Taxes and Freelancing

Here are some tips and strategies for thinking about your taxes. There are special circumstances that apply to freelance writers and other creative professionals, so I will highlight what you need to know to prepare your taxes and to avoid IRS investigations.

First, let me start with some fabulously great news. Being self-employed is quite possibly one of the best tax strategies available today. Other good tax strategies include being a landlord and being an investor. All three strategies have one thing in common: you are in full control of your tax situation, and you can reduce current income by any losses you have from freelancing, renting out property, or investing.

Second, let me tell you that the IRS is fully aware of the tax benefits of being self-employed. They are on the lookout for individuals who (1) have high wages, and a correspondingly high business loss, or (2) have business losses year after year. If you are in one of these situations, you need to start thinking about how to protect yourself in case the IRS audits or "examines" your tax return. We'll discuss that later on.

The basic tax planning strategy goes like this: reduce your taxable income, shift taxable income into nontaxable income, take advantage of tax credits, and pay the right amount of estimated taxes. Being a freelance writer immediately puts you in full control of your taxable income, which means that you can fully control how much taxes you pay. Not to be overlooked are special taxes you get to pay for being self-employed. We'll discuss Self-Employment Taxes and its impact on your tax withholding or estimated tax payments.

Step 1: Getting Organized
Step 2: Calculating Home Office & Depreciation
Step 3: Reporting Your Net Profit & Paying Your Taxes
Step 4: Much Ado About Nothing – or, how to protect your business losses
Step 5: Incorporating Your Business and Stategies to Protect Your Business Losses

All freelance writers and other creative professionals are considered "sole proprietors," unless they choose to have some other form of business. A sole proprietor is just another way of saying "self-employed," "independent contractor," or "freelancer." Income and expenses related to your self-employment is reported on your 1040, Schedule C (PDF). Taking a look at the Schedule C is helpful. You can also download the Instructions for Schedule C (PDF).

The first step to getting organized is to separate your freelance income from other types of income. Keep a record of all your business-related income. Your clients may send you a Form 1099-MISC in January or February to report total payments for the previous year. Form 1099-MISC is like a W-2, it is used to report income you received. The IRS also gets a copy of any 1099s. Your total business income on Schedule C Line 1 must be greater than or equal to the total amount of income reported on your 1099-MISC forms. If you report less income on your Schedule C than reported on your 1099s, you will get a computer-generated audit notice. (That is, the IRS computer matches up your tax return with information the IRS receives, and if there's a difference, you get audited.) The easiest way to avoid an audit is to report all your income, whether you received a Form 1099 or not.

The second step to getting organized is taking a look especially at the various types of business-related expenses you can report. I highly recommend you start tracking your business-related expenses using the same categories on the Schedule C form. You can track your expenses using envelopes to sort receipts, or using a spreadsheet program, or using a personal finance program such as Quicken. The most relevant categories of expenses for freelance writers include:

Advertising – this includes business cards and web-marketing
Insurance – for life, property & casualty, or business insurance. Do not include health insurance under this category.
Other interest – credit card or loan interest, such as interest paid on your computer loan.
Legal and professional services – such as fees your accountant will charge
Office expense – anything other than routine supplies.
Rent or lease other business property – rent paid on a writer's studio, for example
Repairs and maintenance – repairing your computer, for example
Supplies – routine office supplies like paper, toner, pens, pencils, notepads, etc.
Travel – the cost of traveling to a convention, meeting, or business trip
Meals and entertainment – the cost of business meals, but be careful not to go overboard
Utilities –electricity, gas
Other expenses – such as Dues & Subscriptions, Web development, and Business telephone expenses.

Most writers have things like a website, high-speed Internet connection, a computer, various software programs, and a small home office where they do most of their work. Writers will typically subscribe to various magazines, trade journals, or research tools. If your expense does not fit neatly into one the categories above, don’t worry. Just create a new category, and put it in Part V for "Other Expenses." We would put Dues & Subscriptions, Business Telephone, and Website Development under Part V.

Most writers invariably spend money on books, it's what we love most, and so it is natural that we buy lots of books. In order to be a business expense, the books must be a reasonable and customary expense given your profession. As a tax writer, it is reasonable that I would buy lots of books on taxation, running a business, and personal finance. Those would be allowable business expenses. Also allowable would be reference books such as dictionaries, thesauri, encyclopedias, and so forth. I would list this in Part V, Other Expenses. If you are writing book reviews, movie reviews, or any product that might be seen as a personal expense, just keep your receipts along with a printout of your review. That way the IRS auditor will see that your expense was clearly related to your business activity.

Health Insurance expenses. If you are self-employed and you pay for your own health insurance, then you can deduct the full cost of your health insurance premiums on your Form 1040, line 31. In order to deduct your health insurance expenses, you must have a net profit from your business. If you have zero profit or a net loss, you can still deduct the health insurance premiums. But instead of going on Line 31, you deduct them on Schedule A as a medical expense.

Claiming expenses for your home office. The home office is one of the best things about being self-employed. You get to convert a portion of your personal expenses into a tax-deductible business expense. But beware: your home office deduction will be reduced or eliminated if you have a small profit or a loss. Looking at the Schedule C, the home office expense goes on Line 30, right after your tentative profit has been calculated. You can claim home office expenses only if you have a tentative profit, and you can at most reduce your profit to zero by using the home office deduction. You cannot use your home office expenses to create a loss. Since most freelancers already have a loss, they will be ineligible to claim their home office expenses.

Figuring your home office expenses. Calculate your home office expenses using Form 8829 (PDF). You calculate the percentage of your total home expenses that are allocated to your business use. You may calculate the percentage in one of two ways. Percentage of square feet: measure the size of your home office, and measure the size of your home. The ratio of the two will yield your home office percentage. Number of rooms: count the number of rooms in your home. Your home office percentage will be 1 divided by the number of rooms.

Convert Your Home Office into a Regular Office. The limitation on home office expenses can be avoided if you rent an office space or writer's studio. That way your rent and utilities are included as a regular business expenses without regard to the home office limit. For example, let's say your significant other leases a 2-bedroom apartment. He can sub-lease one of the bedrooms to you for use as an office. The lease agreement must be in writing, must not violate the main lease agreement for the apartment, and the monthly rent must be at a fair market value, and you must make actual rent payments. You can now deduct your rent expense without limitation.

Accounting for Your Business Assets. Believe it or not, as a freelance writer you have a number of business assets. A business asset is any property with a useful life longer than one year and which is used to produce income. Thus your website, computer, software programs, and office furniture can all be considered business assets. You have two choices for accounting for these purchases. You can treat them as ordinary expenses and deduct the full cost of purchase in the year the property is bought, or you can treat them as capital expenses and spread out the cost of the purchase over a number of years. No matter which option you choose, you will figure your expense on Form 4562, Depreciation and Amortization (PDF). Now, don't let the word "depreciation" scare you. Depreciation means spreading out the cost of a big purchase over a number of years. That's all. If you want to take the full deduction in the year of the purchase, you want what's called a Section 179 deduction, and is calculated in Part 1 of Form 4562. If you want to spread out the cost over a number of years, you are "depreciating" your property and will calculate the amount in Part 3.

Depreciate or Section 179? Generally, you should calculate depreciation last. Calculate your profit or loss before deciding on how to depreciate your assets. If you have a profit, you will want to use whichever method (depreciation or Section 179) gives you the lowest profit. If you already have a loss before depreciation, you will want to depreciate. That way more of your expenses will be moved to the following years when you may need expenses to offset additional income. Depreciation is tricky to calculate, and moreover you need to "tweak" your depreciate based on the decision factors I just discussed. As such, prepare your taxes using a computer program so you can easily recalculate your depreciation amounts. Since most freelancers have business losses, I recommend that freelancers use normal depreciation methods for their business assets. That means, I recommend against taking Section 179 deduction or any "special" or "bonus" depreciation. If you plan to depreciate your assets, the following material is recommended reading: Tax Topic 704 Depreciation, Publication 946 How to Depreciate Property, and Depreciation from Publication 334 Tax Guide for Small Business.

You calculate your net profit or loss from your self-employment on Form 1040, Schedule C (PDF). The figure on Schedule C Line 31 gets carried to two places: your Form 1040 Line 12, and your Form SE Line 2. If you have a net loss, the loss reduces your taxable income and reduces your tax. Also, if you have a loss, you do not have to fill out Schedule SE.

The basic equation for a Schedule C, or another other business-related tax return, is income minus expenses equals profit. If the profit figure is a positive number, congratulations! You are one of the few self-employed people who made money as a freelancer. If the profit figure is a negative number, you have a business loss. Join the crowd. The vast majority of freelancers incur losses. A business profit increases your taxable income, and increases both your regular income tax and your Self-Employment Tax. The Self-Employment Tax, figured on Form 1040 Schedule SE (PDF), is 15.3% of your net profit and represents the Social Security and Medicare taxes owed on your business profit. As an employee (on a W-2), you only pay half of the Social Security and Medicare taxes (7.65%), and your employer pays the other half. As a freelancer, you are your own employer, so you pay both halves.

Most self-employed people get into tax trouble because of the Self-Employment Tax. You need to set aside money at least every quarter, or better yet every month, towards your Self-Employment Tax. Let's say you anticipate having a net profit of around $1,000. Well, your Self-Employment Tax would be ($1,000 x 15.3%) $153. If you divide that into four quarterly payments, you should be paying $38.25 every quarter to the IRS as an estimated tax payment. You should also calculate your anticipated regular income tax. If you are in the 25% tax bracket, the additional income tax on your business profit would be ($1,000 x 25%) $250. So you should set aside $403 ($153 + $250) over the course of the year towards your estimated taxes. Freelancers who fail to make reasonable estimates of their future taxes often end up owing at the end of the year. Paying a balance due can be a hardship for struggling freelancers. Protect yourself from tax troubles by planning ahead, and making a sincere effort to pre-pay your taxes.

I recommend all self-employed entrepreneurs to enroll in EFTPS, the Electronic Federal Tax Payment System. Once you are enrolled, you can make estimated tax payments by phone or by Web, with the payment debited directly from your checking account. It's like bill pay for your taxes. The nice thing about EFTPS, you can schedule payments ahead of time, and you can designate exactly where you want each payment to go.

If the net profit figure on your Schedule C is a negative number, you have a business loss. The vast majority of freelancers incur losses. This is how losses work.

First, your business loss reduces your total income. On Form 1040, your total income is calculated on Line 22. The loss also reduces your Adjusted Gross Income (Line 36), and Taxable Income (Line 42). As such, your business loss reduces your income tax. If you have a day job (on a W-2), this means you will get a bigger refund compared to someone who earned the same amount of wages but did not have a freelance side business.

Reducing your taxes in this way is an excellent tax strategy. In fact, many tax professionals have encouraged people with high incomes to convert their hobbies into "businesses" so they can have a loss to reduce their income. Not surprisingly, the IRS has caught on to this strategy.

There's no hard-and-fast method for distinguishing between a hobby and a real business just based on the tax return. After all, the tax return is just a piece of paper, and so there's no way to tell a legitimate business from a hobby apart except by using a rule of thumb.

Hobby Loss Rule of Thumb. If a business reports a net profit in at least 3 out of 5 years, it is presumed to be a for-profit business. If a business reports a net loss in more than 2 out of 5 years, it is presumed to be a not-for-profit hobby.

This rule of thumb places a huge burden of proof on newly formed businesses. On the one hand, the IRS expects new businesses to incur a loss. It is normal for a business to have a year or two of losses before becoming profitable. On the other hand, it is likely that a business could have several years of losses before ever making a profit. In fact, several such cases have been sent to the Tax Court.

If you cannot meet the 3-out-of-5 year rule (3 years of profits in a 5-year period), you can still prove your profit motive using the following nine factors:

You carry on the activity in a businesslike manner,
The time and effort you put into the activity indicate you intend to make it profitable,
You depend on income from the activity for your livelihood,
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
You change your methods of operation in an attempt to improve profitability,
You, or your advisors, have the knowledge needed to carry on the activity as a successful business,
You were successful in making a profit in similar activities in the past,
The activity makes a profit in some years, and how much profit it makes, and
You can expect to make a future profit from the appreciation of the assets used in the activity.

This list is found in IRS Publication 535 Business Expenses

An audit to defend your business losses can be a very expensive audit. If you lose, the IRS will disallow the loss. Your business expenses will be limited only to the extent of business income (which means zero profit). And you will have to re-calculate your tax liability, often meaning that you will have to repay some of your income tax, plus penalties and interest. The audit may also be a waste of time and money, since you will have to spend time fighting the IRS and paying an accountant, instead of focusing on making money.

Nonetheless, defending your business loss is in your best interest, because creative professionals have succeeded in demonstrating a profit motive despite years and years of losses. First and foremost, you must carry on your freelance work in a very businesslike manner. This means keeping good records, keeping a business diary showing meetings with clients, deadlines, and projects, having business cards and a web site that promotes your business, and keeping a log of freelance gigs you apply for, and so forth. If you arrive at your audit armed with a daily planner showing all this information, it will be harder for the IRS to prove that you were just a hobbyist. In other words, convincingly demonstrate that you are in business for yourself, and you will succeed in defending your business losses against an IRS examination.

Protecting Your Business Losses By Incorporating

The hobby loss rule-of-thumb applies to sole proprietors filing a Schedule C. One of the surest ways to prove you are serious about doing business is to form some sort of separate business entity. Businesses are separate entities for tax purposes, and so setting up a business for your freelance writing will provide a way for you to separate your personal income and expenses from your business income and expenses. Incorporating your business in a formal way for you to separate your business activities from your personal activities. I discuss incorporating your business and protecting your losses in a separate article.

-Via About.com

Monday, July 20, 2009