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Taxes for Freelancers and Sole Proprietorships

Starting your own business as a sole proprietorship or freelancer can be intimidating. The idea of not knowing how much money you will make regularly and dealing with new concepts like advertising and budgeting is often enough to scare even some of the bravest entrepreneurs away. Freelancers often work on contract for many different clients, so their income can be sporadic. Some freelancers choose to freelance on the side or use the work as extra income. Sole proprietors, on the other hand, are often associated with an established business location, will generally work full time, and are more likely to hire employees. Regardless, their tax treatment is similar.

If you think you are ready to dive in, you should not only consider your workload and future; you should also have a good handle on what your taxes will look like. Planning now can help you avoid a nasty tax surprise at the beginning of next year.

The Basics: How Are Independent Businesses Taxed?

Just like individuals, your business venture will be taxed on every dollar it makes. You should keep close track of your invoices and every cent that comes in your door. You should also monitor and maintain documentation of each expense related to your business. Because freelancers and sole proprietorships are not technically separate taxable entities like a corporation or LLC, your business-related taxes will combine with your regular income tax forms each year.

If you own a sole proprietorship, the IRS considers that a pass-through entity. Your income will be reported on Form 1099s instead of W-2s. As a sole proprietorship, you are actually taxed on your profits, not your total revenues. That means that your expenses are important to decrease your taxable income. You will report your income from your sole proprietorship or freelance business on a Schedule C—a completely separate part of your tax return.

Getting a Tax ID Number

As a small business owner, it might be a good idea to get an Employer Identification Number (EIN) for tax purposes. Your EIN is used just like a Social Security number. It can be used in your tax documents, applying for business licenses, and opening a business bank account.

Not every type of business needs an EIN, however. If you have employees, you must get an EIN. You must also get an EIN if you have certain retirement plans as well. Nonetheless, many freelancers and sole proprietorships forgo getting an EIN because they simply do not need it. Perhaps they work alone, or they only hire independent contractors. The IRS provides a handy checklist to determine whether you actually need an EIN.

Working for Clients: Form W-9

When customers realize you are an independent contractor, such as a freelancer or sole proprietorship, they will often have you fill out Form W-9. This form provides them with basic information about your tax status including a taxpayer identification number (TIN), which is usually your social security number.

Form W-9 is used in conjunction with a variety of 1099 forms that are not exclusively for freelancers and sole proprietorships. Other entities may use W-9s together with the following 1099 forms:

  • 1099-INT: Interest earned or paid
  • 1099-DIV: Dividends from any source
  • 1099-MISC: Income, prizes, and mutual funds
  • 1099-B: Stocks or mutual funds sales (and other transactions by brokers)
  • 1099-S: Proceeds from real estate transactions
  • 1099-K: Merchant card and third-party network transactions
  • 1099-C: Canceled debt
  • 1099-A: Acquisition or abandonment of secured property

Although someone working as a freelancer or as a sole proprietorship can have any of these 1099 forms, the most common is the 1099-MISC.

Services: Form 1099-MISC

Each client that you have that pays you over $600 for your services should submit a Form 1099-MISC to you directly. Form 1099 will include the following information:

  • The name of the payer (your client)
  • The name of the recipient (your name and contact information)
  • The gross proceeds you earned from that particular customer or client
  • Any federal income tax withheld
  • Any state income tax withheld

The type of profits that you receive will have an effect on how the revenues are displayed on this form. Keep in mind, however, that only expenses related to services will require that your client give you a Form 1099, and you must report the income associated with a particular client even if you did not receive this form.

Not every transaction needs to be reported on Form 1099, however. For example, payments for merchandise, telephone services, storage, and similar everyday expenses do not require a Form 1099.

Products: Cost of Goods Sold

If your business is more focused on selling products instead of providing services, you likely will not see many 1099s. Your tracking is going to focus on the cost of your inventory versus how much revenue you bring in for that inventory. It is important to track these expenses because they will be a valuable income tax deduction.

This is known as the cost of goods sold. It is also sometimes referred to as “costs of sale,” and thinking of it this way may help you capture more costs. What costs related to your product help you create the product?

Costs of goods sold include every cost attributable to the production of a good. These costs may include the following items, but this list is by no means exhaustive:

  • Materials used to produce a product
  • Labor costs associated with making the product (hourly wages to employees, for example, but not payments to yourself)
  • Distribution costs (shipping, handling, transportation, etc.)
  • Packing and containers
  • Expenses related to necessary materials in your location

You should also generally include your overhead expenses in your cost of goods sold. Many new freelancers and sole proprietorships often forget this important cost. This includes things like:

  • rent,
  • heat,
  • power,
  • insurance,
  • depreciation, and
  • supervision.

Total Overhead

Your total overhead should be divided up by the number of products you created and added as a cost to each piece.

Businesses that rely on products for income do not have a separate tax reporting requirement for payments from their clients. Instead, you must closely track how much each product is sold for and the cost related to creating each product. This information will be important for your individual tax return. It may be helpful to have a bill of sale for larger transactions, and some states may require it in certain situations.

Sales Tax 101

Perhaps one of the most confusing aspects of taxes for small businesses is tracking sales tax. Sales tax is a point-of-purchase tax that is imposed by state and local governments. It is paid by your customer, not you. It should be added to each and every purchase that leaves your business.

You may need to acquire a permit from your state to start collecting sales tax. Some states do not have a sales tax, but most do. You should also keep an eye out for local sales taxes, but not all areas have these either.

You may be required to pay sales tax quarterly or monthly, and some states require that you fill out a special tax return that reports the following information:

  • Total sales
  • Taxable sales
  • Exempt sales
  • Amount of tax due

Failing to pay sales tax on time can result in penalties, so it is important to understand your obligations. Some goods and services are exempt from sales tax, and these will vary by state.

Sales Tax for Transactions in Different States

Internet businesses are becoming more and more common, and sales taxes for selling to individuals in different states can be tricky. However, most online businesses do not have to collect sales tax right now. There may be some changes in the future regarding this requirement, but the general rule in most states is that you have to have a physical presence in that state to be required to collect sales tax. A physical presence means that you have a location, warehouse, employees, or an office.

Unfortunately, many sole proprietorships do not realize that they need to collect sales tax, and that can get them in trouble with the local and state taxing authorities. Be sure to check your state’s local rules regarding sales tax, particularly if selling products is a major part of your business.

Self-Employment Taxes

As an employee, you not only pay income taxes, but you also pay taxes to Social Security and Medicare. You must still make these contributions as a sole proprietorship or freelancer as well. These charges are known as “self-employment taxes.” They are separate from your income tax obligations, but they are included on your income tax return. The self-employment tax rate is 15.3%. Of that, 12.4% is usually for Social Security and the other 2.9% will go to Medicare.

Employees pay about half as much as sole proprietorships to these programs because the employer will also pay half as well. However, self-employed individuals also get a tax deduction for about half of their self-employment taxes. That way, there is no “penalty” associated with being self-employed. Self-employment taxes are reported on Schedule SE, which is filed in combination with your regular income tax return.

Schedule C: Income Taxes for Freelancers and Sole Proprietorships

All of your income and expenses will end up on Schedule C, which is part of your Form 1040 income tax return. The schedule will indicate your total profit and loss from your business. All of the data you have been collecting all year will end up in this form. Every sole proprietorship or freelancer that has income from their business will file a Schedule C. From an income tax standpoint, this is the only additional filing requirement for these types of small businesses.

Depending on your type of business, this form can be straightforward or somewhat complicated. Be sure to reference the instructions provided by the IRS if you have any questions.

Paying Your Income Taxes: Estimated Tax Payments

One of the most common ways that sole proprietorships and freelancers get tripped up at tax time is by failing to pay their estimated tax payments throughout the year. When you own your own business, there is no one taking out taxes on a regular basis on your behalf. You are obligated to do this on your own by paying estimated taxes. This process involves estimating how much income you have at the end of the year and paying taxes related to that amount.

Sole proprietorships and freelancers must pay taxes four times per year (quarterly). If you are expected to owe at least $1,000 in taxes for the year, you should make estimated tax payments. For someone starting out, it can be difficult to determine how much tax you need to pay. However, failing to make enough payments can result in penalties. Sit down and do some math after you have been operating a few months to take a guess at how much your taxes will be. It is better to overestimate than underestimate. Use the rate schedules and last year’s tax return as a starting point. Paying anything will cut down on the penalties associated with underpayment.

Your state may also require that you make estimated tax payments as well. In most situations, you can go online and make your estimated tax payments. You can also print vouchers to mail in with your check. The federal government also offers options for you to pay by phone or set up a direct transfer. Payments by debit or credit card are also accepted.

Estimated tax payments are due on the fifteenth day of the fourth, sixth, and ninth months of the current fiscal year and the fifteenth day of the first month of the following year. For most small businesses, this is a calendar year, but if your sole proprietorship operates on a different calendar, you should track the months and pay accordingly. It is rare for freelancers and sole proprietorships to change the regular schedule, but it does happen.