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.
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
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
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:
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.
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):
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, Talent
Is Not Enough: Business Secrets For Designers, is available from New Riders.
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