I've Tried That - We lose money so you don't have to!

The taxman cometh, and in this time colorfully known as Tax Season, I’m getting a chuckle (or three!) out of publication 17, known also as the IRS Tax Guide 2011 for Individuals. Did you know, for example, that if you receive a bribe, you must report it as income? If you don’t believe me, check page 92 of the tax guide. Here are some additional freelance activities that you must also report as income:

Illegal activities. Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity (page 94).

Stolen property. If you steal property, you must report its fair market value in your income in the year you steal it unless in the same year, you return it to its rightful owner (page 95).

While I’m reporting my earnings on a hot Lexus, I thought I’d look up what other tax tips the IRS offers for the freelancer. Here are some additional nuggets of information:

Tax Tips for Freelancers

Complete the 1040 Schedule C

If you are just starting out as a freelancer, you may not know which IRS form to use to declare your income and expenses. Form 1040 Schedule C is the standard tax form for a sole proprietor, which is anyone who makes a business profit yet has not incorporated or formed an LLC. You may end up filling out other forms or schedules in addition to the 1040 Schedule C, but this is the standard one to start with.

You owe Uncle Sam two taxes

Yes, you heard right: As a freelancer, you owe the IRS self-employment (SE) as well as regular income taxes. SE tax covers the federally managed Social Security and Medicare programs. When you are employed by a business, your employer is responsible for deducting this tax from your paycheck. However, once you become your own boss, you alone are responsible for paying this money. SE tax must be paid in addition to your regular income tax.

SE tax is 15.3% of your net business profit. Employees pay only 7.65% of their income towards Social Security and Medicare and their employers pay the other half. As a freelancer, you are both your own employee and employer, so you get to pay both halves.

Submit your quarterlies

The IRS requires freelancers to pay their SE taxes on a quarterly basis. If your clients are not taking taxes out when they pay you, then you need to submit quarterly tax payments to the IRS. It doesn’t take a whole lot of money to become subject to SE tax; the IRS qualifies earnings above $400 as being subject to SE taxation. Information about the Schedule SE that you need to submit is located on the IRS Self-Employed Individuals Tax Center. Paying quarterly taxes might seem like a hassle, but it does help you anticipate and pay for your taxes every three months. Also, if you don’t submit your quarterlies, the IRS will penalize you a certain monetary amount when you file your yearly income tax in April.

Deduct your business expenses

The IRS taxes freelancers on their net income, which is defined as the income remaining after business expenses have been deducted from gross business revenues. Thus, business expenses like a home office, advertising, meals, travel and depreciation do help reduce your tax base. Use Form 8829 to calculate how much of your home you can deduct for business use. This includes the square feet or number of rooms utilized for business use, as well as rent/mortgage interest, insurance (except health insurance), property tax, repair and utilities. Equipment used in your business, such as your computer, software and car, can also be used to make deductions. You can deduct up to the amount of your net business profit, and any leftover deduction can be applied to the following tax year.

Don’t forget to calculate depreciation

The software/computer/printer/etc. that you purchased for your business one year ago is no longer worth the money that you originally paid for it and this should be reflected in your depreciation deduction. Use Form 4562 to calculate how much your business lost as a result of depreciation. You can spread out equipment depreciation costs over a set number of years (Form 4562 part III) or you can take the full depreciation in the year of purchase (Form 4562 part I).

Deduct health insurance separately

If you are paying for your own private health insurance, you can deduct it as a personal deduction on Form 1040 provided you have made a net profit from your business. If you do not have a net profit or you have a business loss, you can still deduct your health insurance costs; however, they should be entered on Schedule A and as a medical expense.

Audit alert! Track business losses carefully

If your business sustained a loss, such as a fire that destroyed your home office, you can certainly report this loss to the IRS. However, if you start reporting business losses for more than one year, you may become subject to IRS scrutiny (i.e., audit) under the suspicion of having a hobby rather than a business. In essence, the IRS uses the Hobby Loss Rule of Thumb to determine if your activities are profitable or not. If you report that your activities have resulted in a net profit for at least 3 out of 5 years, then you have a for-profit business. If your activities have resulted in a net loss for at least 2 out of 5 years, then you have a not-for-profit hobby.

Hobbies, unlike businesses, cannot be used for declaring monetary losses as tax deductions since they are technically not-for-profit. On the other hand, true businesses and their losses can be used to create tax deductions. This of course presents a problem to new businesses that may sustain losses for several years before declaring a net profit. As a freelancer, you can protect yourself from being audited by keeping meticulous records of your work, showing your intent to make your business profitable, and proving that you do depend on the income that will inevitably result from your business.

Hopefully, these tax tips will help you reduce your taxes while avoiding an audit. Now, back to reporting my ransom money earnings for this year…