What Freelancers Should Know About Taxesby
Whether you have a side hustle or work for yourself full time, freelancers should know about the tax implications of the work they do. In this article, tax accountant Candace Dixon breaks down what freelancers need to file with the IRS and how professional advisors can help these self-employed clients.
Due to the COVID-19 pandemic and other extenuating circumstances, more people than ever are freelancing. Whether you are part of the “gig” economy (Uber, Airbnb, etc.) or are working as a freelancer, you should be aware of the many tax implications of freelance work.
Typically, you will receive a 1099-NEC (Non-Employee Compensation) and/or a 1099-K (Payment Card and Third Party Network Transactions) if you’re part of the gig economy, both of which are information returns that are reported to the IRS and matched against your tax return. Even if no 1099 form is received, you are required to report your income on your tax return if you make $400 or more.
Whether you have a side hustle or freelancing is your main job, you are required to, at a minimum, file a Schedule C Profit or Loss from Business with your tax return. A Schedule C reports the income or loss from either you on your own, or you as a single-member disregarded entity of an LLC. Either way, there are some taxes you should be aware of. There are seven tax brackets for the 2021 tax year: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent.
The highest individual tax bracket for 2021 is 37 percent based on an income of $523,600 for a single taxpayer. There are six additional tax brackets that depend on your filing status. According to Fundera, the average salary for a full-time freelancer is $68,300 a year, taxed at 22 percent for a single taxpayer in 2021. In addition to your tax rate, you must pay self-employment tax, another 15.3 percent on top of any income taxes. If you stop and think about it, you could very easily be paying 40 percent in taxes and not even know it. Nobody wants to give the government 40 percent of their income if they don’t have to.
If you are a freelancer who has chosen to protect your assets by forming a limited liability company (LLC), you may not have chosen to be taxed as anything other than a single-member disregarded entity and are still filing a Schedule C. A little-known fact is that you can remain an LLC and make an election to be taxed as either an S-Corporation or a C-Corporation.
You could choose to be taxed as a C-Corporation and pay a flat tax of 21 percent at the federal level, but C-Corporations are not for everybody. There is something called “double taxation.” If you take out anything more than a salary, you are taxed twice – once on any profit, and again on the “dividend” you’re taking out. Most freelancers who form a small business will find themselves better off being taxed as an S-Corporation for this reason.
An S-Corporation does not pay tax; instead, profits and/or loss flow to the taxpayer and is claimed on their personal tax return. Self-employment tax is not charged because you are not considered self-employed for tax purposes. Self-employment tax is Social Security and Medicare (FICA). When you’re an employee of a company, 7.65 percent is withheld from your paycheck for FICA, and your employer matches the 7.65 percent. When you’re self-employed, you are both the employee and the employer and must pay the full 15.3 percent self-employment tax.
While S-Corporation income isn’t subject to self-employment taxes the way sole proprietor income is, if you elect to be taxed as an S-Corporation, you must pay yourself a salary in the form of W-2 wages that are subject to FICA taxes, which is known as reasonable compensation. Therefore, saying that you’re “saving” 15.3 percent isn’t exactly true, because you are still going to pay FICA on the amount you take out in reasonable compensation.
There are many ways to arrive at reasonable compensation. One way is to think about what you would make doing the same job if you were working for a company that does the same thing that you do. On the other hand, since the gig economy is a relatively new space, reasonable compensation should be at least half of what your profits are. Revenue Ruling 74-44 gives the IRS the authority to recharacterize S-Corporation distributions or “dividends” as wages subject to employment taxes. Reasonable compensation is a complex issue and not for the faint of heart, and it’s not something you should try to figure out on your own. S-Corporations are audited for this very reason.
Electing to be an S-Corporation isn’t something that needs to be done immediately - you can elect the S status when you file your first tax return by filling out form 2553. Typically, you have until the fifteenth day of the third month to file your S-election; however, if you miss the deadline, you are allowed to file a late 2553 per Rev. Proc. 2013-30 as long as you have an acceptable reason, which could simply be that you didn’t know about it until you sought professional advice.
As you can see, this all has the potential to become complicated, and you should not take blanket advice to become an S-Corporation. Filling out form 2553 is not all there is to it: Most of the time, freelancers will see that the good thing about freelancing is that there is no overhead. The bad thing is, come tax time, there is no overhead.
If you’re working from home as a freelancer, you can take the home office deduction provided you use part of your home exclusively and regularly as the principal place for your business. However, as with any good tax law, there are pros and cons. Depending on which method you use, when you sell the home, you will have to carry back all the depreciation on the part that you called business property. This is a main deduction that freelancers take, but as you are effectively depreciating the home that you live in, the deduction you take today may not outweigh the taxes you pay tomorrow. If you rent, you don’t have to be concerned about depreciation.
You must keep records of the square footage of your home and what portion of it you are using as a home office, because electricity, water, insurance, taxes and other direct and indirect expenses are determined by the percentage you are using for business.
Other possible deductions include car and truck expenses, maintaining an online presence, the cost of supplies not in your inventory and more, for which there are exceptions, specific requirements and/or more than one way to calculate them. Then there are temporary rules related to COVID-19 that come into play: for example, while business entertainment is no longer deductible per the Tax Cuts and Jobs Act (TCJA) of 2017, business meals are still 50 percent deductible, and because of the pandemic, they are temporarily 100 percent deductible for 2021 and 2022, as described in Notice 2021-63.
In my career, I have seen many freelancers who don't think the income they earn “counts," or that it isn’t being reported to the IRS and doesn’t need to be reported on their tax return. Underreporting your income can and will be blown apart at an audit – the IRS is not stupid. Don’t think you can beat the tax man by getting paid in cash and telling the IRS you made less than what your actual living expenses were. Cash is traceable, just like a check, and even if you don’t deposit it, the IRS has various ways to reconstruct your income. It could be as simple as doing a cash flow analysis to figure out what your house payment was and then factoring in that you had to eat something, you had to wear clothes – you get the point. If you’re not reporting at least that much in income, then what did you live on? This is not the IRS’s first rodeo (Revenue Ruling 74-44 was, after all, written in January of 1974) and, no, they aren’t distracted by the pandemic. Trust me, you just can’t hide or disguise your income.
Accountants and authors alike cite the home office deduction and other freelancer “red flags” for a freelancer or small business audit, but you don’t need to rely on their opinions. The IRS itself specifically states that computer screening selects returns for small business audits based on a statistical formula that compares your tax return to the norms for similar returns. Returns may also be chosen for audit because they include transactions you did with someone else who is being audited (i.e., the person who pays you in cash that you may be tempted to not report).
As you can see, there are many ways to determine your income, many tax brackets in which that income can be taxed and many deductions, both temporary and permanent, you may be able to take. These complexities make it more important now than ever to get professional advice. While the IRS has an excellent partnership with tax chains who will do your return for free if you qualify, freelancer returns are not necessarily Free File returns. You may need professional help from a licensed accountant who specializes in tax and has experience working with freelancers and the gig economy.
You might think you can get some free information and proceed by yourself, but the potential unknowns of the current tax laws make it important that you hire a licensed accountant who specializes in taxation. Many people assume that all accountants specialize in taxes, but just because someone is a CPA or has a degree in accounting doesn’t necessarily mean that they specialize in taxation. Tax is a subculture of the accounting industry. A person is required to take only one tax class to receive a bachelor’s degree in accounting.
The gig economy may have boomed during the pandemic, but numerous surveys and publications suggest a noticeable increase in that direction well before COVID-19 that continues today. About 41 million people in the United States were classified as gig workers in 2018 and 2019. Both companies and workers alike are continuing to choose remote or freelance work. A person can now select “remote” as a location rather than a city and state when searching for jobs on Indeed.com, and the United States Bureau of Labor Statistics shows that 20.2 million workers left their employers between May and September of 2021, a move that’s been dubbed The Great Resignation. The 1099-K Requirement coming in 2022 didn’t become part of the American Rescue Plan Act for no reason. The IRS needs to keep track of increasingly unreported income from freelancers, whether it’s intentional or not, and collect taxes due.
Whether you’ve found yourself with a side hustle or derive all your income from freelancing, you can avoid a tax pitfall by getting professional advice.
Candace J. Dixon has been in practice as an accountant since 1996. She has a Bachelor's Degree in Accounting from Saint Leo University in Tampa, Florida, and is a Certified Advanced QuickBooks ProAdvisor. She specializes in taxation and advanced accounting, and is known for being well-versed in the Internal Revenue Code and the gig economy. Her...