Tax Tips 2008 for the freelance or self-employed web developer

Posted by ryan in taxes

WARNING: I'm NOT a tax professional. Consult a tax professional before actually filing anything (I do). It's very likely I've made mistakes here, and it's not my responsibility if you repeat them. So, be smart and consult somehow who gets paid to know this stuff!

It's tax season again, which is an especially daunting task for small business owners (like me) and freelance workers all around. Not only do we get to pay all of our taxes up front, but figuring it all out, and getting the deductions you deserve, can be confusing. So, having suffered through the process, here's my quick and dirty guide.

Before we start, I highly recommend the book Deduct It (aff). This is what I originally used to learn all of this, and you really won't maximize your deductions without it. Everyone has their own unique situation, so check it out.

IRS Forms you'll need: IRS Forms you'll likely need:
  • Form 4562 (instructions) if you need to deduct car mileage or bought some business property of expensive equipment during the year (like a computer)
  • Form 8829 (instructions) - if you use your home as an office

You may also need a host of other forms, depending on your unique situation.

If you're a freelancer or an LLC, you don't actually file any taxes for your business. Instead, you file ONLY your personal tax return, just like everybody else. Let me repeat, you don't file any tax forms on behalf of your business. All you'll need to do is report how much your business made, and therefore, how much your business paid you (the individual). This happens on Form 1040 Schedule C, but we'll get to that.

1040 Schedule C

While you don't have to file any taxes on behalf of your business, you do need to report how much your business made, and include that with your personal tax returns. This all happens on the 1040 Schedule C. Now, it's up to you to have kept good records of your income and cash flow throughout the year. I'm going to assume that you have.

The document itself has 5 Parts (Part I, Part II, Part III, etc). In most cases, Part I is simple. Simply put how much you made from your business on line 1. Generally, after filling in some zeros, you'll end up with that same number on line 7 (but your situation may be different).

Part II is a little more interesting, and can be a real tripping point. As a business, you can legally deduct all of your business expenses. What makes up a business expense is the product of many legal code and court cases. This is one of those places where you should really have someone help you, so that you can keep everything legal and keep the IRS happy.

In its most basic sense, Part II is just a list of all your expenses, partitioned into different categories. Many are simple, but some require extra paperwork. For example, if you want to deduct mileage (e.g., you drive to meet clients), then you need to fill out Part IV of this document (or file form 4562 if required). There are 2 ways to account for mileage. One is the actual-cost method (you actually keep track of everything you spent on your car) and the other is the standard mileage rate (where you keep track of your mileage then multiply it by a standard mileage rate set by the government - http://www.irs.gov/newsroom/article/0,,id=184163,00.html). Line 13 relates to any big purchases you may have made, and requires form 4562 to be filled out. This deals with depreciation, or a piece of the tax code called Section 179 that allows you to expense all of a purchase instead of depreciating it over several years. This is complicated stuff, and you'll probably need some professional help to figure this out.

One more quick note for Part II relates to line 24b (Deductible meals). First, you should know that you need a pretty legitimate reason to deduct a meal, and this area is closely scrutinized by the IRS. Next, you can only deduct half of your meal costs. So if you spend $50 at dinner to woo a new client, only $25 can be claimed here. Finally, when you're travelling on business, you can either keep track of all your meal costs, or use what's called the standard meal allowance, or M&IE rate. Basically, depending on where you are, the government has a set amount you can deduct daily that covers travel, meals and everything else (other than lodging). You can check out the M&IE rates at www.gsa.gov (click Per Diem rates). Again, this stuff can get complicated, as there's a bunch of business related to what exactly constitutes "business travel days" where these meal deductions can be claimed.

The bottom of Part II - just follow the directions and do some simple arithmetic. If you work at home, you may be eligible to deduct part of your rent and utilities. This total is line 30. If you do work from home, you should go fill out Form 8829 before finishing this section.

Part III may or may not apply to you. If you're a service provider (e.g., you make websites), then you don't have inventory nor do you have COGS (cost of goods sold).

Part IV applies if you're claiming your mileage as an expense. If you're depreciating some big purchase (e.g. a computer), then you'll need to file form 4562 in order to fill in line 13 mentioned earlier. If you DO need to fill out form 4562 because of such a purchase AND you are deducting mileage, you should leave this section blank and use form 4562 to deduct your mileage instead.

Part V is an extension of Part II. If you cannot fit any of your expenses into the list of categories, list them here with descriptions. The total from this section should be put on line 27.

When you finally finish this form, your all-important number is line 31. You'll need this number for your 1040 form.

Form 8829 - Home Business Expense

If you legitimately work at home, you can probably claim a small business expense (check with a professional). The real trick is how much of your house can be counted as your office. One common method is the room-count method. It is what it sounds like. If you want more information on figuring out what percentage of your house can count as an office, consult Google. A quirk word of warning however. Even if you live in a 1-room apartment and literally work on your bed, you cannot claim that your office takes up 100% of your living area. The IRS realizes that everyone needs space to live, so if you claim that your office is a high percentage of your living area, they're not going to buy it.

If you lived in multiple locations throughout the year, simply fill out multiple 8829s, one for each place you lived/worked. The total used for line 30 of your 1040 Schedule C will be a sum of all your 8829s.

Form 8829 is mostly self-explanatory. Simply follow the directions, add, subtract and write numbers. Most of the work will be done on lines 16 through 21. Generally, you'll want to put your totals in the indirect expenses column. An indirect expense (e.g. heat) is one that benefits your entire house, not just your office. If you're a renter and are keeping things simple, you shouldn't have to fill out Part III or Part IV. The total (line 35) of this form is used on line 30 of the 1040 Schedule C.

1040 Schedule SE (self-employment tax)

Prepare to have your world rocked. Everyone pays social security and Medicare, and it's expensive. In the normal employment world, (even though many don't notice), your employer splits your social security and Medicare bill with you. In other words, only half of what's actually due for social security and Medicare on your paycheck is deducted. The other half is footed by your employer.

In the world of self-employment, you are both the employee and the employer. In that light, you're responsible for 100% of your social security and Medicare bill. You'll want to sit down, because this can get expensive.

The form itself is really simple. There are actually 2 parts (Section A and Section B). You only have to fill out one part, and you can use the fancy flow-chart to figure out which section you need to fill in. Typically, you'll only have to fill out Section A, which is simple.

First, on line 2, write down your total from line 31 of your 1040 Schedule C. Assuming nothing out of the ordinary (e.g., you're not a farmer nor do you collect disabilities), then you'll just carry that total down to line 3. It's simple math from here. Here's an imaginary example:

Line 2:  80,000.00 (we'll make self-employment look glamorous)
Line 3:  80,000.00
Line 4:  73,880.00 (80,000 x .9325 - there's no good reason for why you do this)
Line 5:  11,303.64 (73,880 x .153)

So, in this case, you'd end up owing $11,303.64 just for the social security and Medicare part of your taxes. Cut this value in half and enter it on line 6. You'll use all of these numbers later on your 1040 form.

Form 1040

This is the form that brings everything together, and is filled out by everyone who files taxes (except that many people fill out a simpler version called the 1040EZ). We're doing this form last because we'll need values off of many other forms we've already filled out.

To a business owner, the most important line in the Income section is line 12. On line 12, place the amount you have on line 31 of your Schedule C. You may have various other types of income that you'll need to input here in the Income section. Namely, line 7 is the line where you put any income you earned from good old-fashioned normal employment, an amount that is taken off the W-2 form that an employer sent you.

The adjusted Gross Income section is where you can deduct a few things to reduce your taxable income. The most important is line 27. Basically, you get to deduct as an expense, half of what you'll end up paying for social security and Medicare (known as your self-employment tax). This goes back to your 1040 Schedule SE. You should put the value from line 6 of the 1040 Schedule E here on line 27.

Also important is line 29. If you insure yourself, you may be able to deduct the cost of that insurance here. Check with a professional.

There may be other expenses - everyone is different. Specifically, line 32 (IRA deductions), and lines 33-34 (tuition and loan stuff) can be pretty common.

Do some adding for line 36 then some subtracting for line 37. Congratulations, line 37 is your adjusted gross income.

From here, it's all pretty straightforward, and should be about the same as any normal employee's 1040. The only differences will be line 57, where you place the amount from line 5 of your 1040 Schedule SE. Also, if you paid any quarterly taxes (if you're reading this, then you probably should be), place that amount on line 63. If you haven't been paying quarterly taxes and should be, you may be eligible for a penalty, which is administered on line 76.

That's pretty much it. Again, I can't stress enough that you should see a tax professional to look everything over. It's extremely important as a business owner or freelancer to make sure you're being accurate and honest with your income and your deductions. Also, be sure to read the instructions. I'm serious! The extensive instruction documents (linked above) that come with each document are fantastic resources for figuring out the most minute details.

Happy taxing!

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