Keeping track of taxes in the US isn’t exactly a piece of cake. There are so many types of taxes that it’s difficult to know which ones apply to you and your business. If you don’t file your taxes correctly with the IRS, it could result in penalties, which could cost your business a lot of money. This article explains the main types of taxes so that business owners can inform themselves to see...
One of the most unpleasant, daunting tasks in a freelancer’s life is filing their annual tax return. If you are a freelancer and want to attempt filing your own tax return without the help of a professional, you should have a decent idea throughout the year of what your taxes will be when it comes to filing season. Keeping on top of your records can save a lot of stress and work.
However, if you have recently become self-employed, you may feel uncertain about filing your taxes. Questions can always arise when filling out your forms. In this article, we will clarify the most important points and provide you with a step-by-step guide to what is important when filing a self-employed tax return. The first thing to cover is what taxes you may be liable for as a freelancer.
- What kind of taxes do freelancers need to pay?
- How to file a tax return: a guide for the self-employed
- When do I need a tax consultant?
What kind of taxes do freelancers need to pay?
Freelancing is a popular choice for many workers in the USA, but for tax purposes, the term does not exist. Freelancers file taxes under the term “self-employed” or “independent contractor.” Depending on which category you file under, you may be liable to different taxes. However, all self-employed people and independent contractors are required to pay state and/or federal income tax, and self-employment tax. Additional tax may be required depending on your type of business, and will be discussed later.
Freelancing is a generic term for commercial activities undertaken by self-employed people or independent contractors. For tax purposes, there is an important distinction between the two categories when it comes to determining how to tax their income. Please consult this IRS guide for more information.
Income tax at federal level refers to the calculated taxable income from business activities, or in the case of a side job, total taxable income. All self-employed people and independent contractors are obliged to declare income tax, regardless of whether their income comes from a commercial enterprise, rental income, interest income, income from participations, or freelance contracted work. However, this does not mean that you automatically are obliged to pay federal income tax: if your income is below the statutory basic tax-free amount, you are not required to pay income tax. At the moment, the national minimum for single filing status is $10,400 if you are under the age of 65. Self-employed people and independent contractors are always obliged to file their taxes (unlike certain other categories of worker), however, if their income falls below this bracket, they are not subject to federal income tax. The threshold for state and local income tax varies from state to state. More information about state tax can be found here.
In 2017, the taxable income threshold was $10,400 for a single individual (under 65), and $20,800 for married people filing jointly (under 65).
While there is no federal sales tax in the US, most states impose their own sales tax on traded goods or services (Alaska, Montana, Delaware, New Hampshire, and Oregon being the exception). That said, the 46 remaining states each have their own sales tax rates and rules. On top of that, many states also allow city and local governments to impose their own additional sales tax onto goods and services, so that residents in certain areas of a state may end up paying more than others. Self-employed people may be required to file their sales tax return depending on their state and locality. More information regarding state to state sales tax rates may be found in this handy state sales tax map.
How to file a tax return: a guide for the self-employed
If you are self-employed and want to file your own tax returns without the help of a tax professional, there are a few things to keep in mind. Simple tricks and tips can save a lot of work and stress at the end of the year. In the following step-by-step instructions, we explain how the self-employed can pay their taxes correctly without too much effort.
Documenting revenues and expenditures: an overview
The most important thing when filing a tax return is to have a clear, comprehensive overview of your financial year. While there is no actual law in place requiring business owners to keep bookkeeping records, it is in their interest to adhere to the “Generally Accepted Accounting Principles” (i.e., the US GAAP, an accounting standards created by the U.S. Securities and Exchange Commission) to run their business smoothly, file their taxes effectively, and explain themselves should they become the subject of an Internal Revenue System (IRS) audit. The same goes for the self-employed. The clearer your records are throughout the year, the easier if will be to file your tax return at the end of the tax period.
As a rule, two Excel tables are sufficient to clearly document income and expenditure: one for revenue and one for expenditure. These tables should include the date, service provider/salesperson, service or product description, gross amount, and document reference number (for receipts, invoices you have kept as proof of purchase/sale) in separate columns. If you are also liable for sales tax, you can create columns for net amounts, sales tax, and calculated sales tax. This will help you keep track of things and save work in the long run.
Organization: collecting and sorting documents
Having revenue and expenses is one thing, being able to keep track of them is another. Business activities always need to be documented, and it is better to have too many than too few. Supporting documents should include receipts for cash payments, transfer receipts, and delivery notes, as well as pay slips, fuel, and entertainment receipts.
Another important benefit of document organization is the legal obligation to keep receipts. The IRS requires all freelancers to keep business records for four years in the event of a discrepancy in your tax return that might warrant investigation. You are also required to hold onto your old tax returns for at least 3 years from the April 15th deadline or date of submission. Many states also impose their own time when it comes to audits. While many of them follow the federal IRS recommendation, some have longer wait periods.
While there is no law stipulating what kind of bookkeeping system you use, it can often be easier and more accurate to use a digital filing system, as well as retaining your paper slips. Recordkeeping requires a good organization system right from the start, and should be user friendly so that you can add new documents to your database as you get them. To do this, programs create different folders where collected documents are systematically filed.
If your business is operating with a cash accounting method, then two core folders are usually sufficient:
- Account statement folder, filed chronologically; the corresponding documents are filed behind each account statement (unless you have a monthly cost and can file a monthly copy of a lease agreement, etc.)
- Folder for cash documents, in sequence with a document number
For very small companies, a simpler method of document organization may work more effectively: a folder that contains documents which are sorted by date and type (telephone bill, postage receipts, office expenses, etc.) is likely to be sufficient. Additionally, account statements need to be stored chronologically, with none absent.
However, if profit is instead determined through the accrual accounting method (profit and loss account and balance sheet), then a different method of document organization is recommended: the Internal Revenue Service (IRS) requires some businesses to use the accrual method, for example, those that carry inventory over certain levels.
- A/R invoice folder, sequential with document number
- Incoming invoice folder, sequential with document number
- Account statement folder, sorted chronologically
- Cash book folder including supporting cash documents, sorted and documented chronologically
Since receipts need to be kept for several years, and machine receipts fade quickly, they should be kept together with backup copies if possible.
Calculating profit: cash method or balance sheet?
Through the topic of determining profits, we are slowly coming closer to the actual tax return. This is because the amount of income tax you pay depends, among other things, on how much taxable profit you have made – so one of the first questions that arises in a tax return is how to correctly calculate your profit. There are two options for calculating profit: Profit is either determined through the accrual accounting method using a profit and loss account and a balance sheet, or by the cash method – where expenses aren’t recognized until the money is actually paid out.
As a self-employed person, you can enjoy a few advantages when it comes to filing taxes. While larger corporations and individuals may have other specific accounting obligations when it comes to proving profits, a simple profit margin report is sufficient for the self-employed. A profit margin report simply refers to the amount of revenue from sales that exceeds running costs of the business, and can be ascertained by simply subtracting your business outgoings from your business earnings. Depending on whether your profits are higher than your expenditures, you fill out different sections of your self-employed tax return (page 1 of the form 1040).
As well as popular accounting programs which can help creating a balance sheet, there is also software available to help you work out your net profit.
There are definitely advantages and disadvantages to working out net profit from cash-based accounting, and using the accrual method with a balance sheet and profit and loss margins. Depending on how complex your business’ structure is, and how consistent your profits are, both options can be beneficial.
Savings: what can I deduct?
Car expenses, office supplies, purchasing goods, travel expenses, rent (for business premises), employee wages – there are many categories of expense that the self-employed can deduct from their tax payment, since many operating expenses can be fully or partially deducted from income. This reduces taxable income and the amount of income tax to be paid. In contrast to employees, the self-employed have a pretty wide scope here, but also run the risk of having their expense claims denied.
When it comes to determining profits, the self-employed should always take into account which items can be deducted from their income. Typical costs that can be fully or partially deducted include:
- Office supplies, books
- Rent (for business premises)
- Training and (relevant) educational costs
- Wages paid
- Cars and other fixed assets liable to depreciate
- Individual retirement plans (IRAs)
- Entertainment costs
- Travel expenses
There are some other items that cannot be deducted directly from tax returns, but can be written off over several years: typical depreciable items are known as durable assets, i.e. purchases of greater value that have longer lives (machinery, computers, office furniture, company cars).
Submitting: filling out your forms and submitting self-employed tax returns
Self-employed people have the option to file their taxes electronically (through the electronic federal tax payment system (EFTPS)), through the mail, or through a registered tax professional.
Which forms exactly do you need to fill out? All self-employed people must submit estimated tax returns on a quarterly basis to ensure that their social security, Medicare, and income taxes are being paid. To do this, you are required to submit a form 1040-ES.
Different forms are required for filing your annual tax return. Schedule C or Schedule C-EZ is where you declare profit or loss as a sole proprietor. Schedule SE (form 1040), self-employment tax is used to file your social security and Medicare taxes. It is also highly likely that you, as a self-employed person, are liable to file an information return to prove your expenses and profits to the IRS.
Once you have completed these forms, the tax return needs to be filed within the deadline. The 2018 tax year came to an end on April 5th. The deadline for filing 2018/19 self-employed tax returns is 31st January 2020. Please keep an eye on the IRS website, as these dates may be subject to change. If you find yourself short on time, you may file for a six-month extension with a written application, or online through the IRS’s electronic filing program, filling out form 4868.
Review: lodging an appeal
One you have submitted your tax return, there is nothing to do but wait. Forms submitted electronically are generally processed within 21 days, and mailed returns can take from 6-8 weeks to be processed.
Once you receive your tax bill or refund from the IRS, it is good business practice to have each tax assessment checked by a professional. After all, even tax officials can make mistakes. Once you receive a determining from the IRS, you have 30 days to launch an appeal. This must be done in written form, and your appeal request should be posted to the IRS address on the letter, rather than directly to the Office of Appeals. Your protest should outline why you consider their determination incorrect, as well as referring to your appeals rights as an individual.
When do I need a tax consultant?
Should the self-employed file taxes themselves, or is it better to have a specialist do it for them? This depends on the situation, but if hiring a tax consultant is an affordable expense, it is worth considering. Hiring a professional has considerable advantages: they save themselves a substantial amount of work, and do not have to worry about having incorrectly submitted documents.
The decision mainly depends on two aspects: how profits are determined, and what size of business you run. Although a net profit calculation is simple, if you choose to go for a balance sheet, this can be much more complicated, and it would be advisable to consult a tax professional. When you reach the point where you have multiple employees, many business owners find the tax filing process to be too complex to undertake alone.
Conclusion: under no circumstance are you legally obliged to hire a tax consultant. However, if your business activities are extensive and you have a complex method of profit determination, a tax consultant is recommended. Regardless of whether you choose to avail of professional help, all self-employed people should have good knowledge of how their taxation works – if they constantly rely on external individuals to handle their tax issues, business decisions may be made from a point of ignorance, which could damage the company from a tax perspective. Having a basic understanding of taxation will help you run your business more consciously and will help you avoid financial disadvantages – with or without a tax consultant.