Taxes can often be confusing, especially if you don’t have taxes automatically taken out from a paycheck through an employer. Freelancers are forced to fully understand their finances and keep detailed records of income and expenses. If you’re just starting out, the following information isn’t meant to scare you. But rather, provide you the necessary information for when you need it.
Track your freelance finances
The first rule of managing your taxes as a freelancer is to get organized. Meticulous records of your income and expenses plus deep knowledge of your business finances can make a big difference on your tax bill.
Using a cloud-based accounting solution designed with freelancers in mind can be helpful and allows you to track all of your income and expenses throughout the year so you don’t have to go scrambling for the numbers you need during tax season.
Depending on the type of business entity you have (see point 3 below), you will file your business taxes on either your personal return if you are a sole proprietor or operate as a single member LLC (using schedule C) or on a separate form if you have a Partnership, C-corporation or S-corporation.
Make sure you note and keep receipts for all of your deductible business expenses, because claiming them will help to reduce your taxable income. Eligible tax deductions related to your business may include:
- Advertising expenses like business cards, online ads, website subscriptions and other tools used to promote yourself and your business
- Business insurance
- Interest paid on your business credit card or business loans
- Lawyer fees and other professional services
- Rent or dues on a workspace – if you work from home, be sure to keep up-to-date pictures or a floor plan of your home office space
- Repairs for your computer, camera and other business-related equipment
- Routine office supplies like pens, paper, staples, etc.
- Travel costs like plane and train tickets related to business purposes
- Business meals with clients and other entertainment reasonable for your business
Remember, you need to be able to provide documentation that the expenses are legitimate should you ever be audited by the IRS. Keeping receipts for your business expenses for at least six years is a good rule of thumb.
Pay your quarterly estimated taxes
This is really important. If you make more than $400 freelancing in a year, you have to claim this income and pay the appropriate taxes on it. Unlike when you work full-time for someone else, your taxes are not automatically withheld from the checks you receive from freelance clients. As a freelancer, you are responsible for paying estimated taxes on a quarterly basis throughout the year.
The amount of estimated tax you owe depends on your level of income and if you’re factoring in state and local taxes as well. You also need to know what taxes you may be responsible for in the city where you are conducting business. This information can usually be found on the website of the city where your freelance business is based. If you do work for clients in other states, you need to know if you will owe taxes, in these locations, too.
Keeping track of your previous year’s tax rate (if your income is similar this year) will give you an idea of how much to set aside or you can check with a tax professional. Generally, consider 33% of your taxable income a good starting point.
In addition to income tax, you are responsible for paying the full freight when it comes to Social Security and Medicare taxes (when you are a W-2 employee, your employer pays half of the 15.3% of taxable income you owe—as a freelancer you are responsible for all of it).
The schedule for estimated taxes in 2017 is:
- For income received Jan. 1 through March 31, estimated tax is due April 18.
- For income received April 1 through May 31, estimated tax is due June 15.
- For income received June 1 through Aug. 31, estimated tax is due Sept. 15.
- And for income received Sept. 1 through Dec. 31, estimated tax is due Jan. 17.
Do not assume that you will be able to pay all your taxes at the end of the year in one lump sum – failing to pay your quarterly earnings will result in fines and penalties. Furthermore, if you miss a quarterly tax deadline, file as soon as possible and speak with an IRS representative about appealing the penalty. Do not wait until the next period to pay. It is often helpful to save money for your tax payments in a separate account.
Select the Right Business Structure for Tax Purposes
One of the first and the most important decisions that a self-employed individual must make is through what type of entity their business will operate. Some business structures are more advantageous than others when it comes to taxes. Here is a summary of the main business structures:
A sole proprietorship is the simplest form of entity in terms of set-up and tax payments. As a sole proprietor you are responsible for claiming the profit and loss of the business as your income. You also must pay self-employment taxes. The drawback of a sole proprietorship is that the individual is personally liable for any damages or credit issues that arise from their business operations.
A corporation is an entity which is separate from its owner. The corporation is formed under the laws of the state in which it is operating, with Articles of Incorporation. Choosing to establish a business as a corporation limits the liability of the individuals participating in it and, from a branding perspective, it may also provide additional credibility to the business.
A subchapter-s corporation (or s-corp) is a corporation and the owners are considered employees. The entity is required to pay these employees a reasonable salary. Profit or losses of the entity flow through to the individual shareholders. Any salary paid is subject to traditional employer and employee payroll taxes. The remaining profit flows through to individual shareholders and, while subject to income tax, is not subject to payroll taxes and is considered passive income. In order to maximize the tax benefit of an s-corp, owners must find the balance between wages and profit distribution.
A limited liability company (LLC) is not a corporation, but it has the liability protection of a corporation. Single-member LLC entities pay tax like a sole proprietorship. Multiple-member LLCs can also be formed which pay taxes like a partnership.
Making sure that your business entity is set up correctly is key. It can be confusing for first-time freelancers, so be sure to contact a CPA or other tax professional if you have questions.
We thank Jonathan Medows, a New York City based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country for this post. He offers a free monthly email newsletter covering tax, accounting and business issues to freelancers on his website, www.cpaforfreelancers.com which also features a blog, how-to articles, and a comprehensive freelance tax guide.