Help I just quit my job!
What new freelancers (and even experienced ones) need to know about taxes
Full details below, but here’s the TL:DR
Save about 1/3 of your income before expenses for taxes
If you spent $ trying to make $, it might be a deduction
Keeping a good calendar is probably more important than keeping receipts (more on why below)
Keep your business and personal finances separate!
You probably need to pay estimated taxes throughout the year
We have a worksheet that can help you organize this information!
These may sound minor, but if you can master these few items, you’ll have a solid foundation!
Save about 1/3 of your income before expenses for taxes in a separate savings account - 1/3? Really? Depending on how much you’re earning, that might sound like a lot, or maybe less than you were expecting, but for most new creative freelancers we find that’s about right.
“So you’re telling me that if I made 30K, I should expect to pay 10K in taxes”?
Well yes, but actually no. When your income is lower, your expenses represent a much larger % of your income, so in most normal cases you’ll pay less than 1/3 at that income level, but as your income grows, those expenses stay about the same and that 1/3 becomes very real very quick. If you don’t have much for expenses and are earning 100K+ in a high tax city like NY, we will typically increase our recommendation to 40%. Get in the habit of putting that $ away from the beginning, and it won’t be as painful to fix the bad habit later!
What taxes do I have to pay? - Depending on how you’re organized (sole prop, LLC, S-corp) you could be subject to a few different types of taxes:
Federal and state Income taxes - These are what most people think about when it comes to taxes. At the federal level, we have progressive taxes that go up as you earn more money (tax brackets) and some states also have a similar increase in rates as your income increases
FICA taxes (aka self employment taxes) - These are your contributions into the social security and medicare systems. You’ve also paid these at your previous jobs, and it’s about 7.65% for you, and 7.65% for your employer, but now that you’re self employed, you get to pay both halves! lucky you!
Local taxes - Some jurisdictions have local taxes imposed on business, notably in NYC, there is the 4% UBT tax, or the 8.85% GCT (for S-corps)
Sales taxes - Technically your clients pay these, but you still need to know about them. Most services are exempt from state sales taxes, but most physical goods are. Depending on the nature of your work, you may be required to collect and remit sales tax.
I don’t want to pay that much in taxes, what deductions can I take? - The IRS allows deductions for expenses that are “ordinary and necessary” but what does that really mean? In a general sense, if you spent the money trying to make more money, it’s probably a deduction (or at least worth a discussion) Here are a few areas of things that are pretty clearly deductions:
Software for work (adobe, dropbox, google etc)
Computers, equipment & phone for work
Other professionals (subcontractors) you pay relating to your work (see 1099’s)
And a few areas that might be a little less clear:
Travel - Traveling to get to a client or meeting is generally deductible, but simply working while you’re traveling doesn’t make the trip a deduction. Same deal for travel for “inspiration.” Without a direct business purpose, the IRS will likely see it as personal.
Meals - The IRS allows deductions for business meals provided that the taxpayer (you or your employee) are present, that there’s a business purpose (meeting) and that it’s not lavish or extravagant for the circumstances. Simply eating while you’re working doesn’t make the meal deductible, however meals while traveling away from home are deductible.
Home office - The tax code does allow for a deduction for the business use of your home! The space must be your primary work location, which should be easy for all of us working from home now, but to qualify for the deduction the “office” space must also be exclusively used for business, and that’s the trickier part if you’re in an apartment in a major city. In most cases, you can carve out a space as a desk in a corner and make a reasonable allocation. It’s calculated based on the square footage of the “office” divided by the square footage of the total home. that % is then applies to the total cost of rent/mortgage, utilities and other costs of maintaining the home.
Health Insurance - while not a direct business deduction in the same way as the above, self employed individuals are allowed to deduct their health insurance as well. It reduces your taxable income for income tax purposes, but not for self employment taxes.
How do I document all this? - First, you need to keep your business finances separate from your personal finances. Depending on the level of work you’re doing, that can be as simple as keeping a separate credit card for business, but if you have an LLC or other entity, you must have completely separate bank accounts for the business.
Once you do that, then we need to talk about substantiation. If the IRS is looking at your books, they want to see 2 key facts about each transaction: 1. that the transaction happened, and 2. that there was a business purpose. In most cases, a bank or credit card statement easily proves the transaction happened, however it does nothing to prove the business purposes. Some things (like equipment, software, contractors) are fairly obvious that they’re business related, but things like travel and meals are more suspect.
For clients with material amounts of business travel and meals expenses, we strongly recommend keeping a detailed calendar that notes where you went who you met with, and the business purpose of the meeting. That completes the picture for the IRS and holds up well in most cases.
When it comes to tax time, we have a nice little worksheet you can use to organize this information for us and make it easy to prepare your tax returns. It will also give you an idea of common categories of expenses many of our clients have!
How do I avoid getting audited? - Audits aren’t fun, but they’re nowhere near as scary as people believe them to be. When the IRS or the state ask to audit your records, what they’re doing is looking for the documentation we discussed above. In many cases, simply providing the documentation is enough and the audit results in no change. If you’ve been a little aggressive in your interpretations of the rules, however, then its possible that the IRS suggests changes to your returns to remove disallowed deductions, and increases your tax.
People often ask “Is X a red flag?” and the general answer is that it’s all about context. While some portion of audit selection is truly random, most audits are done by statistics. They look at the type of industry you’re in, and the %’s of expenses compared with similar people in your field and determine if they look high enough that they’re likely to find some $ by asking for documentation. High amounts of travel and meals expenses are the most common areas to get audited, because they’re also the most common areas people inflate their deductions.
TL:DR if you follow our advice above, an audit isn’t anything to lose sleep over.
Do I need to file taxes quarterly? - “File”? No. “Pay?” Probably. The IRS requires taxpayers to pay their taxes over the course of the year. Yes, even W-2 employees. When you work at a regular job they’re taking taxes out each paycheck and sending them in on your behalf, and in most cases, it’s enough to avoid any underpayment. When you’re self employed, however, you’re the one that needs to write those checks. You have a responsibility to pay in over the course of the year up to the lower of two thresholds: The amount you expect to owe for the year, or the amount you owed last year.
“How do I know how much to pay?” that’s where we come in. We can run a projection for you to calculate your current year estimates, or you can just base them on last year’s total tax (110% of last year if your income was over 150K)
“What I don’t pay"?” they charge you an “estimated tax penalty!” The word penalty is scary, but it’s basically interest on the money. The current (2022) rate is about 3% so if you haven’t been paying estimates, it’s not usually something to lose sleep over. It also helps you with cash flow planning so it’s not a big hit all at once at the end of the year!
That covers the most common questions we get from new freelancers. Think we missed something? Let us know! We’re also always dropping little tips on social, so follow along there for breaking news and random memes.