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Being your own boss, setting your own hours, working in your pajamas from wherever you happen to be at the time – sounds pretty great, right? Its freedom, mobility and the chance to work on what you care about and build a legacy. However, there are challenges that come with being out on your own – learning how to run your business, understanding cash flows and certainly taxation. If you’re a freelancer, independent contractor or consultant you’re considered self-employed for tax purposes if you earn $600 or more annually from your self-employed income. Understanding how you are taxed and what benefits are available to you is critical to your success.
1. Understand how you are taxed
Paying tax as a self-employed person is much different than if you are an employee of a company. Instead of being paid wages that are reported to the IRS, you file a Schedule C with your annual tax return and report your gross receipts and your business expenses. From there, you’re taxed on your net profit. You may receive 1099-MISC forms for compensation paid to you. If your net self-employment earnings exceed $400, you will also have to pay self-employment (FICA) tax. You can deduct from your gross income one half of your self-employment tax on Form 1040.
2. Track your income and expenses
Seems like a no-brainer, right? However, many freelancers find themselves struggling to file their taxes because they simply have no idea how much money has come in and gone out over the year. That’s no way to run a business! Should you be audited, the burden of proof is on the taxpayer to prove the income and expenses on the tax return – so keep those records for at least three years, maybe more in certain situations. Figure out a way to keep track throughout the year – many online “cloud” accounting platforms have cropped up in recent years – some are very simple and intuitive, while others are more robust (including inventory tracking and payroll). Find what works for you and stick with it (or hire an accountant to do it for you – you’ll be happy you did at tax time).
3. Make estimated tax payments
The United States tax system is a “pay-as-you-go” system. For employees, tax is withheld by their employer. For freelancers, the onus is on the taxpayer to make estimated payments quarterly. Falling behind causes problems at tax time when you have significant self-employment income and did not pay taxes along the way. Penalties for not pre-paying tax may apply, or you simply may not have the cash on hand when your tax return is due. This is a very common pitfall but can make your estimated tax payments online through the Electronic Federal Tax Payment System (EFTPS).
4. Know what expenses are deductible
Business expenses are the cost of carrying on a trade or business. To be a deductible expense, it must be both ordinary and necessary. An expense for sheet music would be a deductible expense for a freelance musician, but clearly not for an accountant. Business expenses can be items like rent, interest, taxes, insurance, employee wages, advertising, business use of your home, business use of your car, travel, utilities and many others. Business start-up costs, in most cases, must be capitalized and depreciated (meaning they are not expensed in the year incurred but instead listed as an asset and depreciated over a certain period of time).
5. Post a profit
Many small business owners and freelancers who file Schedule C post losses year after year after year. The problem with this is that the IRS may consider your business activities as a hobby, and that you are not engaged in it for profit. The IRS considers businesses engaged in for-profit activities if the business posts a profit three out of the last five years. There are also other factors the IRS will consider, including the time and effort you’ve put into the business, whether or not you depend on income from the business, knowledge and skills of the business owner and expected future profit. If your business activity is classified as a hobby, your allowable deductions may not exceed the gross receipts for the activity. What commonly happens at an audit is that the IRS determines the taxpayer’s “business” is actually a hobby, and the net loss on the original tax return is wiped out, leaving the taxpayer saddled with additional tax, penalties and interest.
Taxes happen annually, so having a plan is critical to your business. Keeping good records and having a basic understanding of tax laws will help make your dream job a success!