This article is somewhat specific to the needs of freelancers who live in the United States, but I’ve tried to make it useful no matter your country.
I remember when taxes used to be relatively easy.
I’d get my paycheck, my employer would withhold estimated tax payments, and at the end of the year I’d file a relatively simple tax return and get a refund for any withholding overpayments I made a bit later.
And then I started my own business.
…And the IRS went from being a faceless organization that mailed me checks every year to an archnemesis, who I felt was always getting in the way of me, my clients, and even my ability to create jobs.
I dug myself into a hole more times than I’d care to admit, especially as I grew my agency and brought on employees and significant overhead. Early on, I thought of my taxes in a very laissez-faire way: “yeah, I’ll owe some taxes probably, but hopefully I’ll have the money to pay them. And if not, I’ll get a payment plan worked out. What’s the worst that can happen?”
To be honest, it wasn’t doom and gloom.
I did end up taking up the IRS on a payment plan, and it was easy to do. (If you owe less than $50,000, you can usually do this without even needing to talk to an agency. If you’re like me and don’t like needing to tell someone that you screwed up your taxes, that’s a very welcome featured.)
But don’t be like me and end up mucking around with IRS payment plans.
If you take one thing away from anything I do here at Double Your Freelancing, it’s this: Learn as much as you can from those who’ve already forged the trail.
So today I’d like to introduce you to Luke Frye of Timber, an accounting firm that specializes in working with freelancers. He’s helped me prepare this article (since I’m woefully ill-equipped to talk authoritatively about taxes or legal things), and his firm has also produced a really good email course that goes deeper than what we’re able to cover in this article—I’ll link you to that at the end of this article.
1. Form an LLC or incorporate and open a bank account
Creating a company seems… imposing. But it’s really not. There are plenty of online services that will do it all for you at a markup, or you can just contact your local State Corporation Commission and get the paperwork you need. In the US, you don’t need any operating funds to incorporate—all you need to do is pay the state, which is usually a few hundred dollars a year.
You’re given a lot of legal protections by incorporating, especially when you’re backed by an air-tight Master Services Agreement contract. But for tax filing purposes, we’re going to want a company so that we can open up a business bank account and get an EIN (employee identification number) from the IRS.
All money you make consulting will go into your business bank account. You don’t want to have people paying you personally. While it’s not the end of the world if you have mixed personal with business, it’s going to be a tedious process for your bookkeeper and accountant to separate out business income and expenses from your personal.
While you’re at the bank, open up a savings account for your business. This will be where you’ll keep any estimated tax payments until they’re ready to be paid.Additionally, it’s a good idea to start understanding that there’s a difference between
Additionally, it’s a good idea to start understanding that there’s a difference between revenue and profit. As an employee, you’re used to keeping whatever money ultimately hits your bank account. The Feds have already been paid, and whatever’s left is yours. But as a business owner, you should keep a reserve of cash on hand for cash flow hiccups, hiring people to possibly help you in the future, conference tickets and training, and other expenses that are meant to grow your business.
2. Categorize your income and expenses
Most businesses have really granular expense and income ledgers (often known as Profit and Loss Reports) that give them a birds eye view of how and where they’re spending money.
As a freelancer, your categorization should be fairly easy:
- Your income is likely 100% client payments. If you have side products or do any affiliate-ish stuff, you might have had other income streams. Good invoicing software like Freshbooks should make it easy to associate deposits with the invoices you sent.
- You have three forms of expenses: money you pay yourself as the business owner, things your business buys, and money you pay the government.
Let me dive into that second point a bit more.
Pretend I’m your only client and I pay you $20,000 for a project. Your business bank balance is $20,000, and since you did all the work you have no subcontractors to pay.
You’re feeling optimistic about your business and decide to invest in going to DYF Conference Europe (see what I did there?) You buy a ticket and book a flight with your American Express business charge card (their Platinum card gets you into the airline lounges.) Let’s say that all cost $3,000 total.
Your business bank balance is now $17,000, and you have two expenses: DYFConf and an airline ticket. One is categorized as business training, the other is business travel.
What’s now left over is taxable income. You’re going to want to take 30% of that and earmark it for taxes, so you’ll put about $6,000 into your business savings account. The $11,000 that remains is yours to either reinvest in the business or pay yourself personally.
- Business Income: $20,000
- Business Expense – Purchases: -$3,000
- Business Expense – Taxes: -$6,000
- Business Expense – Owner: -$11,000
(Theoretically, the taxes you’re paying are typically tied to you personally, but for the sake of this example I’m claiming them as business expenses. Also, while a single owner LLC can’t deduct personal distributions as an expense, I still like thinking of paying people—including yourself, the solo owner—as an expense for the business.)
Smart business owners make the most of tax laws. They run as much as they can through their business—conference tickets and travel, work computers, online services, etc.—since they’re taxed on what’s left over. This is why a lot of businesses rush to buy what they think they’ll need next year at the end of the current year. Every business purchase lessens their tax bill.
By categorizing your expenses, your accountant is able to see what you’re spending money on. Categorizing your business expenses aren’t always a requirement to file your tax (though they can sometimes affect your tax bill), but should you ever be audited having this data on hand will make that process much easier.
Categorizing also gives you, a business owner, an overall view of what you made and what you spent. Businesses like Double Your Freelancing have multiple forms of income (product sales, conference sales, consulting income, etc.) along with a lot of expenses (payroll and consultant payments, the venue costs for conferences and events, all the airline tickets I buy to get me to the conferences I run and attend, a bunch of online services I pay monthly for, etc.)
Without categorization and the reports they enable, I’d be in the dark about how successful my business is.
3. Pay your taxes
When you’re an employee, you pay into an account that your end-of-year taxes are paid out of. All that money you think you make when you get a tax refund check isn’t anything new. It’s money you’ve earned and should already have in your bank account. But the government held on to it for you, and if they ended up holding on to too much, they’ll pay back the difference.
As a business owner, the government trusts you to be a little more… savvy about your tax obligations.
So instead of immediately capturing XX% of every client payment you get, they trust you to be diligent enough to withhold what you think you’ll owe. And since as a business you have expenses that lead to income being different from profit, there’s no way of knowing what your taxable income actually is by looking at just your revenue. (Brick and mortar store owners, who have high overhead like rent, payroll, inventory, etc. can often have a business that does a few million a year in revenue but only leaves them with $50,000 in profit.)
The best thing you can do for yourself, especially as you build up your cash flow and cash reserves, is to just take a percentage of money that’s left over every month after expenses and literally forget about it. Put it in that savings account. Then, every quarter, pay your estimated taxes. If you pay too much into it, you’ll get a refund after you file your taxes.
There’s a lot more to cover
…But hopefully, this article gave you a good crash course on basic accounting for small businesses.
Conceptually, it’s pretty easy. But there are a lot of nuances that make it worthwhile to hire a pro who knows their stuff. Things like mileage deductions, equipment depreciations, writing off the part of your home that you work out of, and so on. All things that ultimately can save you thousands of dollars in taxes.
As a small business owner, you have a lot of options available to you for tax deductions. And nowadays, there’s a wealth of software available that streamlines everything from bookkeeping, invoicing, storing paper receipts, and more.
Talking too authoritatively about deductions or accounting tools is a bit beyond my comfort zone. The best I could do is talk about my own anecdotal experiences, which may or may not help you all that much.
What you need to do is talk to a licensed CPA who can help you pay everything you owe (and nothing more) and ensure that you stay compliant with the labyrinthine tax authorities.
I’d recommend you reach out to Luke and his team at Timber. They only work with freelancers, and like you work 100% digital (by employing software like Dropbox, Bench, and Xero.) I wouldn’t recommend trying to file your taxes on your own—it’s significantly more complicated now that you’re a business owner and need a personal and business return filed annually. And a lot of the big firms don’t understand the way freelancers who work from their laptops at co-working spaces operate.
And if you want to learn more about what I just covered, Timber’s created a free email course that dives into the 5 essentials of accounting prep. Enroll in that and give Luke a shout. (They’re a sponsor of Double Your Freelancing and fully support everything we’re doing here to help freelancers.)