When you are a freelancer every cent counts, especially when it’s going towards tax payments. Knowing which expenses are deductible and which aren’t can mean the difference between owing the IRS money and getting a juicy refund.
The trouble is that unless you work as freelance accountant you are probably no expert in tax law. You may worry so much about the consequences of claiming for a deduction you are not entitled to that you decide to play it safe and forget altogether about a perfectly-good write-off.
Home Office
A classic example of this is the write-off of your home office as a deduction. This is potentially a huge write-off many freelancers shy away from. Granted, the IRS does require you to work for it. For instance, you may, among other things, have to calculate the area of your office and represent it as a percentage of your home’s total area (see reference 1). Yet, even if your office is only 10 percent of your home’s total area, you can deduct 10 percent of your mortgage, property tax, insurance, repairs, and utility and services bills. Just this well-known write-off could save you thousands of dollars. By most standards, that is a lot of moolah. Imagine what you could save when you start looking into the more esoteric write-offs most freelancers either don’t know about or prefer to give a wide berth.
Depreciation of Your Work Tools
The minute you drive your new car off the dealership’s lot it loses, on average, 11 percent of its value, and after 5 years it is only worth 37 percent of what you paid for it. (See reference 2). Things lose value, and fast. The good news for freelancers is that this painful phenomenon, technically called depreciation, can become your ally when it comes to tax season.
You can deduct the depreciation of any tangible property as long as you use it in your business and it has a useful life of more than one year. Stuff that lasts less than a year you can usually deduct as a business expense.
However, not all property depreciates at the same rate, and you must follow IRS rules strictly or risk your getting your deduction shot down if your business is audited. The IRS uses the Modified Accelerated Cost Recovery System, MACRS, which assigns a depreciation rate on property depending on its estimated useful-life expectancy and how old it is. Cars, computers, cell phones, cameras and office machinery are considered 5-year properties, while office furniture is a 7-year property. Once you know what category the property you are claiming for falls in, it is simply a matter of multiplying its purchase value by its depreciation rate in an MACRS table.
For example, if you buy a new computer for $1,000, you can deduct 20 percent in the first year, 32 percent in the second year, 19.2 percent in the third year and so on. (See reference 3)
Health Insurance
This is a new one. Until 2010, self-employed workers, which represent 78 percent of all small business in the United States (see reference 4), could not claim their health insurance costs when calculating their taxes. Now you can claim 100 percent of your health costs. This means you can save up to 15 percent of your health insurance tax, if you deduct it from you self employed tax. With self-employed workers paying an average of $10,880 in health insurance bills, this translates into a whopping yearly tax saving of $1,664. (See reference 6)
Unpaid Invoices
Banks are not the only ones who have to worry about bad debts. As with all businesses, freelancers have to face clients who don’t want to, or can’t, pay their invoices. If you use the accrual accounting method to calculate your taxes, you can deduct unpaid invoices from your self-employed tax.
The accrual accounting method reports income when you earn it as opposed to when you are paid for it. If you use this method, you could end up paying taxes on income you never receive. Not a good habit if you want your business to be profitable. Most self-employed workers use the cash method, which only reports income you have already received. However, some self-employed workers are required by law to use the accrual method and open themselves up to huge tax bills if they don’t keep tabs on unpaid invoices. (See reference 7)
Payments to Subcontractors
As your business grows you may find you have more work than you can handle by yourself. One option is to share the work with another company or freelancer as a subcontractor. Although sharing the load with others is an excellent way to take on more work and make more money, it can become a huge tax burden if you report as income payments you make to subcontractors.
The solution is to make sure you declare every payment to a subcontractor as a business expense. For this to work, you need to be anal with your record keeping and have a formal contract agreement you can use to prove your business relationship is of contractor and subcontractor and not employer and employee. This is important, because if the IRS decides you are employing a worker instead of hiring a subcontractor, you could be liable to all kinds of extra taxes and fees. (See reference #8 )
References and Resources
Reference 1: IRS Publication 587 Home Office Deductions.
Reference 2: Edmunds: How Fast Does A New Car Lose Value Infographic.
Reference 3: IRS Publication 946: How to Depreciate Property.
Reference 4: National Association for the Self-Employed
Reference 5: IRS: Tax Changes for Small Businesses
Reference 6: National Business Association Lower Health Insurance Costs for Self-Employed
Reference 7: IRS Business Bad Debts
Reference 8: Independent Contractor or Employee?
About the Author: Andrew Latham started working as a freelance journalist while working as a volunteer teacher in Nicaragua. It started as a way to pay the bills and put his bachelors degree in English to work, but has now become his new career. He had previously worked as an assistant editor for a print real estate magazine and as a project manager for a construction contractor. That experience has been invaluable in creating a niche for himself as a copywriter in the real estate, construction and mortgage finance industry.
