Freelancing is a great career option that lets you make your own choices. You get to be your own boss, work with clients you love on projects you’re passionate about, set your own hours, and work however and from wherever you want.
But there’s one thing about freelancing that you don’t have a choice about – taxes. As with any job, even freelancers have to give the government its due.
You probably figured out years ago that unless you want to end up publicly shamed on American Greed, you have to send your money to the Man. You’re not new to the tax system.
But freelance taxes? Eeeesh. When you’re working for yourself, no one is taking your taxes out of your paycheck each month, and you are responsible for this pesky little thing called self-employment tax (it is real).
Being in charge of your own taxes can be hard, and everyone’s situation is a little different. Are you an independent contractor? Did you pay other freelancers to help you out on projects? Did you pay them more than $600?
I asked tax attorney Andrew Zaikis – a former criminal tax prosecutor with the Massachusetts Attorney General’s Office and currently a senior tax counsel with the Massachusetts Department of Revenue– some of your most pressing questions about taxes for freelancers.
This guide will tell you everything you need to know to figure out:
- Your (mysterious) filing status
- The ins and outs of which tax form(s) you need to fill out
- How to estimate taxes so you don’t get stuck with an unmanageable bill
- What you can write off and deduct, like how to write off a Skillcrush class
- And much more
After reading this guide, you’ll know what to plan for and what to avoid, and you’ll have practical advice and tips where to get more help.
So, stop dreading your taxes and start getting them taken care of today. Your business, and your income, of course, depends on it, and this guide will make it easier and clearer for you to do what you have to keep working your freelancing magic.
Here’s what Andrew Zaikis has to say:
- Filing Status: Am I freelancer?
Freelancer is a term for a person who is self-employed and not necessarily committed to a particular employer or client for the long term. But “freelancer” really isn’t a term that is used in the tax code.
You’re better off referring to yourself as being self-employed or an independent contractor since these are more familiar terms in the business world and in the tax code. You don’t have to be one or the other, and sometimes you can be both.
A self-employed person works for him or herself and is not considered an employee for tax purposes.
But don’t panic if you’re working as a freelancer after hours and holding down a 9-to-5. If you open up a lemonade stand in your free time and sell drinks to the public by the side of the road, you are the classic example of a self-employed person.
An independent contractor is a self-employed person or business entity who provides goods or services under terms specified in a written contract or verbal agreement. Think of it as a self-employed person who works for another person or business entity.
Selling a cup of lemonade to a stranger won’t necessarily make you an independent contractor. Providing gallons of prepared lemonade to a caterer for a wedding under some sort of verbal or written agreement would make you an independent contractor.
So, if you run a WordPress blog and make money off of advertisements, you are self-employed. But, if you have a contract – or other arrangement, like a verbal agreement, to build someone else’s WordPress site, you’re an independent contractor. And, if backing up WordPress sites is just one of many tasks included in the job description at your full-time-salaried gig, you count as an employee.
But you definitely don’t want to file as a self-employed person or independent contractor if you’re not one. The IRS will expect you, or the corporation in the first example, to withhold income taxes and payroll taxes from their compensation and will penalize you if you don’t.
- How do I keep track of all of this?
As soon as you decide to start freelancing, you should start thinking about how to handle your taxes. For starters, it’s important to separate your business activities from your personal activities for tax reporting purposes. That means not buying pizza using your business debit card, unless, of course, the pizza is a business expense. More on that later…
Establishing that you are a self-employed person and that you have a business that qualifies for deducting expenses calls for creating and following basic accounting and financial practices. Set up a set of books or ledgers to track your income and your expenses. Consider using software like Quicken or QuickBooks to track your business receipts and disbursements, or in the meantime, set up a simple spreadsheet. A few accounting pointers to keep in mind:
- Do not put personal funds into your business account and do not put business receipts into your personal account.
- Get printed receipts for everything that you purchase or pay for on behalf of the business.
- If you pay cash for something, be sure to get a receipt for the purchase and retain these receipts for reporting purposes.
- Be sure to write memos on your business checks. Unless you characterize the nature of the payment by writing “payment for office supplies” or some such similar notation, the IRS will be able to dispute that this payment was for a business expense. A $100 check payment to John Smith from your business account might be a loan, might be a gift, or might be payment for a personal expense. More importantly, a year or two from now you might forget yourself what this payment was intended for.
Accounting might seem like a hassle, but good, accurate, and documented business records will provide a basis for correct tax returns and minimal tax problems for you.
- What’s an EIN number and do I need one?
You don’t need to register with the IRS to be considered an independent contractor or self-employed. You can just classify yourself and use your Social Security number. You should however, consider getting an Employer Identification Number (EIN) number to identify your business as a taxable entity.
An EIN number is a 9-digit number assigned by the IRS and used to identify a business entity. The EIN number will help you separate your business from your personal activities. You’ll use this EIN number in setting up your business checking account and in identifying your business on various tax forms and returns.
It’s easy to get an EIN number assigned to your prospective or ongoing business. They’re now issued online through irs.gov, and you can get one within a few minutes. Be wary of non irs.gov sites that advertise that they can get you an EIN number. These are private websites that will charge you a substantial fee for what is actually a free government service.
- What if I got paid in cash?
You should maintain a record of cash receipts and make a habit of requesting printed receipts for any cash payments. If the person or entity paying you cash doesn’t want to issue you a receipt or invoice, consider making your own receipt to reflect the payment and have the person you’re paying sign it.
Remember that chances are that a person giving you cash may have her own business records and be deducting their payments to you as legitimate business expenses. In situations where no record of a payment is being issued to you, there’s nothing to prevent the person paying you from inflating the amount they claim to pay you. Or, even if they keep good records by way of a cash journal of their payments to you, the IRS might contact you at some point to confirm that you properly reported the cash payment on your own tax returns.
In other words, failing to accurately report your business receipts is never a good business practice and can come back to bite you in the form of financial penalties and interest charged by the IRS.
- What’s a 1099? What happened to the W-2? What do I do with these?
Under the US tax code, workers are either consultants or independent contractors, who have income reported to them on a Form 1099, or they are employees, who have income reported to them on a Form W-2.
W-2 – for employees of a company
1099 – for independent contractors and self-employed folks
Most of us are familiar with getting a W-2 form from our employers and having deductions taken for withholding taxes, Social Security, and Medicare taxes. You might also be familiar with receiving a 1099 from your bank every year telling you how much interest you’ve paid on your checking or savings account that year.
When other business entities or employers pay you for services, they issue you a Form 1099 to report to you, and the IRS, the money that they’ve paid you in that taxable year. You usually get these forms in January or February, and the forms report income that was paid to you by those businesses or employers in the prior year.
Be sure to keep these forms since you’ll have to report these amounts on your tax return. Almost all of these forms will show that no income or payroll taxes were taken out of these payments to you and that will raise several tax issues and tax payment obligations that you’ll have to deal with. Exciting, isn’t it?
- Do I have to issue 1099’s to other people? When do I send them and to whom?
As either a self-employed person or an independent contractor, you’ll have to issue a 1099 form to any person, LLC, or partnership that you pay at least $600 in one calendar year. The only exception is that you do not have to issue a 1099 to any corporation that you paid. As Forrest Gump says, “One less thang.”
If you anticipate that you’ll be paying some person, independent contractor, or non-corporate business entity more than $600 in any year, you should have them fill out and return a Form W-9 to you. I know, I threw that W-9 in there as a surprise.
A W-9 asks the payee for their name, type of entity, address, and tax identification number, Social Security number for an individual and/or EIN number for a business entity. With the information on this form, you can fill out the 1099 form at the end of the tax year. Copies of the form are mailed to the recipient of your payments and to the IRS.
The forms are due to the IRS by Feb. 28 to report payments made in the previous calendar (taxable) year. You can get copies of all of these forms at irs.gov.
- I hired someone in another country to do some contract work for me – do I have to send her a 1099?
If you find yourself in a situation where you are making and sending payments to someone outside the United States, you should consult a tax professional for help in filling out the various specialized tax forms that apply in these situations. In other words, it gets tricky. You should be aware that, generally, the IRS requires you as the payer to withhold 30 percent of any payments like this.
- Income tax, payroll tax, and self-employment tax. What do I need to know?
When you get a W-2 form, it usually reports various deductions of payroll taxes that have been taken out of your gross total wages. Those deductions usually include amounts for federal income taxes, state income taxes, Social Security, and Medicare taxes.
By contrast, when you get a 1099 form, it usually doesn’t report any of these deductions. While you might be happier with the larger amount that you get with a 1099 Form, it also comes with a lot of tax headaches for you.
When you get any 1099 Form, alarm bells should go off in your head. The form is basically a notice that you, as opposed to the person who paid you, are now responsible for all associated taxes that are due in connection with you getting this payment. That personal responsibility includes the payment of federal income taxes, state income taxes, Social Security, and Medicare taxes. All of these tax obligations on your part need to be anticipated and planned for through the preceding taxable year and fulfilled by you paying estimated taxes to the IRS and state taxing authorities.
Self-employment tax is a tax consisting of Social Security and Medicare taxes mainly for individuals who work for themselves. It’s similar to the Social Security and Medicare taxes that are withheld from the payroll checks of most employees. If you’re in business for yourself and earn more than $400 a year, you must pay self-employment taxes on your income.
Self-employment tax is 15.3 percent, 12.4 percent for Social Security and 2.9 percent for Medicare taxes, of the first $118,500 of your self-employed income. If you’re making more than that, get yourself some professional tax help.
Self-employment taxes are reported on a Schedule SE and attached to your Schedule C. You might notice that these amounts are twice the amounts that are routinely taken out of your W-2 wages. That’s because the IRS requires employers to match the amounts withheld from their employees for these payroll taxes. Since there’s no employer, only the people paying you for your goods or services, when it comes to 1099 Form income, you’re on the hook for both parts of this payment. That’s why the rates are twice what you might be used to.
Now might be a good time to think about raising your rates, right?!
- Okay, so what’s the deal with estimated taxes?
Remember the reality of being a freelancer is that no taxes, federal or state, are being taken out of your business income and that, at some point, you’ll have to pay taxes for this income.
If you owe more than $1,000 in additional taxes, or less, for state taxing authorities in any given year, the IRS requires you to pay estimated taxes on this liability. Estimated payments are partial payments of your final year-end tax liability that you pay during the course of the taxable year.
For example, if you’ll owe $4,000 in additional taxes for your business income, the IRS requires you to make four $1,000 payments during the course of the calendar year. The payments are required be paid on or before four specific dates – April 15, June 15, Sept. 15, and Jan. 15 – using specific IRS payment forms.
If you don’t arrange to make these payments throughout the year and you end up with an unpaid liability at the end of the year, the IRS will impose late payment penalties on top of the taxes that you owe.
To properly figure out your estimated tax payments, you need to keep accurate and current business records that will give you an ongoing calculation of the amount of profit that your business is making. Knowing the amount of profit that you’re making in any given quarter will let you determine how much to send to the IRS as an estimated payment.
Or, you can skip this ongoing calculation hassle by making sure that you pay the IRS withholding and estimated payments in an amount up to 100 percent of the amount of your last year’s tax liability. For example, if your tax liability last year (2013) was $4,500, make sure that you pay the IRS at least this same amount ($4,500) in either withholding or estimated taxes for this calendar year (2014).
With this payment, the IRS will forgive you and not impose any late payment penalties if your final tax liability for this year (2014) amounts to more than $4,500.
- Okay so there were 1099s, W-2s, and surprise W-9s. Where do I actually report my business income?
You’re probably familiar with the basic personal income tax form (Form 1040 or Form 1040A) which you used to report W-2 wage income from your previous employers and take your personal exemptions.
As a self-employed independent contractor, you must report all income on your personal income tax return (Form 1040). The business itself is not taxed separately unlike corporations, which have to report income on a corporate tax return.
The profits or losses of your business are listed on a Schedule C, which is attached to your personal Form 1040 income tax return. The Schedule C form has lines for you to report the gross receipts of your business and the various standard business deductions that are allowed under the IRS code.
- Talk to me about tax deductions.
As a self-employed independent contractor, you can deduct your business expenses like any other business. That’s good news.
Operating expenses, product advertising, travel, computers, supplies, utilities, and internet and phone charges are just some of the many business expenses that you can deduct against your business income.
And don’t panic if your deductions outweigh your profits. You don’t have to make a profit every year. It’s often the case that a new business operates at a loss for the first year or two. What’s required by the IRS is that you have the intent to eventually make a profit from this business.
If you’re starting your business on the side and still have a full-time job, any losses from your business can offset your W-2 wage income from your employer. So, this can help lower your overall tax burden.
- So, can I deduct the cost of this awesome laptop I bought to build websites for clients? If I can, how?
When you’re a freelancer, you have lots of different types of costs. Some of these costs are for expenses that are immediate or that are used in the course of the taxable year, like utility bills, office supplies, phone charges, and some of these costs are for items that will be used over several years, like a computer, laser printer, or desk.
For these latter items, the IRS usually requires you to depreciate them over their useful lifetimes. If an item is determined to have a useful lifetime of 3 years and costs $3,000, the IRS will allow you to expense, or deduct, 1/3 of the cost of the item for each of the three years after you purchase it and start using it.
An exception to this rule is a widely-known business tax break called the Section 179 Deduction. This allows a business owner to immediately deduct the full amount of depreciable items in any tax year up to a certain dollar amount. While the 179 rules have recently been changed, they still allow you to deduct up to $25,000 in depreciable business expenses in the 2014 taxable year.
That means, for example, that if you were to purchase $15,000 in computer, printer, and network equipment in 2014, you could deduct the full $15,000 on your 2014 tax return as an expense rather than deducting only portions of this amount over the next few years.
And about your original question – As long as your new computer was used exclusively for business purposes, you could deduct the full cost of it on your tax return. To do so, you have to report the specifics of the deduction on Part 1 of Form 4562 and attach it to your Schedule C.
- Can I deduct educational expenses for taking courses that directly support my business? In other words, can I write off Skillcrush as a tax expense?
Yes, as a self-employed independent contractor, there are some instances where you may be able to deduct the costs of work-related education or training, such as a Skillcrush Blueprint, as a business expense on your Schedule C Form.
To be deductible, your education must maintain or improve your job skills. If your past work involved some aspects of working with websites or design, or even if any of your past work required you to learn to code to improve your overall skills, you might be able to deduct these educational costs. So, if your Skillcrush courses help you improve and maintain your digital skills for work, then you may be able to go ahead and deduct it.
However, educational costs cannot be deducted if they are part of a program that will qualify you for a new trade or business. Think about it this way – if you could deduct educational expenses that prepared you for an entirely new area of work, you would be able to deduct college expenses, and that’s not legal or possible. So, if you are using the skills from Skillcrush only for you to start an entirely new venture that you have absolutely no experience in, then it’s not deductible.
But, if you had a little bit of technology skills or previous work experience in technology or design to start, you fall somewhere in between, and so, it depends. The distinction is far from clear, and whether or not such costs can be deducted depends upon the specific facts of your situation.
As always, if in doubt, consult a tax professional.
- At what point should I throw in the towel and hire an accountant to help me sort this out?
As this overview has shown, complying with your tax obligations can be complex and confusing. There are business records to be set up and maintained, forms to be filed throughout the year, payments to be made at different times, and numerous forms to be filled out and attached to my personal income tax form. Unless you want to expand your knowledge base to include tax preparation and planning, you should consider using the services of an accountant as your business begins to grow.
Fortunately, accounting costs shouldn’t be astronomical, and they tend to be proportional to your business income. As your business expands and grows, so will your accounting bill. You can keep your costs down by keeping and maintaining your own business records and giving them to your accountant to work with. If instead you have your accountant prepare and maintain your books and records, your accounting bill will be substantially higher.
Good accountants are worth their fees and can often advise you about additional deductions you can take and whether or not you qualify for various small business credits and deductions that aren’t addressed in this article.
After all, your job is to make yourself more money while your accountant’s job is to make sure you don’t get into any tax difficulties along the way. Just be sure to talk to other small business owners, get some recommendations, and interview the accountant before you decide to employ her.
Note: This article is not intended to be legal or professional tax advice. It is meant to give you general guidance in how to comply with general tax code requirements and to familiarize you with some of the forms and principles involved in running your own business.
Image credit: CC by Simon Cunningham