Income Taxes for Freelancers
Previously in your career, you may have been on someone's payroll. As you recall, they withheld estimated tax amounts from each of your paychecks and forwarded those amounts to the government on your behalf. Now that you are an independent businessperson, you are required to do that for yourself.
To start off on the right foot, visit the tax information site www.irs.gov and download the PDF file for publication 583 “Starting a business and keeping records.” It is a good overview of tax issues for entrepreneurs.
Estimated tax payments
How does it work? As you go through the year, you'll be receiving payments from various clients for services performed. Consult with your CPA to determine the amount of state and federal tax that you owe on that income. Then, on a quarterly basis, make estimated tax payments. For federal income tax and self-employment tax (Social Security and Medicare), you must use form 1040-ES (“Estimated Tax for Individuals”). State income tax must be reported on the appropriate form for the state in which you live. Personal tax rates change every year. Individual income tax tables and tax rate schedules are published each year in the federal 1040 and state tax booklets. Be sure to check the booklets for the current rates.
The tax that you owe will be based on income minus “ordinary and necessary” expenses for the type of business that you are operating. For most freelancers, those expenses will include amounts related to the business use of your home. If you are reporting a home office to the IRS, your use of that space must be “exclusive and regular.” That is to say that the space used for your business cannot serve any other purpose and you must actually conduct your business there on an ongoing basis. Direct expenses that relate only to the business part of your home can be deducted in full. Indirect expenses for maintaining and operating the entire home can be deducted in a proportionate amount. Rent expense (or depreciation if you own your home) is determined by the percentage of you home's total area that is used for business. Unrelated expenses such as lawn care are not deductible.
Be aware that there are some limits to the amounts that you can deduct. In general, the IRS does not want you to show a loss resulting solely from the cost of the business use of your home. More detailed information can be found in IRS publication 587 “Business Use of Your Home” which can be downloaded as a PDF.
Most freelancers also report expenses that relate to business use of their personal car. There are two ways to calculate the value of this. This first method is to use the “standard rate” published by the IRS. The standard rate changes every year (for example, the 2004 rate is 37.5 cents per mile). You must keep a diary of business mileage, including the date, destination & purpose of each trip. At the end of the year, you simply add up that business mileage and multiply it by the standard rate.
The second option is to value the business use of your car on an actual cost basis. This involves a bit more paperwork. On the first day of January, record the beginning odometer reading for the year. Then keep a diary of business mileage, with the date, destination and purpose of each trip. On the last day of December, record the ending odometer reading for the year. From these numbers, you will calculate what percentage of the total miles driven during the year related to your business. Meanwhile, you must keep detailed records of all actual costs incurred during the year (insurance premiums, gas & oil expenses, repairs and maintenance, etc.). On the last day of December, add up the dollar total of all expenses, then apply the business mileage percentage to determine the deductible cost.
Additional information about both options can be found in IRS publication 463 “Travel, Entertainment, Gift and Car Expenses.”
Your quarterly estimated tax deposits are due on April 15, June 15, September 15 and January 15. In most cases, they must add up to 90 percent of this year's liability or 100 percent of last year's liability, whichever is lower. The IRS does charge fines for underestimating, as well as interest on any late payments. If this is your first year of freelancing, you'll have to work with your CPA to calculate the proper amount each quarter. After your first year, the process becomes much easier because you can simply divide the previous year's total by four.
Your final, completed tax return for the year is due on April 15. It will show your total tax liability minus the four prepayments that you have already made. If it turns out that you owe a small additional amount, that must be paid when you file the return. (If for some reason you have overpaid, you can request a refund or carry the extra amount forward to be applied to next year's tax liability). As a self-employed businessperson, you need to use the federal long form 1040 (and the state long form as well) and include the following attachments:
- All of the 1099s that you received from your clients
- Schedule C “Profit or Loss from Business or Profession” including car expenses
- Schedule SE “Computation of Social Security Self-Employment Tax”
- Form 8829 “Expenses for Business Use of Your Home”
- Form 4562 if you are reporting car depreciation
Be sure you have the cash
In order to make all the various tax payments on time, you'll need to keep enough cash in your business bank account. A good rule of thumb is to set aside one third of each client payment that you receive during the year. In this way, you'll accumulate a tax reserve so that you won't have to scramble when you're on deadline to make tax payments.
Business versus hobby
What happens if your freelance business is not profitable? The IRS expects you to report a net profit in at least three out of five consecutive years. This is often called “the hobby test.” If you are not able to meet this requirement, they will attempt to re-classify your creative activities as a hobby rather than a business. This is important because, if you are not recognized as a business, you will no longer be able to deduct business expenses from your taxable income.
If you have not been profitable in three out of five consecutive years, you will need to prove to the IRS that you are indeed actively engaged in business with a clear profit motive. In order to evaluate your situation, the IRS will look at nine profit motive factors. Here is a list of those factors (along with some notes about how they might be applied to design):
- The manner in which the taxpayer carries on the activity
(Are you diligent and business-like in seeking and completing projects?)
- The expertise of the taxpayer or his/her advisors
(Do you and your collaborators have the design and implementation skills necessary?)
- The time and effort expended by the taxpayer in carrying out
(Is the majority of your time dedicated to making your design business successful?)
- Expectation that assets used in the activity may appreciate in
(You should be selling your projects for more than it cost you to produce them.)
- The success of the taxpayer in carrying on other similar or
(Have you been more profitable in some other line of work?)
- The taxpayer's history of income or losses with respect to the
(Could it be that you are only experiencing temporary losses due to relocation or repositioning?)
- The amount of occasional profits, if any, which are
(Is it possible that a few good projects are profitable enough to offset the bad ones?)
- The financial status of the taxpayer
(Are you wealthy enough that you do not need profits from your design work?)
- Elements of personal pleasure or recreation
(Designers are passionate about their work and experience significant personal growth by taking on tough challenges. We are not Sunday painters-design is a problem-solving process and a highly customized professional service.)
About the Author: <p>Shel Perkins is a graphic designer, management consultant and educator with more than twenty years of experience in managing the operations of leading design firms in the U.S. and the U.K. He has served on the national boards of AIGA and the Association of Professional Design Firms. He has been honored as an AIGA Fellow "in recognition of significant personal and professional contributions to raising the standards of excellence within the design community." The third edition of his best-selling book, <em>Talent Is Not Enough: Business Secrets For Designers</em>, is available from New Riders. </p>