities are being signed rather than afterwards.

What happens to health coverage, disability and the rest?

You buy each piece separately or you go without, and there is no self-employed version of the benefits package to enroll in. This is the part of working for yourself that is most often discovered late, because none of it fails on a particular date. It simply is not there.

The reason is the structural one from the top of this guide: the exclusions that make employer benefits cheap are drafted to reach employees, so there is no pre-tax premium arrangement to join, no health flexible spending account, no dependent care account, and no employer-paid group life. What exists instead is a small number of provisions written specially for the self-employed, each doing part of the job under its own conditions.

Health coverage

Coverage generally comes from one of three places: the individual market through the health insurance Marketplace, a spouse's employer plan, or continuation coverage from the job you left, which is time-limited and which you pay for in full including the share the employer used to cover. Our insurance guide works through how plans differ and how to compare them.

What replaces the employer exclusion is the self-employed health insurance deduction, and four features of it decide whether it is worth anything. It comes off income directly rather than as an itemized medical expense, so it does not depend on itemizing or on clearing a percentage-of-income floor. It is capped at the earned income of the particular business the plan is established under, so a loss-making business supports no deduction, and profit from a second business cannot support premiums under a plan established under the first. It is unavailable for any calendar month in which you were eligible to participate in a subsidized health plan of any employer of yours, your spouse's, a dependent's, or a child of yours who was under 27 at year end; eligibility rather than enrollment is the test, so a spouse's plan you turned down still ends it, and a single day of eligibility ends the whole month. And it does not reduce self-employment tax, only income tax. The statute carves out exactly one year, 2010, in which it did reduce self-employment tax, which is why an older source may say otherwise.

Three further details are worth knowing because each is regularly missed. The child covered under this provision need not be your dependent, only under 27 at the end of the year. Medicare premiums you pay voluntarily to obtain insurance in your own name can be used to figure the deduction, which matters to anyone still working past 65. And long-term care premiums are tested separately from medical coverage, so a spouse's employer medical plan blocks the medical half of the deduction and leaves a separately purchased qualified long-term care contract available, subject to an age-banded annual limit on the premium that counts.

One piece of the employer benefits stack does carry over intact, and it is the only one. A health savings account belongs to the individual rather than to any employer, so a self-employed person whose coverage is a qualifying high-deductible plan can open and fund one on exactly the same terms as an employee, and deduct the contribution against income whether or not they itemize. Where an employee's version usually runs through payroll and escapes payroll tax as well, a self-employed contribution reduces income tax only, which is the same asymmetry that governs the premium deduction above.

Disability, life, and the two systems you are outside of

Disability coverage is the largest uninsured exposure most self-employed people have, because the income and the person are the same asset. Group long-term disability through an employer is how most people have ever had it, and there is no self-employed equivalent in the tax code: no deduction for the premium, and the policy is bought with after-tax dollars. The tax treatment then inverts in the buyer's favor, which is the useful half of that: because the premium was paid with after-tax money, benefits on an individually owned policy are received tax-free, where an employer-paid group benefit is taxable to the employee. Our insurance guide covers how much coverage and for how long, and the disability insurance entry covers the definitions in a policy that decide whether it pays.

The state programs that pay for short-term disability generally exclude the self-employed rather than charging them. The Social Security Administration's account of the state temporary disability programs, in a 2016 edition that predates the newer paid-leave programs, lists the self-employed among the principal excluded occupational groups and names California as permitting voluntary election, and California's election is worth understanding for what it does not buy: a self-employed person who is not an employer may elect into disability compensation only, not into unemployment, while one who becomes an employer can elect into both. Newer state paid family and medical leave programs are a different animal, and some of them do let the self-employed opt in. Washington's election lasts an initial minimum of three years, covers family and medical leave together with no choice between them, requires the person to pay 100 percent of the premium with no employer share, and starts its qualifying hours count from the date the notice is filed rather than from when the work began. Those four features generalize the whole theme better than any adjective: buying back what an employer supplied is slower, costlier and less flexible than having had it. Whether any of it is available where you live is a question for your state.

Life insurance follows the same pattern with no consolation. An employer can carry the first $50,000 of group term life without it being income to the employee, and there is no self-employed counterpart anywhere in the Code, so term life insurance, which covers a fixed number of years and pays only if you die inside them, is bought with after-tax dollars by someone nobody prompted.

Unemployment insurance does not reach you, and this is definitional rather than an oversight. Employment for these purposes means service performed by an employee for the person employing them, and the Department of Labor states the conclusion in one sentence: it therefore does not include self-employment. No federal unemployment tax is owed on your earnings, no wage credits arise from them, and no entitlement follows. Our government benefits guide describes that gap as structural rather than accidental, which is the right way to hold it: a larger cash reserve is the substitute, and there is not another one.

Workers' compensation is entirely state law, and the useful generalization is about the default rather than the rule. An owner working through a corporation is typically inside the system and has to opt out; an owner working as a sole proprietor or a partner is typically outside it and has to opt in. So the default flips on the entity choice rather than on what the person does all day. California illustrates the shape: an employee is someone in the service of an employer, which a sole proprietor is not, while officers and directors rendering actual service for pay are employees who may elect to be excluded, and a dedicated chapter sets out how an employer elects coverage. Two beliefs get in the way here, and neither survives contact with the statutes. There is no federal workers' compensation mandate on private employers, so the question is a state one from the start. And the states do not all require it either, nor is the single well-known exception the only one. Our insurance guide sets out which states depart from the pattern and what the coverage does; the point here is the owner's own position, which flips with the entity and is worth checking against your own state rather than a national summary.

What retirement plan should a business owner use?

Usually a solo 401(k) while there are no employees, and the reason is a piece of arithmetic rather than a preference. An owner wears two hats and can contribute in both capacities, as the employee making a salary deferral and as the employer making a contribution on top of it. At modest profit the deferral is the larger of the two by a wide margin, because it is a flat dollar amount rather than a percentage of anything, and it is the only route that gets a small business owner to a meaningful contribution at all.

That is also the whole of the difference against a SEP IRA, whose ceiling looks similar on paper. A SEP takes employer money only. The salary-reduction version was closed by statute for years beginning after 1996, so a SEP established today has no employee deferral at all and, because catch-up contributions are defined as extra employee deferrals, no catch-up either. A useful naming point follows from the structure: the plan is a SEP and the account underneath it is an ordinary traditional IRA, which is why SEP money is swept in with every other traditional IRA when a later conversion or distribution is taxed. Both SEP and SIMPLE plans have been able to accept Roth contributions since 2023, so anything written before then describes a system that no longer exists.

One piece of arithmetic in this area confuses almost everyone who meets it, and it has a clean explanation. The employer contribution is limited to 25 percent of compensation, but for an unincorporated owner the figure that actually applies is 20 percent of net earnings. That is not a different rule; it is the same rule applied to a base that is itself reduced by the contribution being computed. Solving for a contribution equal to 25 percent of what is left after it gives 25 divided by 125, which is 20 percent, and the IRS publishes the resulting rate table. A second and earlier reduction sits in front of it, because half the self-employment tax comes off before the rate is applied, so there are two haircuts in order rather than one. At low income a different limb binds first: the overall contribution ceiling is the lesser of a dollar amount or 100 percent of compensation, and for a small business it is often the percentage that decides the answer.

A SIMPLE IRA trades ceiling for administration and locks the employer into contributing. Every year the employer must ordinarily choose between a dollar-for-dollar match up to 3 percent of pay and a 2 percent contribution for everyone eligible whether they defer or not, and tell employees which before the election period opens; there is no year in which the contribution can be skipped. It is also an exclusive plan, so maintaining one forecloses a solo 401(k) or a SEP for the same year, and the ongoing administration is heavier than either alternative, with deferrals due within 30 days of the end of the month they relate to and a 60-day employee election window before the year begins. It is limited to employers with no more than 100 employees earning at least a modest amount. Two rules deserve emphasis because they are unique: a withdrawal in the first two years of participation carries a 25 percent additional tax rather than the usual 10 percent, and inside that two-year window the only destination a SIMPLE can be rolled to tax-free is another SIMPLE, so an attempted rollover anywhere else is a taxable distribution that also attracts the 25 percent and may become an excess contribution in the receiving account.

For an owner with high and stable profit and few or no employees, a cash balance plan or another defined benefit design can absorb multiples of what any of the above allows, because the contribution is driven by a promised benefit and an actuary's calculation rather than by a percentage of pay. The trade is an annual actuarial valuation, a funding obligation that is not discretionary, and a commitment measured in years, so it is worth investigating where the profit is both large and reliable and not before. A profit sharing plan lets the employer decide each year what to put in, including nothing, which is the flexibility that starts to matter once there are staff. Our retirement planning guide sets out where any of this belongs in the order of operations.

What breaks the day you hire someone

All three of the common plans break, differently, and this is the thing nobody plans for because the plan was chosen when the business had one person in it.

• A solo 401(k) stops being solo. It is worth being clear that this was never a separate kind of plan: the IRS states that a one-participant 401(k) is not a new type of 401(k) and has the same rules as any other, and everything distinctive about it follows from the absence of common-law employees. With none there is nothing to test, no top-heavy minimum to fund for anybody else, and a lighter annual filing. Hire one employee who meets the plan's eligibility terms and it becomes an ordinary small-business 401(k) that must pass top-heavy testing, which bites when most of the plan's money belongs to owners and key employees, and nondiscrimination testing each year or adopt a safe harbor design, which buys relief from the main annual tests in exchange for guaranteed contributions to staff. A genuinely employed and paid spouse is the exception and does not break it. Because the plan document's own eligibility terms decide how long the exemption lasts, they are worth reading before signing rather than after hiring.
• A SEP must cover everybody, at the same percentage. Eligibility is three conjunctive tests: the employee is at least 21, has performed service for the employer in at least three of the immediately preceding five years, and received at least a modest indexed amount of pay for the year. The middle one is about service rather than money, so a part-time or seasonal worker in their third year qualifies. Contributions then have to bear a uniform relationship to compensation, which means the owner cannot take 20 percent for themselves and give staff 3 percent. A SEP also cannot impose a last-day-of-year employment condition, so somebody who left mid-year still shares, and the money is the employee's immediately with no vesting schedule.
• A SIMPLE obliges you to contribute. The match or the 2 percent nonelective contribution is compulsory once there are eligible employees, in every year, which is the sharpest contrast with a SEP.

One small administrative consequence rides along with any of these plans and is easy to miss: having a qualified retirement plan is itself a trigger for obtaining an employer identification number, even for a sole proprietor with no employees who would otherwise use their Social Security number.

What changes when I hire someone?

A tax question becomes a compliance calendar, and it starts at employee number one rather than at some later size. Nothing about the first hire is optional or discretionary, and most of the obligations are deadlines rather than judgments.

The federal list, in the order it arrives. Before the first payroll: an employer identification number, and a Form I-9 on which the employer attests under penalty of perjury to having examined documents establishing that the person is authorized to work. Within 20 days of the hire: a report to the state new-hire directory. From the first payment: income tax withheld according to the IRS's tables, the employee's own share of Social Security and Medicare collected by deduction from wages, and the employer's own share paid on top, at 6.2 percent for Social Security up to an annual ceiling and 1.45 percent for Medicare with no ceiling at all. Federal unemployment tax is the employer's alone and is never withheld from the worker: the statutory rate is 6 percent of the first $7,000 of each employee's wages, and an employer that pays its state unemployment contributions on time earns a credit of up to 5.4 percentage points against it, capped at 90 percent of the tax, so the federal cost usually lands well under one percent of that $7,000. The credit is reduced for employers in states that owe the federal government money, so the effective rate is a state question rather than a national number. Then quarterly employment tax returns, an annual federal unemployment return, and a Form W-2 for each employee by January 31.

One detail there is worth stating because it is commonly reversed: the annual rather than quarterly employment tax return is not elective. The default is quarterly, and the annual version is available only on the IRS's written notice, which has to be requested during the first quarter of the year. And state obligations sit alongside all of the above, including state income tax withholding where it applies, state unemployment registration, and workers' compensation coverage, which is state law and which the insurance guide covers.

The other expensive version of hiring is not hiring at all, at least on paper. Paying somebody as a contractor who should have been an employee produces liability for the tax that should have been withheld and the employer share that should have been paid, and it can be raised by the worker as well as by an agency. The relief provision described in are you in business is the main defense, and its gates are worth revisiting before the fact rather than after: the information returns must actually have been filed, and the business must not have treated anybody in a substantially similar position as an employee. Consistency and paperwork are what preserve the argument, and both are decided long before anyone asks.

The employment statutes attach at different sizes, not all at once

Most of the major federal employment statutes have a headcount threshold, they are not the same number, and none of them is a headcount on a given day: most are measured over a run of weeks, and the health-coverage one as an average across the whole preceding year. Three of the thresholds below share an identical clock, which is 20 or more calendar weeks in the current or preceding calendar year. That is the structural point worth more than the numbers: you can cross a threshold because of last year's staffing and not realize it.

• 15 employees. The federal prohibitions on discrimination by race, color, religion, sex and national origin, and on disability discrimination, both reach an employer with 15 or more employees for each working day in each of 20 or more calendar weeks in the current or preceding year.
• 20 employees. The age discrimination statute, protecting workers 40 and over, uses the same weeks-based clock with a threshold of 20.
• 50 employees. Federal family and medical leave reaches an employer with 50 or more employees on the same clock. It then has a second test on the employee side, so a business can be a covered employer with no eligible employees at all: an eligible employee must have 12 months of employment and 1,250 hours of service in the previous 12 months, and the definition excludes an employee at a worksite where the employer has fewer than 50 employees if it has fewer than 50 within 75 miles of it.
• 50 full-time employees, counted unusually. The obligation to offer health coverage or pay a penalty reaches an employer that averaged at least 50 full-time employees in the preceding year, where full-time means an average of at least 30 hours of service a week. For the threshold count only, part-timers are added back by dividing their aggregate monthly hours by 120, so a business with 30 full-timers and 40 half-timers can be covered while believing it has 30 employees. There is a seasonal-worker exemption where the workforce exceeds 50 for 120 days or fewer in the year.
• No threshold at all. Federal minimum wage and overtime law is the odd one out. Enterprise coverage turns on annual gross volume of sales or business done of not less than $500,000, and individual coverage can reach a single employee engaged in commerce regardless of the employer's size. That $500,000 figure is statutory and has not moved since 1990, so it reaches steadily more businesses each year in real terms.

Two things belong alongside that list. The first hire also changes the retirement plan, as described in retirement plans, and that is the item most likely to be discovered a year late. And our employee benefits guide describes what the resulting package looks like from the employee's side, which is worth reading before designing one.

How do people get out of a business?

By sale, by transfer to family or a co-owner, by winding it down, or by dying while still running it. The last of those is the one most likely to happen without preparation, and for a great many owners the exit is simultaneously the largest financial event of their life and the least planned part of it.

The structural problem is that a private business is a concentrated, illiquid asset that is hard to value and is also the owner's income, so the household's outcome depends on one transaction, there is no price until somebody makes an offer, the number is negotiated rather than observed, and the owner cannot simply stop while deciding. Our estate planning guide makes the sharpest available version of the point, which is that the absence of a succession plan can destroy the value of the asset within weeks of an owner's death.

What can actually be sold depends on what the business is. A sole proprietorship has no entity to transfer, so a buyer acquires equipment, inventory, receivables, a customer list and perhaps a trade name individually, and contracts and leases in the owner's name generally have to be assigned or renegotiated one at a time. Where an entity does exist there are two quite different transactions available: a buyer can purchase the assets, or purchase the ownership interest itself. They are not variations on one deal. They differ in what the buyer takes on, including which liabilities follow the business, and they produce different tax results for each side, which is why the choice between them is among the most negotiated points in a small-business sale and one where each side's preference tends to be the opposite of the other's.

Payment over time is common and carries one trap that is on the face of the statute. Where at least one payment is received after the year of sale, the installment method applies by default; what is elective is electing out of it. Under that method each payment is split between recovered cost and gain in a fixed ratio, so tax follows the cash. The exception is depreciation recapture, which has to be recognized in full in the year of the sale as though every payment had been received then. A seller who has written off equipment heavily and takes a small deposit can therefore owe tax exceeding the cash actually collected that year. Inventory cannot ride the installment method at all.

Buy-sell agreements, and a 2024 decision that broke the commoner structure

A buy-sell agreement is the document that says what happens to an owner's share when they die, become disabled, or want out, and how it gets paid for. Where there is more than one owner it is the single most valuable document the business can have, because it converts the worst moment into a procedure. There are two ways to build it, and the Supreme Court itself described both in 2024. In an entity redemption the company is contractually required to buy the departing owner's shares, and the company owns and pays for the life insurance that funds it. In a cross-purchase the owners agree to buy each other's shares and each holds a policy on the other.

In a unanimous decision in 2024 the Court held that a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces the corporation's value for federal estate tax purposes. Two brothers had funded a redemption with company-owned life insurance; the estate valued the company excluding the insurance proceeds on the basis that the redemption obligation offset them, and the Court held that a hypothetical buyer would treat the proceeds as a net asset, because the valuation question is what the shares were worth before the company spent the money. The estate's own position, the Court noted, was internally inconsistent: a corporation that pays out to redeem shares should be worth less afterwards than before. The consequence for the commoner structure is direct: insurance bought by the company to fund a redemption inflates the value of the whole company, and therefore inflates the value of the deceased owner's share of it.

Three qualifications belong with that, and each keeps the point from being overstated. The Court expressly declined to hold that a redemption obligation can never reduce value, giving the example of an obligation that would force a company to liquidate operating assets. The effect only produces tax where the estate is large enough to be taxable at all, and our estate tax entry carries the current exclusion. And the Court also observed that a buy-sell agreement is ordinarily not decisive in valuing shares for estate tax, even though it may set out how a price is to be reached, which is not what most owners assume the agreement does. The alternative structure is not simply better either: the Court named its two costs, which are that each owner has to pay the premiums on a policy covering the other, creating the risk that one of them cannot, and that it has its own tax consequences. What the decision establishes is that the choice between the structures has a tax consequence most people did not know about, which is a reason to have the agreement reviewed rather than a prescription for how to fix it.

One tax provision is worth naming as the single genuine reason a small business might choose to be a C corporation, and it is a decision that can only be made at the beginning. Gain on the sale of qualified small business stock can be excluded from tax, on a scale that now reaches 50 percent of the gain at three years of holding, 75 percent at four and 100 percent at five for stock acquired after mid-2025. It has to be stock in a C corporation, issued to the original holder, and the corporation has to have been a C corporation for substantially all of the holding period, so it cannot be retrofitted and a later conversion does not qualify stock issued earlier. That makes it the one item in the whole entity discussion that is a genuine one-way door. Two limits matter before anyone gets excited: the exclusion has dollar ceilings and the corporation a size limit, both indexed and neither stated here, and the excluded-business list shuts out most professional practices, including health, law, accounting, consulting, financial services, farming, and hotels and restaurants. It is close to the same list that removes the qualified business income deduction from certain service businesses, which is not a coincidence: one statute borrows it from the other.

Common mistakes

• Treating an LLC as insurance. The statutes remove liability that attaches to you solely because you are an owner. They do not touch liability for your own acts, they yield to a personal guarantee, and they do not reach unpaid payroll taxes. An owner who forms an entity and skips the coverage has bought the narrower of the two protections and believes they bought the wider one.
• Assuming no 1099 means no tax. An information return tells the IRS what you were paid. It does not create the tax and its absence does not remove it, and the thresholds that decide whether a payer must send one have moved repeatedly and are unrelated to what you owe. Cash income is as taxable as an invoice.
• Setting aside for income tax only. Two taxes reach the same profit, and at modest income the one people forget is often the larger. A set-aside sized for income tax alone under-reserves by roughly 14 percent of the profit.
• Taking an S election for the payroll saving without pricing the rest of it. The saving is real above a level of profit and it is bounded by a legal requirement to pay a defensible wage. Against it sit a corporate return with a per-shareholder monthly penalty for lateness even at zero tax, payroll filings, federal unemployment tax on your own wages, state filings, a five-year bar on re-electing, the loss of tax-free fringe benefits, a lower Social Security record, a smaller qualified business income deduction below the threshold, and a personal exposure to unpaid withholding that did not previously exist.
• Driving the S corporation salary to zero. Beyond being the posture the case law treats worst, it caps the self-employed health insurance deduction at the same figure, because the deduction's ceiling is measured by the Medicare wages in Box 5 and the premiums are deliberately reported in Box 1 instead.
• Letting a first hire quietly break the retirement plan. A solo 401(k) stops being exempt from testing, a SEP requires the same percentage of pay for every eligible employee including part-timers in their third year, and a SIMPLE obliges a contribution every year. None of it announces itself, and the plan document's eligibility terms decide how much warning you get.
• Minimizing profit so aggressively that the Social Security record suffers. Credited earnings are what an eventual benefit is computed from, using the highest 35 years, so a thin year does not merely average down; it occupies a slot. Claim every legitimate expense, and know that the goal of a year is not the lowest possible reported profit.
• Using withheld payroll tax to make rent. It is the one bill that cannot be stretched, because the money was never the business's and the penalty is the whole of it, assessed against a person rather than the company.
• Waiting until the return is being prepared to open a retirement plan. An employer contribution and even the plan itself can often be put in place after the year has ended, and a SEP is available up to the extended filing deadline. But a sole proprietor's first-year salary deferral has to be made by the unextended deadline, in later years the election has to be in place before the money is earned, and a SIMPLE cannot be established after the year at all.
• Running the business and the household out of one account. It makes profitability unanswerable, makes the tax return more expensive to produce, undermines the separateness an entity was formed to create, and removes the only reliable basis for deciding what can safely be drawn.

When is professional help worth paying for?

Most of the work on this page is administrative and can be done by anybody willing to make a list and work through it. Five situations are different, and the test in each is the same: the cost of getting it wrong exceeds the cost of an hour of somebody's time, usually by a wide margin, and the mistake is difficult or impossible to unwind afterwards.

• The first year. Not because the arithmetic is hard, but because several decisions made in it are hard to change: the accounting method, the entity, whether an EIN and a separate account exist, and whether the records will support the deductions. Getting the structure right once is cheaper than correcting a pattern later.
• An entity or election change. The S election is the clearest case, because it depends on a defensible wage, on where the household sits relative to the qualified business income threshold, and on a five-year commitment, and because the number that makes it work is not a percentage anybody can look up. A change of classification can also be a taxable event rather than a filing.
• The first hire. This is the point at which misclassification, payroll deposits, the retirement plan and workers' compensation all arrive at once, and where the personal exposure for withheld tax begins. It is also the cheapest of the five to get right, because the whole of it is process.
• An exit, or the absence of a plan for one. A sale, a transfer to a co-owner or family, or a buy-sell agreement that has not been looked at since it was signed. Valuation, deal structure, the installment mechanics and the estate consequences interact, and none of them can be revisited after the transaction.
• Any year the business and the household have stopped being separable. If you cannot say what the business earned, what you drew, or which obligations are personal, that is not a bookkeeping problem. It is the point at which every other question on this page has become unanswerable.

It is worth knowing which profession does which part, because the boundaries are real. Forming an entity, drafting an operating agreement, a buy-sell agreement or a sale contract, and handling an employment dispute are an attorney's work. Preparing the returns, setting the accounting method and running payroll are a tax preparer's or an accountant's. A financial planner's role is the one that spans them: deciding what the structure is supposed to achieve, how the eight jobs at the top of this page get covered, and how the business fits into the household's own finances. Our advisor directory can be filtered to advisors who work with small business owners, and the guide to finding an advisor covers what to ask.

Key terms in small business and self-employment

Definitions for the terms this guide uses most, each linking to a fuller entry.

Browse all 24 small business and self-employment terms in the glossary.

Frequently asked questions