This month marks the beginning of a time most of us in the creative freelance world dread: tax season.
Back in my first year as a bona fide freelancer just out of school, I simply totaled up my invoices for the year and lumped them onto line 21 of my form 1040 ("other income"). It took two years for the IRS write me a sternly worded letter about this not quite cutting it, but when it finally arrived, the accountant I hired to help me sort things out took a look at the documents and uttered the sort of sigh usually reserved for 6-year-olds who try and bake a cake from scratch. I'm sure it was all he could do to refrain from going "Tsk, tsk" as well.
The problem isn't that there's a lack of information about filing taxes in the U.S. —on the contrary, a quick online search will turn up more tips, pointers and official instructional documents than any of us could consume in a lifetime - but since pretty much everyone in the country has to file, sorting the useful information from the completely unrelated is daunting to say the least. Freelancers new to their Self-Employed status have a lot of concerns and responsibilities that typical salaried workers don't.
So as a favor to you, and to all the accountants fighting the urge to groan at your mistakes, I've compiled a few basic pointers for the (unincorporated) self-employed, that I wish I'd had back then. It goes without saying that I'm not a certified accountant, nor do I work for the IRS, so if this is your only reference when doing your taxes, you're...hmm...foolish. If you're worried or confused about how you're going to accurately and successfully complete your taxes, these tips may serve as a good starting point:
W-2 vs. 1099 - This is the most fundamental difference between the typical freelancer and the typical staffer - at the end of the year, you get a stack of 1099 forms from your clients, rather than a W-2 from your boss. Since no taxes were removed at the time of payment, you have to pay up everything you owe when you file, and it can be quite a lot. Above a certain amount, you can also be penalized for waiting until tax time to pay (the government likes their money sooner rather than later), which is why Quarterly Estimated Tax was invented. If you make a significant fraction of your income from freelancing, and estimate you'll owe more than $1,000 at the end of the year, you need to set up quarterly payments; the forms are here.
Schedule C and Schedule SE - Assuming you're working as a sole proprietor (not a partnership or corporation), and you make most of your money as a freelance designer or other creative professional, these are the two main documents you'll need to complete in addition to your 1040. Schedule C is where you report the income from those 1099s, as well as your business expenses, resulting in a net income (or loss...but this is unusual for designers, who typically have a fairly low overhead). You then take the results of this form and use them to calculate your Self-Employment Tax on Schedule SE. When you're done with that, your net business income and Self-Employment Tax go on lines 12 and 57 of your form 1040, respectively. Got all that?
If you decide that freelancing is something you're going to stick with for the long haul, it's worth examining options other than basic self-employment. Bryan Engel, a New Jersey-based accountant with a sizeable roster of freelancer clients, suggests that "forming a corporate entity such as an S-Corporation [can] minimize your total tax liability by not having to pay self-employment tax."
Business Expenses - This is one area where you can really save some money. Filling out everything correctly can potentially save you a ton of money. Sites like Quickbooks offer helpful tips for freelancers and it's definitely worth your time to do some more research, but to get you started here are five deductions that are absolutely essential for the self-employed:
Deduction #1: Mileage expenses
Do you realize that every mile you drive for your business can result in approximately a 55 cent deduction? This is especially big if you work from home, because having a home office basically means your "commuting" mileage is non-existent and any use of your car for business, whether it's to meet clients or attend a conference, is deductible.
Many freelancers don't make full use of this deduction because of the burden that comes along with keeping records. The IRS requires that you provide documentation for each trip - your destination, the purpose of your trip, and the number of miles driven. Historically, tracking mileage meant keeping a log of odometer readings. However, with modern mapping software like Google Maps , you can simply enter your starting and ending address and have the driving distance calculated for you. So go back through your appointment book or calendar and find those business trips you neglected to log and get that 55 cent per mile deduction.
Deduction #2: Meals
If you schedule a lot of lunch and dinner meetings with clients, make sure you keep those receipts. So long as you're discussing business (and that you pick up the tab), half of those expenses are deductible. Why only half? Because the IRS knows you need to eat anyway, so they won't give you the full write-off.
Note - you need only discuss business before, during or after the event, so don't feel the need to talk with your mouth full.
Deduction #3: Reimbursable expenses
Reimbursable expenses are costs you incur on behalf of a client that you then bill back to them. Normally, these expenses are not deductible since you end up getting paid back, rather they are a deduction for your client.
However, you should look out for this interesting case. At the end of the year, your client should send you a 1099MISC form, showing how much they paid you. Make sure to compare the amount on that form with the actual invoices you sent to the client. Sometimes, clients will just add up the total for all invoices paid, even if those totals include reimbursable expenses. If that happens, they are basically reporting those payments as income for you, in which case you need to make sure to include those reimbursable expenses as deductions for your business.
Deduction #4: Depreciate your equipment unless you make a lot of money
Unless you buy a lot (as in more than $128,000 worth) of equipment, you can write off the full purchase price for that equipment in the year in which it's first used. However, if you aren't making a lot of money, you might be better off saving part of this deduction for future years, when business is better and you are in a higher tax bracket. You can do this by "depreciating" the item, which means writing off the cost over multiple years.
Most freelance equipment gets depreciated over 5 years (computers, copiers, fax machines, etc.) Office furniture gets depreciated over 7 years. So, see how your overall profit and loss is looking for the year before deciding which way to go—it can make a difference down the road when you might be earning more.
Deduction #5: Bad debt (as in, clients who don't pay)
Ok, you probably won't like this, but this won't be a deduction for most freelancers (I know I'm breaking from the theme, but it's important.) Why isn't this one a deduction? Because most freelancers pay taxes based on money they actually receive and deduct money they actually pay. This is called the "cash" method of accounting.
In the case where a deadbeat client simply doesn't pay, you never really got the money to begin with, and have nothing to report as income from them. Therefore, no deduction.
You could choose to use the "accrual" method of accounting, in which case you could write off deadbeat clients—but then you'd have to pay taxes on money anyone owes you, even if they haven't yet paid. As you can imagine, most freelancers don't choose this option.
There are of course thousands of other deductions to be had, and every freelancer's situation is different, which is why doing some research is both necessary and tedious. A few others to keep an eye out for include: a fraction of your utilities and rent or mortgage payments if you work primarily from home; travel expenses to conferences, vendor visits, or research trips; stock photos and artwork; the cost of hiring out work to other freelancers. Note that if your total business expenses come to less than US$5,000 you can use form C-EZ instead, which doesn't require you to itemize them (though you do need to keep documentation on hand should the IRS come knocking) - any more than that and you'll be using the long form, which requires you to list out deductible expenses by category. And that is lots of fun.
Back on the main 1040, there are a few other lines worth extra attention from freelancers. Line 27 is where you get to deduct half of your Self-Employment Tax from your overall income, line 29 provides a deduction for those of you who pay for your own health insurance, and line 33 lets you deduct interest on student loans—together these can make a sizeable dent in your taxable income, so be sure to read up on them.
If examining the list above has you thinking it's all too much, you're not alone. For many freelance designers, hiring an accountant or engaging some other form of tax assistance is as integral a step in setting up shop as buying the latest Adobe Creative Suite. When I mentioned on Twitter a few days back that I was researching this article, Kenneth Wong, a San Francisco-based CAD and technology writer responded: "Tax tips from a freelancer: Find an affordable accountant."
Note: This article was originally written by Carl Alviani.