When you become a freelancer, your tax situation changes dramatically. As a regular employee, you probably didn’t need to worry much about taxes. Your employer withheld taxes from your paychecks, paid the money to the IRS and state tax department, and you filed tax returns each year to reclaim some of your money or add more to the government coffers.
As a freelancer, you have no employer to pay your taxes for you; you must pay them directly to the IRS and your state. This requires paying taxes not once but four times a year, something you may have never done before. And it will
be up to you to calculate how much you owe. (An accountant or tax preparation software can do this for you.) To make
these filings, you’ll also need to keep accurate records of your business income and expenses. And the tax return you must file at the end of each tax year will likely be more complicated than the ones you filed when you were an employee.
Federal and state taxes
You must pay both federal and state taxes, but the federal government takes the biggest bite. Federal taxes include:
- income tax
- self-employment tax, and
- employment tax.
Everyone who earns more than a minimum amount must pay income tax. Unless you’ve formed a regular C corporation, you’ll have to pay personal income tax on the profits your business earns. If you’re one of the few freelancers who have formed a C corporation, you’ll be an employee of your corporation and you’ll pay income tax on the salary you earn. The corporation will file its own separate tax return.
Self-employed people are entitled to Social Security and Medicare benefits when they retire, just like employees. And just like employees, they have to pay Social Security and Medicare taxes to help fund these programs. These taxes are called self-employment (SE) taxes. Anyone who has net yearly earnings from self-employment of $400 or more must pay SE taxes.
Life would be too simple if you only were required to pay federal taxes. But, states get into the act as well, and depending on which state you live in, the income tax rate can range from 3% to 11%.
For more information on taxes for freelancers, visit the IRS website at www.irs.gov. There you can download all IRS publications including Publication 334, Tax Guide for Small Business. For a link to your state tax agency, go to www.taxsites.com/state.html.
State sales tax
Almost all states and many municipalities impose sales tax of some kind. The only states without sales tax are Alaska, Delaware, Montana, New Hampshire, and Oregon. All states that have sales tax impose it on sales of goods or products to so-called “end users”—people who purchase their products. If you provide only services to clients or customers, you probably don’t have to worry about sales taxes. Most states don’t tax services at all or tax only certain specified services. Notable exceptions are Hawaii, New Mexico, and South Dakota—they all impose sales tax on all services, subject to certain exceptions.
If the products or services you provide are subject to sales tax, you’ll have to get a state sales tax number. To find out how to apply for a number, contact your local tax office or chamber of commerce or check your state’s official website. Many states impose penalties if you make a sale before you obtain a sales tax number. Generally, you pay sales taxes
four times a year, but you might have to pay monthly if you make a lot of sales.
When You Become the Employer
If you hire employees, you’ll have to keep lots of records and file quarterly and annual employment tax returns with the IRS. You’ll have to pay federal employment taxes, which consist of half your employees’ Social Security and Medicare taxes and an additional tax called the federal unemployment tax (“FUTA”). You must also withhold
half your employees’ Social Security and Medicare taxes and all their income taxes from their paychecks. These taxes you must pay monthly, by making federal tax deposits at specified banks. You may also deposit them directly with the IRS electronically.
If you live in a state that imposes income tax, you’ll likely have to withhold state income taxes from your employees’ paychecks and pay the money over to your state tax department. You’ll also have to provide your employees with unemployment compensation insurance by paying state unemployment taxes to your state unemployment compensation agency.
For more information on your tax duties as an employer, see The Employer’s Legal Handbook, by Fred Steingold (Nolo).
Reporting your income to the IRS
When you’re self employed, no income tax is withheld from your compensation, and you don’t receive a W-2 form. However, this doesn’t mean that the IRS doesn’t have at least some idea of how much money you’ve made. For one thing, if a client or customer pays you $600 or more over the course of a year, the client must report the payments by
completing and filing IRS Form 1099-MISC with:
- the IRS
- your state tax office (if your state has income tax), and
To make sure you’re not underreporting your income, IRS computers check the amounts listed on all the 1099 forms it receives from your clients or customers against the amount of income you report on your tax return. If the amounts don’t match, you have a good chance of being flagged for an audit.
Your clients need not file any 1099 form if you’ve incorporated your business and the client hires your corporation, not you personally. This is one reason clients often prefer to hire incorporated businesses—and not just because it saves them filling out a form. The IRS uses Form 1099 as an important audit lead. If a company files more 1099 forms
than average for its type of business, the IRS is likely to conclude that it must be misclassifying employees as independent contractors and conduct an audit.
Only businesses, as opposed to regular people, need to file a Form 1099 for payments they make to you. For example, if you help fix your neighbor’s computer or are someone’s regular massage therapist, they don’t need to worry about filing these forms, even if they do pay you more than $600 in a year. Nor are your clients or customers required to report payments to you solely for merchandise or inventory.
You don’t have to file the 1099s you receive with your tax returns. Just keep them in your records.
Make sure your 1099s are correct. You should receive all your 1099 forms for the year by January 31 of the next year. Check the amounts your clients say they paid you against your own records. If you find a mistake, call the client immediately and request that a corrected Form 1099 be sent to both you and the IRS. You don’t want the IRS to think you’ve been paid more than you really were.
Tax deductions for freelancers
If you’re like the vast majority of freelancers, you’ll have to pay personal federal income tax on the net profit you earn from your business activities. This is true whether you operate your business as a sole proprietorship, S corporation, partnership, or limited liability company. The only exception is if you’ve formed a C corporation, something few home-based freelancers do.
For information on how to choose the best legal form for your business, see Working for Yourself; Law & Taxes for Independent Contractors, Freelancers & Consultants, by Stephen Fishman (Nolo).
The key phrase here is “net profit.” You’re entitled to subtract all of your business-related expenses from your gross income—that is, from all the money or valuable items you receive from your clients or customers. You pay income tax on the resulting net profit, not your gross self-employment income. So, for example, if you earned $50,000 this year from your consulting business and had $15,000 in business expenses, you would pay taxes on your net profit of $35,000—not your gross income of $50,000.
- ordinary and necessary
- directly related to your business, and
- for a reasonable amount.
Ordinary and necessary. An expense qualifies as ordinary and necessary if it is common, accepted, helpful, and appropriate for your business or profession. An expense doesn’t have to be indispensable to be necessary; it need only help your business in some way, even in a minor way. It’s usually fairly easy to tell whether an expense passes this test.
Let’s say, for example, that you’re a freelance writer and hire a research assistant at $15 an hour. This is clearly a deductible business expense. If, however, you also pay a masseuse every week to work on your bad back, this is not an ordinary or customary expense for a writer. The IRS would not likely allow it, no matter how much you say it helps you concentrate on your writing.
Related to your business. An expense must be related to your business to be deductible. That is, you must use the item for your business in some way. If you buy something for both personal and business reasons, you may deduct the business portion of the expense. For example, if you buy a home computer and use it half the time for business and
half the time to play games, you can deduct half the cost as a business expense. The cost of a single phone line (whether a land line or cell phone) is not deductible because the IRS figures you’d have to pay for it anyway. You can, however, deduct charges for business long-distance phone calls on that line. You can also deduct the entire cost of a second phone line (a cell phone or land line) that’s used exclusively for business.
Mixing business and personal use can become a bother. The IRS requires you to keep records showing when the item was used for business and when for personal reasons. You might, for example, need to keep a diary or log showing the dates, times, and reason the item was used. For low-cost items, it might be easier to just buy two, one for business use and one for personal use.
Deductions must be reasonable. In theory, you can deduct as much as you want—with no limit—so long as you’re not inflating the amounts you actually spent and the amounts were reasonable under the circumstances. Certain areas, however, such as entertainment, travel, and meal expenses, are hot buttons for the IRS. The IRS imposes restrictions on these deductions. For example, you can deduct only 50% of your business entertainment or meal expenses.
Also, if the amount of your deductions is very large relative to your income, your chance of being audited goes up dramatically. One recent analysis of almost 1,300 tax returns found that people whose business deductions exceeded 63% of their revenues were at high risk for an audit. You’re relatively safe so long as your deductions are less than half
of your revenue. Just make sure you can document your deductions in case you’re ever audited.
Inventory: Not a Business Expense
Many freelancers sell personal services, not goods, to their clients or customers. However, if you also regularly charge clients for materials and supplies—for example, you’re a consultant who also sells clients a book you’ve written—you must maintain an inventory for tax purposes. You can’t deduct inventory costs in the same way as other costs of doing business. You have to wait until individual goods are actually sold during a tax year to deduct their cost. For more information on this rather complex tax topic, see Deduct It!, by Stephen Fishman (Nolo), IRS Publication 334, Tax Guide for Small Business, and IRS Publication 538, Accounting Periods and Methods.
Claiming your deductions
Some expenses can be deducted all at once; others must be deducted over a number of years. It all depends on how long the item you purchase can reasonably be expected to last. This is what the IRS calls its useful life.
The cost of anything you buy for your home business that has a useful life of less than one year may be fully deducted in the year you buy it. This includes, for example, business telephone bills, photocopying costs, postage, and other ordinary business operating costs. Such items are called current expenses.
Certain types of costs, called capital expenses, are considered part of your investment in your business rather than operating costs. Subject to the important Section 179 exception (discussed below), you must deduct the cost of these expenses over several years.
The two main kinds of capital expenses are:
- the cost of any asset you will use in your business that has a useful life of more than one year—for example, equipment, vehicles, books, furniture, machinery, and patents, and
- business start-up costs, such as fees for doing market research or attorney and accounting fees paid to set up your business.
However, many capital expenses can be deducted in a single year under Section 179 of the Internal Revenue Code. You can use Section 179 to deduct the cost of anything you use for your business if it’s tangible personal property of a type that the IRS has determined will last more than one year—for example, computers, business equipment, and office furniture. For example, if you bought a $5,000 computer for your business, you could use Section 179 to deduct the entire $5,000 from your income taxes for the year. You can’t use Section 179 for land, buildings, or for intangible personal property such as patents, copyrights, and trademarks.
If you use property for both business and personal purposes, you may deduct the cost under Section 179 only if you use it for business purposes more than half the time. The amount of your deduction is reduced by the percentage of personal use. You’ll need to keep usage records.
Businesses that lose money or look like hobbies
If the money you spend on your home business exceeds your business income for the year, your business incurs a loss. This isn’t as bad as it sounds, because you can use the loss to offset other income you may have—for example, interest income, or your spouse’s income if you file jointly. You can even accumulate your losses and apply them to reduce your income tax in future or past years (by claiming a refund).
However, if you keep incurring losses year after year, be very careful not to run afoul of the hobby loss rule. This tax law could cost you a fortune in additional income taxes. The IRS created the hobby loss rule to prevent taxpayers from, say, making a half-baked effort to be a freelance ski instructor in order to rack up deductible expenses while enjoying their favorite activities. If the IRS views what you do as a hobby rather than an actual business, there will be severe limits on what expenses you can deduct.
What do you have to do to show that your venture is a business? As in acting school, your motivation is key: You must be engaged in this activity to make a profit. (A profit, remember, means that the gross income from your activity exceeds the deductions you take for it.) It’s not necessary that you actually earn a profit every year. (Lots of ultimately
successful businesses lose money in their early years.) All that is required is that your main reason for doing what you do is to earn money.
You don’t have to worry about the IRS labeling your business as a hobby if you earn a profit from it—even if that happens just three times in any five consecutive years.
Careful year-end planning can help your business show a profit for the year. If you’re concerned about a loss for tax purposes, take steps before time runs out. For example, if clients owe you money, press for payment before the end of the year. Also, put off paying expenses or buying new equipment until the new year. Such steps will help you show a small profit and avoid audits and hobby-loss arguments.
If you keep incurring losses and can’t satisfy the profit test, you by no means have to throw in the towel and treat your venture as a hobby. You can continue to treat it as a business and fully deduct your losses. However, to prepare for a possible audit, you will need to be able to convince the IRS that earning a profit—not having fun or accumulating tax deductions—is your primary motive. The IRS looks at certain objective factors in making this determination, such as whether you act like you’re running a business, your expertise, and the time and effort you put into it.
Claiming the home office deduction
A potentially valuable deduction for home-based freelancers, particularly those who rent, is the home office deduction. Don’t be fooled by the name; this deduction isn’t limited to home offices. You can also take it, for example, if you have a workshop or studio at home.
Home office deduction an audit flag? Many self-employed freelancers are afraid to take this deduction because they think it increases their chances of an audit. The IRS says this isn’t so. In any case, you have little to fear from an audit if you’re entitled to the deduction.
Qualifying for the home office deduction. To qualify, you must use a portion of your home regularly and exclusively for your home business. Unfortunately, the IRS doesn’t offer a satisfactory definition of regular use. The agency has decreed only that you must use a portion of your home for business on a continuing basis—not just for occasional or incidental business. You’ll satisfy this test if you use your home office a few hours each day.
Exclusive use means that you use a portion of your home only for business. If you use part of your home as your business office and also use that part for personal purposes, you cannot meet the exclusive use test and cannot take the home office deduction. For example, if you sit at your office desk both for work and to shop online, pay personal
bills, and write personal emails, forget the deduction. Or if you use your den only for business, but also have a fold-out couch where guests occasionally stay, you’ve just lost your deduction because the room isn’t used exclusively for business.
You needn’t devote an entire separate room in your home to your business. But some part of the room must be used exclusively for business. If, for example, you use part of your living room as an office, separate it from the rest of the room with room dividers or bookcases. The more space you use exclusively for business, the more your home office deduction will be worth.
Satisfying the requirement of using your home office regularly and exclusively for business is only half the battle. You must also meet one of these three requirements:
- your home office must be your principal place of business
- you must meet clients or customers at home, or
- you must use a separate structure on your property exclusively for business purposes.
In most cases, your home office will be your principal place of business, so this requirement will pose no problem.
How much you can deduct. The amount of your deduction depends on the percentage of your home you use for business. To calculate it, divide the square footage of your home office by the total square footage of your home. For example, if your home is 1,600 square feet and you use 400 square feet for your home office, 25% of the total area is used for business.
Alternatively, if all the rooms in your home are about the same size, figure the business portion by dividing the number of rooms used for business by the number of rooms in the home. For example, if you use one room in a five-room house for business, 20% of the area is used for business.
If you’re renting your space, the home office deduction can be quite valuable. You get to deduct part of your rent—a substantial expense that is ordinarily not deductible. You can also deduct the expenses described under “Indirect Expenses to Include in Your Home Office Deduction,” below.
If you own your home, you’re allowed to deduct your depreciation, mortgage interest, and property taxes. This isn’t such exciting news, however, given that you were already allowed to deduct your mortgage interest and property taxes. But homeowners may, in addition, deduct the various direct and indirect expenses described below.
You may also deduct the entire cost of what you spend just for your home office. The IRS calls these direct expenses. They include, for example, painting your home office or paying someone to clean it, or buying a lamp and a rug for the office.
There is an important limitation on the home office deduction: It may not exceed the net profit you earn from your home office.
Indirect Expenses to Include in Your Home Office Deduction
Both owners and renters may deduct a percentage of their expenses for keeping up and running an entire home. The IRS calls these indirect expenses. They include:
- utility expenses for electricity, gas, heating oil, and trash removal
- homeowners’ or renter’s insurance
- home maintenance expenses that benefit your entire home including your home office, such as cleaning, roof and furnace repairs, and exterior painting
- condominium association fees
- snow removal expenses
- casualty losses if your home is damaged—for example, in a storm, and
- security system costs.
Keep good home office records. Be sure to keep copies of all your bills and receipts, such as your:
- IRS Form 1098 sent by whoever holds your mortgage, showing the interest you paid for the year
- property tax bills
- utility bills, insurance bills, and receipts for payments for repairs to your office area, and
- a copy of your lease and your canceled rent checks, if you’re a renter.
Special concerns for homeowners who take the home office deduction. Ordinarily, profit you make when you sell your home—up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly—is not subject to capital gains tax. However, if you take the home office deduction, this rule doesn’t apply to the portion of your house that you use for business. Instead, your house is treated as two separate properties for tax purposes.
You’ll have to pay 20% capital gains tax on the profit you earn from the portion of your house used as a home office. For example, if 20% of your house was used as a home office, you’d have to pay tax on 20% of your home-sale profit. If your home has gone up in value dramatically since you bought it, you’ll have a huge tax bill.
You’ll also have to pay tax on any depreciation you took on your home office.
To avoid this tax trap, you must use your entire home as your principal residence for at least two of the five years preceding the year of sale. So if you plan on moving, it’s best not to use a home office (or at least, not to take the deduction) for least two years before the date of sale. And if you think you might need to move on short notice, your
safest tax strategy is to not take the home office deduction.
Filing your estimated and annual taxes
By April 15 of each year, you’ll have to file an annual income tax return with the IRS showing your income and deductions for the previous year and how much estimated tax you’ve paid. You must file IRS Form 1040 and include a special tax form in which you list all your business income and deductible expenses. Most freelancers use IRS Schedule C, Profit or Loss From Business. You must also include IRS Form SE, showing how much self-employment tax you were required to pay.
Tax matters are more complicated if you incorporate your business. If you form a regular C corporation, it will have to file its own tax return and pay taxes on its profits. You’ll be an employee of your corporation; you’ll have to file a personal tax return and pay income tax on the salary.
If you have employees, you’ll have to keep lots of records and file quarterly and annual employment tax returns with the IRS. When you hire other self-employed people, however, you don’t have to pay any employment taxes. You need to report payments only if they’re over $600 for business-related services to the IRS and to your state tax department if your state has income taxes.
State taxes. You’ll also have to file an annual state income tax return with your state tax department. In all but six states—Arkansas, Delaware, Hawaii, Iowa, Louisiana, and Virginia—the return must be filed by April 15, the same deadline as your federal tax return.
Paying estimated taxes. Federal income and self-employment taxes are pay-as-you-go taxes. You must pay these taxes as you earn or receive income during the year. Unlike employees, who usually have their income and Social Security and Medicare tax withheld from their pay by their employers, freelancers normally pay their income and Social Security and Medicare taxes directly to the IRS. These tax payments, called estimated taxes, must be made if you expect to owe tax of $1,000 or more when you file your return for the year.
Estimated tax payments must usually be made four times every year on IRS Form 1040-ES, on April 15, June 15, September 15, and January 15. If you freelance part-time and have a job, you could have your employer increase your withholding instead of paying estimated taxes yourself. You have to figure out how much you owe in estimated taxes each year—the IRS won’t do it for you.
On every freelancer’s bookshelf. If you decide to build a career as a work-at-home freelancer, you’ll want a copy of attorney Stephen Fishman’s book, Working for Yourself: Law & Taxes for Independent Contractors, Freelancers & Consultants (Nolo). The book discusses the nitty-gritty details of the freelance life, from choosing a business structure to entering into client agreements to paying estimated taxes.