Monday, March 24, 2008

Tax Myths and Misconceptions for Freelancers

Last year was my first full year in business--and my first year making money entirely as a freelancer. Like a lot of first-year contract workers, I thought I was prepared for my tax bill--but it was much more painful than I expected. Part of the reason for the pain is that I'm a pretty frugal person by nature; I don't spend a lot on electronics or equipment unless I really feel I need them. My laptop is a few years old, but it still runs just fine--and I haven't replaced my printer in years. Still, I thought I'd be okay when it came to taxes--partly because of a few misinformed assumptions. Here are my big ones--and if you're operating under any of these, be warned.

Note: I'm not a tax professional or attorney, and this post shouldn't be construed as professional tax advice to you personally. Consult with an accountant or a tax attorney for more information on your situation.

All those deductions will cancel out your tax bill. I have a few family members and friends who own stores, build boats, run car mechanics' shops, and so on. In my first year of business, these sage businesspeople advised me not to worry too much about taxes--"the deductions will take care of it," they said.

Here's the thing about freelance writing, though: it's a low overhead business. Our big-ticket items tend to be things like printers, computers, and faxes--things you don't buy every year (although you can deduct the depreciation) and things that don't cost much more than a few thousand dollars. Sure, you can deduct a fraction of your housing expenses (if you have a single room dedicated to an office); your Elance fees (yeah, we're all earning a lot of money on Elance these days); your PayPal fees; your office supplies; and even some car expenses if you use your car for business. But that still adds up to pretty small potatoes--or at least it did for me. If you don't have any major equipment expenditures or employee salaries; or if you didn't buy some big-ticket website overhaul or spend a lot of money on classes and conventions, you may find yourself hurting at tax time.

You won't make enough your first year to pay much in taxes. I do pretty well--but I'm not ridiculously wealthy. I assumed that this year wouldn't be a big-ticket year for me in terms of taxes. I made about as much last year as I did in my nonprofit job the year before, and if any of you have worked in nonprofits before, you know they don't exactly pay top-tier wages. I figured I"d be under the tax radar.

But here's the thing: when you're an independent worker, you get smacked upside the head with the self-employment tax. That's 15% of your total earnings, just for social security and medicare. You've also got federal taxes, state taxes, and city taxes to deal with--and some cities levy extra taxes on businesses, too. I still wound up paying about 30% of my net income, total--even though I managed to scrape together enough deductions to make myself look just-this-side of poverty level.

A sole proprietorship is the best organization for you. I always assumed that a sole proprietorship was the appropriate business organization for me. I'm a sole proprietor, after all. No employees; no shareholders; just me and my computer. I thought it was better because it was easier to deal with, too--less paperwork needed. But that's not necessarily so. There are distinct tax advantages to incorporating--and nobody told me beforehand that I should think about this when I formed my business.

You don't need to save; you can finance your tax bill. Except if you do that, it comes with heavy fees and a high interest rate. If you have the money in the bank, you may be better off paying the bill--even if it'll wipe out your savings. The bottom line? Save a percentage of each client payment you recieve. It's tough to do--it takes tremendous willpower on my part--but if you don't, you'll be in trouble later. And pay your quarterlies, so you don't get hit all at once at the end of the year.

Don't assume everything will work itself out when it comes to taxes. Be proactive. Meet with an attorney or a tax accountant in the beginning stages of your business to determine the best organization--and save religiously for the day Uncle Sam comes knocking.


Anonymous said...

So true. I've done this now for two years, and while it's a fantastic gig, taxes just blow. All the nice deductions and other things we're told will help do a bit, but not enough. The best way I've figured to handle this is just as you suggest - save a portion of each check that comes in. I actually calculate how much I make each quarter, how much I should pay in taxes (figuring around 25%), and how much should be in my account to pay for it. Works well (most of the time, anyway!)

Minion said...

Its really insane how much in taxes you have to pay. Thank you so much for giving us your good advice on this topic. Did you file taxes for your freelancing when you were still working at your full-time job?

Unknown said...

Been here, done it to death. I hate April with a passion known only to other English majors faced with a Calculus class. I hate taxes. I hate forms. I hate IRS love letters correcting my forms. Do yourself a favor - start with Schedule C. The instructions never tell you that, and you can't go anywhere until that one's filled out.

I wouldn't discount sole proprietorship right away, Jennifer. I took a small business course once and we went over the different designations. They all have their down sides to them. I chose sole proprietorship based on those down sides.

Jaclyn said...

Thanks for sharing this information. My freelance portfolio just keeps building and I've heard a lot of tax horror stories when it comes to freelancers. Thoughtful information is always good.

Jennifer Williamson said...

@Quiet Rebel: Yep, they sure do. It's painful, innit?

@Min: Yes, but it wasn't a big fraction of my income at the time and I was making a lot more under the standard W-2--and at the end of the day, I really didn't have much idea of what percentage was taken out from my outside work. There may be no way to tell unless you've been there.

@Lori: Thanks for the input. My accountant is pushing the incorporation thing but I still don't really have a great grasp on all the costs and benefits as they would apply to me. I may get a second opinion before taking the plunge.

@Jaclyn: That and the feast-and-famine are the two major downsides of this career, unfortunately. To me, taxes are the worse of the two.

Unknown said...

Here's a link to a Wikipedia article on sole proprietorship. It also includes links to the other forms of business..

Anonymous said...

You can deduct your health insurance premiums, too...and some other medical expenses if you itemize.

Kathy@TheFlawlessWord said...

I used to do some corporate taxes for a living and I STILL hate doing my own taxes. After 8+ years at this freelancing thing, I think I finally have my quarterly payments down so that I don't owe much or get much of a refund come April 15th. The WORST part of owing money is that your first quarterly installment is due the exact same day as last year's taxes. Leave it to the IRS to come up with that brilliant idea, huh? And I'm with Lori. I operate as a sole proprietor and probably always will. I don't need any more paperwork bogging me down than I already contend with.

Anonymous said...

Best thing I ever did was to hire a great accountant. He has taken this big tax monkey off my back. And his suggestions have really paid off.

If you're still handling your tax returns, do yourself a favor: Hire a CPA who specializes in freelancers and small businesses. Yes, you'll spend a few bucks. But you'll also save yourself a ton of time and headache.

I became a freelancer to enjoy life a bit more -- not to agonize over this stuff.

Anonymous said...

If you can, put that percentage of each client payment you receive into a high-yield savings account (like ING). Then you're earning interest that you can put toward later tax payments.

I'm with Ed -- hiring a good accountant was the best business move I ever made. He estimates my quarterly taxes for me and takes care of everything from car depreciation to home office utilities.

Good luck!

Star Lawrence said...

If you think you have to deal with the IRS a lot now, try incorporating!