Sunday Mailbag

October 7th, 2007 | Posted in Freelancing

Q: Sorry for the boring question, but how do you deal with income taxes as a freelancer? I see by your logo you are incorporated. Are there tax benefits to that over being self employed? Do you have to pay quarterly estimated taxes?

A: Taxes? Boring? Surely you jest!

Being self employed is great except for the paperwork, especially the estimated tax payments. Somehow when your tax payments appear as numbers on your check stub as an employee, and you never get the money in the first place, it’s less painful than to have to remove it from your checking account. It’s like you didn’t really earn the money when it’s deducted… we are conditioned to that since our first job. It really hits you how much we pay in taxes when that money is paid out rather than withheld.

Of course we all have to fork over some of our hard earned money to Uncle Sam, and if there’s one thing the government doesn’t do well is “simple”. Whether you are self employed or incorporated (at least as an S-Corporation), you will have to make quarterly estimated tax payments both to federal and to state (unless you live in an income-tax free state like Alaska, Florida, Nevada, etc.). IRS Form 1040-ES is used to calculate and pay your estimated taxes on a quarterly basis. The formula is basically 110% of what you paid in taxes last year broken into 25% and due each quarter. States differ but most follow a similar formula. You can owe taxes at the end of the year as long as you made your estimated payments without fear of penalty, and if you end up owing less you will of course get a refund. Income tax is income tax, and your only recourse to reduce your tax burden is to make sure you claim all the deductions you are legally entitled to, or earn less money.

If you are self employed, there is another tax you have to be aware of and save some money for paying. It’s called the Self-employment tax, or SE tax. SE tax is social security and Medicare, which you have to pay yourself instead of splitting it with your employer. This is not paid quarterly. IRS form Schedule SE (Form 1040) is used to calculate and pay this tax. The self-employment tax rate is 15.3% of your combined wages, tips, and net earnings. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). There is a partial ceiling for this tax, as only the first $94,200 of your combined wages, tips, and net earnings (2006 figures) is subject to any combination of the 12.4% social security part of SE tax or social security tax, should you have both employment wages and self-employed earnings. However there is no ceilng on the Medicare part, and all your combined wages, tips, and net earnings are subject to any combination of the 2.9% Medicare part of SE tax or social security tax.

Fun, eh?

As far as benefits to incorporating, there are some and the most tangible deal with the SE tax. I touched on this in a mailbag some time back:

There are basically two ways for you to be a business entity, either a sole proprietorship or a corporation (S-Corporation actually). A sole proprietorship is being self employed, where you’re personal legal entity is the business itself. An S-Corp is a type of corporation where the business itself is the legal entity. The easiest of the two is the sole proprietorship, where you simply have to file two extra yearly tax forms, a Schedule C (business profit and loss) and a Schedule SE (Self employment tax, basically social security). As an S-Corp, you pay yourself a salary and have to file the appropriate forms, pay withholding, etc. Lots of paperwork, let alone the actual incorporation and other legal rules to be adhered to. However as an employee of your corporation, you choose your salary level (within reason), and the remainder of the corporation’s income rolls over to you at the end of the year as ‘dividends’. All this is still your taxable income, but the distinction is that only your salary is subject to social security and Medicare taxes. The main benefit to incorporation is avoiding some Social Security taxes, and it all depends on your income level. If you earn over a net of $50,000 a year as a freelancer, it would probably be wise to incorporate. You can then salary yourself $20,000 a year, and pay only about $3,100 in social security taxes while the other $30,000 is “dividend income” and only subject to income tax. If you made that same $50,000 as a sole proprietor, you’d end up paying $7,650 in social security taxes. That saves you $3,550 a year. The more disparity between what you actually make and what you pay yourself as an employee of your corporation, the more you save. There are no hard and fast rules as to what percentage of net revenues you need to pay yourself in salary before the IRS cries “foul”, but if you net $250,000 and pay yourself $5,000 a year you will probably get to know your IRS auditor very well. However, being an S-corp has a few costs like a yearly fee with your state (usually around $100) and a lot of paperwork headaches, plus some costs to file a corporate tax return. Sometimes the extra tax savings are not worth it.

Since there is no ceiling on the Medicare part of SE tax, you will still save some money as long as your salary is less than the business net, but the bulk of the savings would be realized by the difference between that $94,200 earnings cap and your level of paid salary. Say you earn $100,000 a year as a freelancer. If you were a sole proprietor you’d pay $14,580.80 in SE tax. If you were an S-Corp and salaried yourself at $25,000, you’d only pay $3,825.00. That’s a savings of over $10,000. Would the IRS balk at a $25,000 salary when your company nets $100,000 annually? 25% of company net profits paid to a CEO is a pretty high figure, but there are no guarantees and as I said above no set rules.

My advice is always to find a tax professional to do your taxes, preferrably one with a background in self employed people and especially creative ones. Ask around and you’ll find a few accountants who specialize in artists, musicians, actors, etc. They will know how to maximize your deductions and make sure you abide by current tax law, which changes frequently.

Thanks to Grant Jonen for the question. If you have a question you want answered for the mailbag about cartooning, illustration, MAD Magazine, caricature or similar, e-mail me and I’ll try and answer it here!

Comments

  1. grant says:

    everyone should check out :
    America: Freedom to Fascism, A film my the late, great Aaron Russo, about how the IRS is a fraud and how it was never passed through congress. I personally pay income taxes but in no way would i ever think it goes to “uncle sam” basically the dollar is a debt. note to which you owe your income to a private bank called the Federal Reserve.

    Grant#2

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