Before joining the Xero Education Team, I spent five years running my own business. Mostly I loved being a freelancer, for all the reasons you’d expect. I set my own schedule, I traveled frequently, and the best part, I brought in enough money to fund my fantastic lifestyle.
Life was grand … until it came time to file my taxes.
Inevitably, I’d have to dip into my emergency savings account to pay my federal and California state income taxes. I’d have to wade through piles of receipts, or worse, go over my calendar with Google Maps and a spreadsheet to add up all the mileage from road trips so I could deduct them on my Schedule C.
If only I knew
Now that I’m employed, Xero does most of the hard work when it comes to my taxes. But my heart still goes out to freelancers – all 14.6 million of them. I’m sure they would rather spend more time focusing on their businesses, and less time stressing over keeping track of expenses, mileage and how these affect how much tax they’ll owe.
I recently talked to Dave Emmerman, Xero Platinum Partner and partner of Emmerman, Boyle & Associates LLC, to see what tips he could offer to make all of these things less painful. Here are the top five things I learned:
1. Just because someone is self-employed doesn’t mean every expense is deductible.
“Freelancers might think that if they’re self-employed, every time they go to Starbucks or the gas station it’s a deductible business expense. But that’s not how it works,” says Dave. “There needs to be a justifiable business purpose for any expenses claimed as a deduction.” In other words, expenses like groceries and anything that falls under the general cost of life aren’t deductible as business expenses.
Dave reports that claiming inappropriate deductions is the number one problem he and his colleagues see among freelancers. This problem is further complicated when people don’t have separate bank or credit card accounts for business and personal use.
The solution? “Clearly separate business expenses from personal expenses,” he explains. “And resist the temptation to deduct anything that you cannot justify as a business expense.”
2. Even if an expense was for a business purpose, don’t assume you can deduct 100% of the expense.
Dave explains that on the actual Schedule C form, there are 20 general areas for deductions. These include travel expenses, office expenses, professional fees and vehicle expenses.
“There are some common traps,” he says, “like the meals and entertainment category, for example.” Turns out freelancers can usually only deduct 50% of expenses in this category. If freelancers don’t calculate their potential deductions properly, they might think they owe less in taxes than they actually do.
For people who use their personal vehicle for business purposes, things can get tricky. There are two different ways to handle those expenses. You can calculate your actual usage, or take the standard mileage deduction. The method you can use depends on several factors including whether the vehicle is owned or leased, and whether there have been any special depreciation allowances on it.
Knowing the rules of the road will help ensure that freelancers are setting aside enough for taxes (see no. 4).
3. Never ever wait until the end of the year to categorize expenses.
“A little preventative maintenance goes a long way,” Dave explains. “I can’t stress this enough. It’s critical to stay on top of your income and expenses throughout the year rather than waiting for the year to end.”
He says there are a few reasons for this. The first is that the amount of transactions builds up really quickly, and it’s very difficult to go back and organize everything after the fact. (Remember: freelancers need to have a business reason to deduct each expense!)
Dave’s firm also sees people miss out on deductions they’re entitled to. This is because they’ve completely forgotten about their business expenses by the time tax filing season comes around.
But another reason to keep track of expenses and income throughout the year is to prevent any serious surprises at tax time. Which brings us to the next tip…
4. It’s a really good idea to set aside enough to cover all your taxes.
I experienced this first-hand. I thought I was sitting pretty when checks came in from my clients, and then I felt the sting in April when I had to dig into my savings to pay my taxes. Freelancers owe a portion of their income to the federal government (plus another portion to the state government). And when someone doesn’t have the money to pay taxes, there are penalties and interest to pay the IRS, plus interest on the penalty … and that interest continues to accrue until everything is paid.
What’s challenging, especially for people who are used to receiving a paycheck, is knowing just how much to set aside for taxes. Dave says, “people don’t realize there’s a big difference in the taxes owed when someone is formally employed, compared to what they owe if they’re self-employed.”
When working as employees, you pay a certain amount of income tax, and your employer pays an additional amount of tax on your behalf. Freelancers are responsible not only for their income tax, but self-employment tax, which includes Social Security and Medicare. In other words, freelancers are responsible for the portion of tax their employer would have paid.
5. There’s an easier way to do all of the above.
Not sure whether an expense is deductible, which method to use to calculate your vehicle deductions or how to calculate your estimated taxes? Always consult a tax professional for guidance.
The easiest way for freelancers to avoid these tax-time surprises – and to make sure they have enough money saved to cover all taxes -– is to stay on top of income and expenses, categorize those expenses properly throughout the year and keep a regular eye on estimated taxes owed.
Fortunately, there’s an easy way to do that, all from a mobile phone: Xero TaxTouch! It takes just a few minutes to set up, and Xero TaxTouch makes it fun to stay on top of your expenses. Simply swipe right or left to separate business from personal expenses, even if they’re intermingled in the same account. Tap to choose the proper category, and you’re done. Easily add mileage from business trips. See estimated taxes at a glance. No more stress, no more surprises.
And if you pair Xero TaxTouch with professional advice from an advisor like Dave, you’ll be good to go!