Taxes for Freelancers: The Basics

If you're a freelancer, your taxes are going to be a little different than if you're employed at a company.


Because as a freelancer, the IRS considers you a small business. This means that in their eyes, you are both the employee and the employer- and you have to fill out tax forms for both. Even if you hire a tax preparer or CPA to do it for you, I recommend understanding the basic concepts. It sounds pretty complex at first, but once you get a hang of what's going on, you can use your knowledge to run your business optimally and never get a shock at tax time.

Don't be an "ostrich freelancer" - burying your head in the sand when it comes to your business. When you know what's going on, no one can take advantage of you!

Employee vs. Contractor

When you're a freelancer, you are a contractor. This means that instead of being an employee of the company, you're a separate business that the company has hired to do some work for them, often with some kind of spoken or written contract in place.

You've probably hired contractors, too. When you get a haircut, you hire someone to do some work for you, but they are not your employee. Same with a plumber or a roofer, or the guy who does your taxes.

It would be silly to say that these folks are your employees: you don't dole out their health insurance or vacation time, and they probably work for lots of other people who aren't you. They probably bring their own tools and set their own hours. And when your hairdresser is done cutting your hair, she doesn't file for unemployment!

When you're a contractor, it's the very same thing. You may do freelance work for individuals, or for businesses. If you do over $600 worth of work for a business during the year, they will issue you a Form 1099 for the end of that year. This tells you- and the IRS- how much you made from them.

The IRS starts to get realllllly suspicious if the amount on your 1099 is more than you claimed to have received when you file your taxes.

You're your own boss - for better or for worse

If you were an employee, your employer would take some things out of your paycheck:

- A good guess of what your Federal taxes will be based on what you told them about you when you filled out a w-4 form. If you overpaid, you get the overpayment back as your tax refund when you square up with the IRS in April.
- Same thing for State and Local taxes
- 6.2% of your earnings for Social Security, and 1.45% for Medicare taxes. These are called FICA taxes.

By law, your employer has to take these out. If they're not doing that, you're either a freelancer already, or your employer is paying you illegally "under the table".

As an employee, you might also get these things taken out of your paycheck if you choose them:

  • 401(k) Contributions: Part of your paycheck goes into a special retirement bank account where it is held for you until you retire or leave the company. That special bank account gets gentler tax treatment from the IRS, so you lose less of it to Uncle Sam. If you leave the company, it can be transferred into another special bank account called an IRA. 
  • Health Insurance
  • Union or Uniform dues, if you have them

Employer's Share of Payroll Taxes - Double Ouch for Freelancers

In addition to the taxes they set aside from your paycheck, they also pay an additional 7.65% for Social Security and Medicare: the employer's share of FICA taxes! When you're an employee, you never see this because it comes straight from your employer, but it is one of the costs of hiring someone.

If you are a freelancer, none of this comes out of your paycheck, but you still owe it. You are expected to take it out yourself, because you are your employer.

That's right: that means you have to take out both the employer's share AND the employee's share of FICA taxes! 15.3% of your freelance income vanishes to the tax man right off the bat- and that doesn't even include federal or state taxes! This means, by definition, freelancers have an extra 7.65% tax burden over employees. Adjust your billing rate accordingly.

It's not fair!

No, no, it's not fair. And to add insult to injury, a lot of would-be employers decide to hire people as contractors for the sole purpose of not having to pay that extra 7.65% tax on them, and also to get out of offering them health insurance and having to run a payroll to keep track of it all. This shoves not just the tax burden but the recordkeeping burden onto the contractor.

The IRS has noticed and really clamped down on the rules about who can be a contractor, and who has to be hired as an employee. They've come up with some guidelines on how to tell if you are misclassified.  They have also made it crystal clear: nannies are never contractors.

If you have been hired as a contractor, but should really be an employee, there is a form you can fill out called an SS-8. The IRS really does not like tax dodgers, and will swoop in to collect that 7.65% that your employer has been wrongfully fopping on to you.

If you're actually a contractor, however, then the tax burden is truly yours to carry. Set your rates high enough that you can absorb it, refuse jobs that underpay you, and put the money aside so that it's there when the time comes to send it to the IRS. It was the IRS's money the moment your client handed the check to you. Don't spend it.

Yes, taxes as a freelancer are rough. But if it makes you feel better.... you also get a few extra benefits as a freelancer:

You get an extra layer of tax write offs.

What is a write-off? It's basically an amount that you get to exclude from your income for tax purposes.

Let's say you draw someone a picture for $1000, but spend $100 on supplies. You should only really be taxed on the $900 that's left over, so the IRS lets you write off the cost of supplies.

Since the IRS sees you both as the You-Business and the You-Person, you get two chances to take deductions. These reduce the amount of your income which gets taxed, which in turn helps reduce your taxes.

So, you get to take business deductions and personal deductions.

You take business deductions on a form Schedule C (take a look at it, but don't freak out: your CPA or tax preparer can help you fill it out). Here, you deduct your advertising costs, your utility costs, the costs of your supplies and everything else the You-Business spent to make money- as long as it is ordinary and necessary. (No writing off that trip to Cancun! You know it wasn't for business reasons!!)

This is why it is so important to keep a separate list of everything you spent as a business. It's best to have a separate bank account for business-related expenses.

Once you've deducted your business costs, you are left with a new number. The simple math goes like this:

  Total amount of $ Received from Clients
- Costs

Net Income

The FICA taxes that you pay are based on this after-deductions number, the Net Income. In fact, you take the number from the schedule C and move it right on to Schedule SE, where you figure out how much you owe in self employment taxes!

 So you can really cut off large amounts taxes you owe by deducting all your business spending! Just be careful: the amount you will get from Social Security when you are old is tied to your net income. You have to pay in to Social Security to get money out of it. People who over zealously took business deductions have been very disappointed in the size of their Social Security check. 

After you deduct your business expenses on the Schedule C, you get to take your second layer of deductions: your personal deductions. You take these as you normally would if you weren't a freelancer: either the standard deduction or itemized deductions.

This doesn't mean that you can write off the same thing twice. But it does mean that you can write off a lot of things in the business section that you wouldn't be allowed to if you were an employee, like pencils and paper that you bought, computer software, or art supplies. If you are a stripper, you can write off your stripper shoes and the makeup you wear on stage. If someone pays you to take pictures of yourself covered in spaghetti, you can write off the spaghetti.

If you bought a lot of spaghetti and only used half for your photoshoot, only write off half the cost of the spaghetti.

Just keep good documentation in case the IRS asks you to defend your claim. I like to keep the date, the payment method, the amount, and the client or project it went towards. The receipt covers most of this.

Other Tax Benefits for Contractors

1/2 Personal Tax Write Off For Self Employment Tax

You know how you pay double FICA? You can write off 1/2 of the total amount from your schedule SE on your federal income taxes. It is only fair that you shouldn't have to pay federal taxes on that money. Employees never even see that money, let alone pay income tax on it, as it comes straight from their employer.

This can be a HUGE tax deduction, and affects your modified adjusted gross income (MAGI), which means it lowers your total income in the eyes of the IRS. This is handy when it comes to qualifying for an Obamacare subsidy.

Health Insurance Write Off

Since you are your own employer, you're responsible for your own health insurance. This can be very difficult as a freelancer. Luckily, every penny you spend on your own health insurance as a self-employed person is tax deductible!

And guess what- it's also "above the line", so this lowers your MAGI too!

When squaring up your Obamacare / ACA credits, this creates a chicken-and-egg scenario. MAGI affects your ACA credit, which affects your MAGI, which affects your ACA credit, which affects your MAGI..... I literally could not do my taxes without it turning into a calculus problem! If you're looking for the solution, this blogger figured it out. 

Estimated Taxes and Safe Harbor

Remember when I was telling you how employers take some money out of your paycheck as a guess of what your Federal, State and Local taxes may be?

As a freelancer, you have to do that yourself, too. If you expect to owe more than $1,000 in taxes, you must send in estimated taxes four times per year. How will you know if you might owe $1000 or more? There's a worksheet on page 6 of this IRS guide. Fill in the numbers to the best of your ability- it is just a worksheet to help you figure it out, not an official form you need to send in to the IRS.

Send in your estimated taxes every quarter. They are generally due on the 15th of April, June, September and January for the quarter that precedes them.

Safe Harbor

Taxes are pay as you go, meaning, the IRS wants you to send them the tax you owe soon after the quarter you started owing it. Even if you send in all the taxes you owe on the last day to file, you might still be penalized! This is why employees have withholdings, or money that's been set aside, taken out of their paycheck by their employer.

Now you are your employer, so estimated taxes will take the place of your withholdings.

But as a freelancer, it's hard to estimate what you will make. What if your income suddenly goes up with a surprise project late in the year? This is where safe harbor protects you.

If you withheld enough this year to cover all of whatever your tax amount was last year (or 110% if your income is over 150k), you're protected from the penalty. So, the bare bones way to do it if you expect your income to increase is to figure out how much your total tax was last year, and be sure to send that same amount in. You can find the total on line 63 of form 1040, or line 12 of 1040-EZ.

Keep in mind, you're going to deal with some taxes as an contractor that you didn't have to tussle with as an employee: namely self employment tax, which is a doozy.

Safe harbor won't change the actual amount that you'll owe, so to avoid getting kicked in the pants with a giant bill at the end of the year, I'd suggest you send in estimated payments that are as close to reality as you can make them, unless you can get some kind of fantastic interest rate in your savings account. Either way, set that money aside somewhere safe. Do not spend it. It belonged to the IRS the moment you received it.

Ways to Reduce your Taxes as a Freelancer

Business Deductions: Make sure you are taking all of the business deductions you are entitled to. Of course, never lie, but think hard about what you can really deduct. Talk to other freelancers to see what they are deducting. Remember: the mantra is "ordinary and necessary".

Start a traditional IRA: Contributions to traditional IRAs also lower your Modified Adjusted Gross Income, which can save you money both on taxes as well as your Obamacare premiums. Depending on your situation, a Roth may be better for you (although it won't reduce your taxes this year), so be sure to have a conversation with your advisor before.

Traditional Solo 401(k)s: Much like IRAs, traditional 401(k)s give you an additional $18,000 / yr to legally hide from the tax man.

The problem with a lot of peoples' 401(k)s is that their employer only offers crappy funds in a crappy plan. As your own employer, you can start your own Solo 401(k) anywhere you want, and choose somewhere that doesn't have crappy funds with high fees! I like Vanguard and Fidelity.

Since you are your own employer, you can even give yourself a "match"! Talk to an advisor to see what works best for your specific situation. I also recommend reading The Simple Path to Wealth by JL Collins if you are new to retirement investing. It is an easy read which will get you oriented.

Health Insurance: If you were on the fence about buying the better health plan, knowing that it's tax-deductible for self-employed folks might influence your decision.

Freelancers, do you have any tips and tricks for staying organized for tax time? Let me know in the comments!

Notes: The tax forms I provided links to are for the year 2016, so make sure that if you're trying to fill them out, use the correct year, whatever it may be. Since everyone's situation is different, this isn't tax advice, but rather general information to get you oriented to the way things work as a Sole Proprietor. Always talk to a CPA or business adviser about the right business structure- I had a friend who downloaded some legal forms online without understanding what they meant, and made her small business a C Corp. Cutting corners on the CPA cost her more in the long run when she screwed up her tax situation. Don't do that!

1 comment:

  1. Great tips for all soon to be jobless people.I must say by following your above mentioned tips,someone can make maximum utilization of his time and money.