Freelancing provides many great benefits - the pride and satisfaction of owning your own business, flexibility in how you accomplish your work, improved work-life balance, amongst others. However, with all the benefits comes all of the burdens of ownership including paying income and employment taxes. Understanding these obligations is important to ensure taxes are paid on time and without stiff penalties from the Internal Revenue Service. For the purposes of this article, I will assume that you are either a sole proprietor or the only member of an LLC which has not made a Form 8832 election to be treated as a corporation (and is also treated as a sole proprietor). Freelancers operating in the corporate form (with or without an S election) face additional reporting requirements and restrictions at the entity level.
Employer Identification Number
Most businesses are required to have an Employer Identification Number (EIN) from the Internal Revenue Service in order to process their ongoing tax obligations. Sole proprietors can use their social security number(SSN) in lieu of an EIN if they do not have employees or file excise, employment, alcohol, tobacco, or firearms returns. Despite this, freelancers may still want to get an EIN for their work as many businesses who pay you are required to get your either your SSN or EIN (through Form W-9) in order to meet their own information reporting requirements to the IRS (usually Form 1099-MISC). Having an EIN both future-proofs your business in the event you do need to hire employees of your own to help manage your work and minimizes the risk of identity theft through disclosure of your SSN to your vendors.
Like your former employer, you as a freelancer are subject to income tax on your freelance work’s gross income minus deductions and credits. As the vast majority of freelancers will be on the calendar-year cash method, this means that you recognize income when you receive payment from your clients and recognize deductions when you pay your vendors. Your income and loss is reported on Schedule C(-EZ) of your individual Form 1040.
As a former employee, you and your employer used to split payroll taxes (Social Security and Medicare) on your earned income. Half would be paid by you the employee and the other half paid by your employer who receives a deduction for his share as an ordinary and necessary business expense. A freelancer pays both the employee and the employer half of payroll taxes but receives a deduction for the employer’s “half." This puts freelancers on parity with regular employees with respect to payroll taxes at the end of the tax year but the freelancer is responsible for making the whole payment of taxes.
Federal income tax is a pay-as-you-go tax in that taxpayers must pay tax as they earn or receive income during the year. Generally, estimated tax payments must be made if a taxpayer expects to owe more than $1,000 of tax when their tax return is filed and if withholding and refundable credits for that year is expected to be less than both 90% of the tax to be shown on the return or 100% of the tax shown on the previous year’s return. For regular employees, tax is paid throughout the year through employer withholding every pay cycle. Since freelancers don’t have employers who withhold income tax on their behalf, a freelancer may have to make estimated tax payments every quarter. Freelancers can pay either an equal amount every quarter or use an annualized income installment method to adjust for periods of the year where income is not evenly earned.
In addition to your own tax liability, you may have information reporting requirements for certain payments made in your trade or business. For freelancers, this generally falls within three categories:
These transactions are reported on Form 1099-MISC. One copy goes to the Internal Revenue Service and another goes to the person who you made the payment to. You will also need their tax identification number which you can get by giving your payee a copy of Form W-9.
Although the IRS does not mandate what information you should retain and how long to retain it for, all taxpayers should have sufficient records to substantiate each line of their tax returns. This information should be retained until the applicable statute of limitations runs and the tax year closes. For most returns, the limitations period is 3 years - there are exceptions for substantial underpayment, fraud, or not filing a return, filing a claim for credit after filing a return, and worthless securities or bad debt deductions.
Why Is This All Important?
Failure to file and/or pay taxes as well as failure to comply with information reporting requirements can subject you to interest and penalties. Particularly egregious conduct can subject you to criminal tax charges resulting in fines and imprisonment. Although the IRS can and is willing to work with taxpayers to meet their ongoing obligations including waiver of penalties and payment plans, the IRS is serious about enforcing the tax laws and does not hesitate to use its enforcement arsenal.
Understanding and complying with your tax obligations is important in order to avoid interest and penalties from the Internal Revenue Service. To the extent you have trouble with your taxes you should seek the advice of a competent tax professional who can help guide you and your freelance business so that you meet all of your obligations required by law. Although taxes are one more plate to juggle while freelancing, they should not stop you from seeking success for yourself, your business, and your clients.
This article is legal information, not advice, and may be subject to changes in the law following publication. Before relying on any information presented here, consult with a competent tax professional to discuss your particular circumstances and situation. Also, the Internal Revenue Service insists that I provide you with the following notice. Circular 230 Notice: In compliance with US Treasury Regulations, please be advised that any tax advice given herein (or in any attachment) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing, or recommending to another person any transaction or matter addressed herein.