Taxes and Freelancers

Recently Jeff was approached by another very talented illustrator/concept artist with the idea of creating a virtual studio.

The business model for something like this already exists, of course.  The most notable art studio being Massive Black, which has grown into a full-blown business with physical offices in San Francisco and  satellite offices in Shanghai and Bangkok.

Looking at the challenges of creating a small business takes on a whole new level when you enter into a limited partnership. This is a topic we will tackle later on, but for now let’s start small by looking at an illustration business owned by a sole proprietor.

Taxes and You

Understanding how an individual freelancer needs to operate within the U.S. tax system.

Today we’ll look at tax law.  Most illustrators work for and by themselves, which is considered by U.S. tax law to be a sole proprietorship.

Let’s create an example to work with.  Allan Spangreen is our imaginary illustrator working freelance.  Allan is a U.S. Citizen, so he already has a social security number, which is his tax ID, so he doesn’t have to apply for a tax ID number for his business.  If Allan were a resident or nonresident alien, he would need to get an Individual Taxpayer Identification Number (ITIN) by filling out Form W-7, Application for IRS ITIN.

Allan is the sole proprietor of Allan Spangreen Illustration.  This means the government, for tax purposes, considers him and his business to be one in the same.  He cannot hire anyone for the business with the exception of his wife Betty (or husband Bob depending on which state you’re in- that’s a whole new can of worms that we won’t get into right now because I don’t actually know what the tax law says about same-sex marriages).  Betty should be making an income from working with Allan.  If they file jointly, this is not an issue, but if they file individually this should be taken into account and hopefully Allan and Betty did the proper accounting for this each time Allan was paid for a commission.  For now we will assume that Allan and Betty file jointly.

Allan works as a freelancer, which comes with some caveats.

• Self Employment Tax- Firstly, Allan needs to set aside 15.3% of his income for what is called “Self Employment Tax.”  This is a tax that is taken out of most people’s earnings that work at a “regular” job before they’re issued, and it goes towards social security (12.4%)  and Medicare (2.9%).  Allan has to pay this tax if he makes more than $400 doing his freelancing.
• Estimated Tax- While most “wage earners” have their federal income taxes withheld, this is not the case of freelancers.  If Allan expects to owe more than $1000 (including SE tax) he needs to be making  Estimated Tax payments.  These are quarterly payments that he will make, and they’ll usually be a certain percentage of his income.  If Allan fails to make these payments quarterly, he will be charged interest- not good, we want him to avoid that. There is a very helpful guide, including a worksheet to help you figure out what your Estimated Tax payments should be here.  (Full PDF of 2009 Tax Rate Schedules here.)  Also remember that you have to pay state taxes, provided you live in a state, so setting aside some money for that, too, will be very important to you later.
• Deductions- Allan can deduct HALF of his SE tax in figuring his Adjusted Gross Income.  Business expenses can also be taken as deductions, but you have to keep good records.

A few very important tips:

1) Bank Accounts. Keep your personal bank account and your business bank account separate!  I cannot stress this enough- not only will it help you to distinguish what funds you really have in your business and help you save for taxes, but it will also provide an infallible accounting system, as the bank statements will show you exactly what your monthly deposits and withdrawals are.

2) Records.  Any company you work for where you earn more than $600 must issue a form 1099-MISC to you.  If you are earning royalties from work, the business paying you the royalties must send you a 1099-MISC if the royalties are over $10.  These forms are important, because they are how the government knows that you’re earning money.  If a company fails to issue a 1099-MISC to you by Jan 31st of the year following when you earned the income or royalties, ask them for one.

Keeping your own records is imperative as well.  Create a spreadsheet with your commissions and earnings in it, and separate it out by year.  You only have to report income that you actually received in the calendar year, Jan 1 – December 31.  You’ll also want to keep track of your expenses- and to do this best, you can create an income statement for the business, or a personal income statement.  I will do a later post about Income Statements and Balance Sheets and how they will help your business.   For tax purposes, you should know that you are entitled to deductions for materials for your business.  Art supplies, business cards, printing supplies, paper, trips to art shows, the cost of your website… all of these things are business expenses and need to be recorded and backed up, so keep your receipts.

3) Tax Software.  Truly, makes life so much easier.  When you use tax software, the tedious reading of legalese is minimized, and you can simply focus on the bottom line.  I highly recommend TurboTax’s online system.  It’s easy to use, very smart, and will even help you file both federal and state taxes.   It will cost you around $70, but an accountant would charge you three times that, so it ends up being a bargain, plus it is a great learning tool.

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That’s all for taxes and freelancers today, but please send your questions to me via the contact page, and I will do my best do address them in the blog.