Q: Taxes… Even though I have been a full time caricature artist for over 12 years, this is a major area that I have regretfully been lazy in researching and acquiring the proper knowledge base that I should probably have….¬¨‚Ä† Like a lot of caricature artist I make the majority of my living as an independent contractor, I also do some freelance on the side but very little… I do not have a CPA and I am not incorporated, as a result I probably pay too much…. Would you happen to have any tax advise you would like to share with a fellow caricature artist? 🙂
A: The main tax advice I give to freelancers and self-employed artists (like caricaturists) is to find an accountant familiar with creative business-people like musicians, actors and artists, and have them to your taxes and advise you on your allowable deductions. I am constantly surprised by what is and is not deductible, and knowledgeable accountants not only know the difference but also know what is ACCEPTABLE by the IRS and can help you make your tax return as “red-flag” proof as possible. They can also advise a strategy on how to maximize your deductions and save proof for them for the next year. Many years ago the IRS identified self-employed people as a big target for auditing, as so many don’t do their taxes right or cheat on their deductions/underreport their income. They found self-employed income earners a big source of back-tax revenues, penalties and fees. As a result, filing a Schedule C makes you much more likely for an audit. Call up a few local talent agents for musicians/actors and ask for a recommendation for a tax return preparer. DO NOT go to H&R Block or any of the fast-food type tax return preparers, they don’t have a clue how to handle an artist’s tax returns.
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 13.3% of your combined wages, tips, and net earnings (That rate is 2% less thanks to the 2010 Tax Relief Act, which was extended thanks to the 2011 Payroll Tax Cut Extension). The rate consists of two parts: 10.4% 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 $106,800 of your combined wages, tips, and net earnings (2011 figures) is subject to any combination of the 10.4% social security part of SE tax or social security tax, should you have both employment wages and self-employed earnings. However there is no ceiling 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.
One of the things you might want to consider, depending on your income level, is incorporating your business. There are several tangible differences in being a sole proprietorship i.e. self-employed individual versus being 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 become your corporation’s employee 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 $25,000 a year, and pay only about $3,325 in social security taxes while the other $25,000 is “dividend income” and only subject to income tax. If you made that same $70,000 as a sole proprietor, you’d end up paying $6,650 in social security taxes. That saves you $3,325 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 $106,800 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 $13,300 in SE tax. If you were an S-Corp and salaried yourself at $25,000, you’d only pay $3,325.00. That’s a savings of almost $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.
There is also a Limited Liability Company designation for businesses that have different sets of rules with regard to taxes and structures, but I am not familiar with that one. My advice is always to find a tax professional to do your taxes, preferably one with a background in self employed people and especially creative ones, and to ask about things like possible incorporation. 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.
Here are some links to more info:
Thanks to¬¨‚Ä†Dave 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!
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