When you launch a small business, taxes may not be your priority. Chances are that your focus is on drafting a business plan, creating a website, obtaining financing and either renting commercial space or creating a home office. Taxes may not be top on your list, but they should be a major consideration before starting your enterprise.
Choosing your business structure
First you must select your business structure. There are several types of business or legal entities for the self-employed, including:1
- Sole Proprietorship
- Limited Liability Company (LLC)
The entity you choose will play a significant role when operating your business—from how you and your company pay freelance taxes to your liability for business debt. For most freelancers, sole proprietorship is the default business structure when starting a company instead of forming a LLC or a corporation. In fact, sole proprietors and contractors represent 80% of the 30 million small businesses in the U.S., according to Bloomberg.2 As far as freelancers go, an annual study by Upwork released last September found that 59 million Americans had completed some freelance work in the previous 12 months, 2 million more than in 2019.3 “Cause I’m the taxman. Yeah, I’m the taxman,” a Beatles’ song
When is the tax deadline for freelancers?
Freelancers have to pay taxes four times a year:
- January 15: Self-employed workers have to pay fourth quarter 2020 estimated taxes by January 15, 2021. Each quarter, freelancers need to file the 1040-ES form.
- April 15: Freelancers have to pay first-quarter 2021 estimated taxes7, along with income tax and self-employment tax for the year.
- June 15: Deadline for freelancers to pay second-quarter estimated taxes.
- October 15: Third-quarter estimated taxes are due.
What’s the minimum that freelancers need to earn to file income taxes?
Usually, $12,200 is the minimum income that a single person must earn to file an income tax return, and $24,400 for married couples filing jointly. However, if you are a freelancer, $400 (not a typo) in earnings is the minimum that triggers the requirement to file a tax return.5 This is only true for freelancers who receive the entire amount they bill for completing a project and taxes are not withheld by the client, as would be the case if the employee is a full-time worker and paid via a W2. Why $400? The freelancer may not be on the hook for income tax on the $400, but he or she still has to shell out for self-employment taxes for earnings of $400 or more. As a sole proprietor, you are responsible for Social Security and Medicare taxes (just like employees and employers pay) on your net business income, or the self-employment tax, usually about 15.3% of 92.35% of your profit. Certainly if you have business expenses, you must file a Schedule C or C-Ez to report them. For example, suppose you grossed $5,600 in earnings in one year and incurred $4,600 of expenses, your net would be $1,000. In this case, you can not avoid the taxman. Your earnings are below the minimum for income tax, but you have to file a return and pay self-employment taxes. Single freelancers who are younger than 65 and gross more than $12,200 annually have to pay federal, state and city taxes (for married couples filing jointly, the gross income would be $24,400 if each one is younger than 65). In addition, individuals who work for themselves have to pay self-employment tax that includes Social Security and Medicare taxes. Full-time employees (and some contractors) who receive a W-2 pay half of the total Social Security (6.2%) and Medicare (1.45%) taxes, while employers are responsible for the other half. Thus, self-employed individuals are responsible for paying both portions of the Social Security (12.4%) and Medicare (2.9%) taxes because taxes are not withdrawn from their payments.
How to file taxes as a freelancer
- Form 1099-MISC The most-important form for a freelancer is the 1099-MISC, usually referred to as a 1099. When you receive $600 or more from a client during a calendar year, the client is obligated to send you a 1099 documenting your income by Jan. 31 (i.e., if you were paid $600 for a project in 2020, you must receive the 1099 by Jan. 31, 2021). Freelancers do not have to attach the 1099 forms when filing their tax returns, but it’s prudent to keep them for future reference in case the IRS audits the returns. You still have to report income earned from clients that compensated you less than $600 during the year as a freelancer, even though you did not receive a 1099 from these customers. It’s best to maintain accurate records of income earned during the year.
- Form 1040-ES The next most-important form is the 1040-ES, used to compute and pay your quarterly estimated taxes. This form is vital because it helps you keep pace with your income taxes, reduce the total amount you will owe on April 15th and avoid penalties for underpayment. Freelancers benefit from paying taxes throughout the year because taxes are not withdrawn each paycheck.
- Other Forms Your firm’s business structure will also determine which forms you have to file. A sole proprietor will file one tax return on April 15, IRS form 1040, and list business income and deductible expenses on Schedule C, Profit or Loss from Business. If your enterprise is a partnership, the business income and losses are distributed to each partner and reported on their individual tax returns. Each partner files a IRS Schedule E with his or her return, detailing the partnership income and deductions. Partnerships must also file an annual tax form, Form 1065, U.S. Return of Partnership Income, to inform the IRS about your partnership’s annual earnings, deductions, profits, losses and tax credits. Just like other freelancers, each partner must pay income tax, along with Social Security and Medicare taxes (i.e., self-employment tax) on their share of the partnership income.
Freelancers can deduct a long list of business expenses so it’s worthwhile to study all the deductions permitted by the IRS and track all expenditures. The list includes items that are purchased to conduct business such as books, magazines, reference material, purchases of equipment and business insurance. Other categories include travel and entertainment such as airplane tickets, trains, Uber rides, subways and buses, along with business meals. Membership to professional organizations qualify too, along with costs of day-to-day business costs such as office rent, office supplies, and utilities.6
What are tax penalties for freelancers & how can you avoid them?
The IRS stipulates that you may be charged a penalty if you don’t pay sufficient tax either through withholding (full-time workers) or estimated tax payments during the year. You also may be charged a penalty if your estimated tax payments are late, even if you will be eligible for a refund when you file your tax return. The IRS’s formula for calculating underpayment penalties is a bit complex and it’s best to take all possible steps to avoid them. Generally, the IRS will impose an underpayment penalty when you pay less than 90% of your tax liability during the year. The standard penalty is the federal short-term funds rate plus 3% of your underpayment, but the IRS will lower your penalty if you pay the taxes before April 15. Full-time workers who notice that if they did not pay enough taxes during the year can ask their employer to withdraw more tax; it’s trickier for freelancers. If your income fluctuates each year, the best way to estimate your quarterly payments is to use the 1040-ES worksheet from the IRS.8 The worksheet shows you how to calculate your expected tax liability and provides several common deductions you may qualify to claim. To prepare for quarterly tax payments, many experts recommend setting aside 30% of each client payment for taxes to ensure you can meet your tax obligations. That amount should be enough for federal (including Social Security and Medicare), state and self-employment. However, freelancers who are based in cities with high taxes, such as New York City, may be wise to increase the amount in the kitty to 40% of all earnings. Freelancing brings many rewards such as independence and variety of work, but it also entails a greater level of responsibility. If you are new to freelancing, you may have not given much consideration to paying taxes. New freelancers may be used to a traditional job where the employer automatically deducts all the necessary taxes, along with FICA, unemployment insurance, Social Security and Medicare payments for you. The first step is knowing your business structure; will it be a sole proprietorship, LLC or partnership. Freelancers often launch their enterprise as sole proprietor but later switch to a LLC for tax reasons. The threshold is just $400 from one client in a year for the IRS to consider you to be self-employed. At this point, you must file taxes as a business owner. You will be responsible for the standard income taxes based on your tax bracket and filing status, along with a self-employment tax of 15.3%—that is the Social Security and Medicare taxes you would have paid as a full-time employee, along with the half that would have been covered by your employer. Freelancers will also have to start paying taxes four times a year. The IRS Form 1040-ES will be your guide to assist you accurately estimate how much taxes you will owe each quarter to avoid the dreaded underpayment penalties. Once you become a freelancer, maintaining your books and tracking earnings and expenses will be essential; you can’t just rely on receiving 1099 forms from your clients at the beginning of each year. Freelancers can seek many tools such as self-employment calculators to simplify the process. Finally, carefully study all the items that can be deducted to save money at tax time. Sources:
- IRS. Self-Employed Individuals Tax Center
- Michael Sasso, Mark Niquette and Ben Brody. Self-Employed Get Raw Deal in U.S. Multritrillion-Dollar Rescues. Bloomberg.com.
- New Upwork Study Finds 36% of the U.S. Workforce Freelance Amid the COVID-19 Pandemic, September 15, 2020.
- IRS form, Schedule C, Profit or Loss from Business.
- Susan Lee provides detailed information about freelancer’s tax requirements on her site, Freelance Taxation.com.
- Freelancetaxation.com. Tax Deductible Expenses for Freelancers.
- IRS. Link to form 1040-ES.
- IRS form. 2021 Form 1040-ES.