Spring is in the air. The days are getting longer. Flowers are just starting to bloom. And of course, tax day is rapidly approaching.
With the growth of the freelance (or “gig”) economy, more and more people are answering new and different types of questions as they prepare to pay Uncle Sam. Tax issues challenge all types of freelancers and self-employed workers—from those working full-time for themselves to those just picking up small gigs here and there throughout the year.
If you’re a freelancer, you are a business
If you’re doing this type of work, don’t forget that you are indeed a small business, even if it’s just you in your sweatpants most of the time. It may seem like a hassle, but it’s important to understand the tax implications of how you earn your money, and how those implications impact your tax-filing status.
The IRS provides a lot of information for self-employed taxpayers at IRS.gov. In the Self-Employed Individuals Tax Center, you can find information on a variety of topics, including basic explanations of tax obligations, forms, deductions, and links to other online tools like Small Business Taxes: The Virtual Workshop. The Virtual Workshop is a series of videos designed to help the small business and self-employed community. The U.S. Small Business Administration also provides resources for self-employed and freelance business owners.
Highlights for freelancers
Taxes you may owe: You might owe multiple taxes on your freelance income. First, you have federal income taxes, and—depending on where you live—state and municipality income taxes. Second, you have the self-employment tax, which covers Medicare and Social Security, the FICA deductions you would see on a paycheck.
Quarterly payments: The IRS requires many self-employed workers to make quarterly, estimated tax payments. These quarterly payments are a way for you to pay your income and self-employment taxes since an employer is not withholding them for you. Form 1040-ES, Estimated Tax for Individuals, helps you calculate estimated payments based on your earnings. The form also has blank vouchers to use when filing your quarterly payments.
The home office deduction: Lots of people have lots of advice about the home office deduction. Unfortunately, this advice is often incomplete or incorrect. It pays to do your homework, because the IRS has very specific guidelines about what does, and doesn’t, qualify. The home office deduction trips up a lot of people because of the “exclusive use” requirement. If you use your home office for your freelance work, but also to Skype with your parents, have a corner set up for arts and crafts, and do other personal things, then that office doesn’t qualify for the deduction.
Retirement plans: As a freelancer, you’re entitled to set aside a tax-deferred portion of your freelance income for retirement. The easiest way to do this is through a Simplified Employee Pension Plan, or SEP, which is a special form of a traditional IRA (individual retirement plan). Don’t let the name fool you—you don’t need any employees other than yourself to qualify for a SEP. In fact, you can set up a SEP to shelter some of your freelance income even if you also have a regular job that has a retirement plan. The formula for calculating how much of your self-employed income can be set aside can seem a little daunting—it involves using a worksheet with maddeningly abstruse instructions—but it’s well worth the effort.
Health insurance: Don’t forget that under the Affordable Care Act (aka Obamacare), you must carry a minimum level of health insurance or you will get slapped with a penalty come tax time. If you don’t have acceptable health insurance coverage through an employer, you’ll need to get it through one of the government-run healthcare exchanges, a professional organization like the Freelancers Union, or directly from a private insurance company. The good news is that the premiums can be written off as an adjustment against your income—which is better than their being an itemized deduction—provided you have no option to get acceptable coverage through an employer (either yours or your spouse’s).
Mistakes to avoid
Jonathan Medows, CPA, managing member of MEDOWS CPA, and founder of CPA for Freelancers (an online tax and accounting resource for freelance professionals) has been handling tax issues for his clients since 2004. When asked about some of the common mistakes he sees, he pointed to not keeping records up to date, and not planning for healthcare or retirement.
“Not reporting all of your income” is also a big one, according to Medows. Then there are the extremes of “not claiming expenses” versus those who don’t understand that you “can’t write off everything.” Medows says a lot of people want to take deductions for things like clothing, which is really only okay If you wear a uniform or are required to have safety equipment. “I wear a suit every day. That’s my ‘uniform’, but that doesn’t make it deductible,” he explains.
Medows understands that a lot of freelancers want to try to do everything themselves for their business, but suggests that getting professional advice can be money well spent. “A big mistake I see is not sitting down with an attorney to talk about and set up the proper entity for your business and meeting with a CPA and figuring out a financial plan.”
While not all freelancers need to set up an LLC or do extensive financial forecasting, everyone does need to understand their own specific situation and make sure that they are calculating and paying the right taxes at the right time.