How to Do Your Taxes as an Independent Contractor or Freelancer

Right Side Up recently hosted a webinar on how to navigate taxes for independent contractors or freelancers, led by Mark Edler, Accounting Manager for Right Side Up. Mark covered what you need to know to handle 1099 income, estimate quarterly taxes, and take advantage of deductions that can save you money. Watch the full webinar for all of Mark’s tax insights.

Before we dive into the wonderful world of taxes, please note that this article and the webinar linked above contain informational content and are not intended to serve as legal or financial advice from Mark or Right Side Up. Consult with your CPA about specific advice for your individual situation.

Filing taxes as an independent marketing consultant doesn't have to be complicated—but we do understand that it can be intimidating if you’re new to freelancing. To handle your taxes like a pro, you’ll need to know what kind of income you’re working with, how to set up an organized recordkeeping system, and which deductions will save you the most money. And we’ll explain how to do it all—along with helpful tips about LLCs and retirement planning—below.

Tax Documents and Recordkeeping Recommendations for Freelancers

There are two basic types of documents that are used to report your income during tax season—W2 and 1099 forms. Both documents show how much you were paid, but with one big difference depending on your employment type.

What is W2 income?

The most important difference between being an employee with W2 income and a contractor with 1099 income is that when you earn W2 income, you employer will withhold taxes from your paycheck, including:

• Federal income tax
• FICA taxes (Social Security and MediCare)
• State taxes (if applicable)
• Local income taxes (if applicable)

And what is 1099 income?

If you’re paid as a contractor and receive a 1099, the client paying you will likely not withhold taxes on your behalf—that’s where taxes can get a bit tricky for freelancers. This means that you’re responsible for estimating, withholding, and paying all of your own taxes. The IRS requires most freelancers to make quarterly tax payments or be subject to a penalty if you pay your taxes in one lump sum during tax season.

If you don’t want to do your estimating and withholding manually, there are platforms that can do it for you, including Catch, an all-in-one benefits solution that Right Side Up has partnered with for our marketing consultants.

If a company pays you less than $600 annually, they aren’t required to send you a 1099, however, you are still required to report that income on your tax return.

How to keep your income and expenses organized

The best way to set yourself up for stress-free tax preparation is to create an organized, regularly updated system to track your income and expenses. Here’s what we recommend:

• Use software like QuickBooks or Bonsai to compile your records in one place.
• Categorize and reconcile your books at least monthly to avoid an end-of-year crunch.
• Use a single bank account or credit card for all business transactions.
• If you use software, set up automatic categorization for your transactions.

There are a lot of options out there to keep track of the numbers for your business. In general, QuickBooks tends to be the standard for small business owners. QuickBooks online has constantly added improvements to the software that makes it easy to use. QuickBooks Self Employed should be sufficient for most freelancers and only costs $15 per month, but be sure to do your own research to find the software that’s best for your business.

You may need to create a P&L, which is a statement that captures your profits and losses. The best way to do this is to compile all of your records into a single software or spreadsheet and generate a summary. Most software platforms allow you to generate a summarized report for you or your accountant to use for taxes—just make sure that all of your income and expenses are pulled into the platform correctly.

To make things even easier, nearly all bookkeeping software platforms can import your bank feed, which saves you from spending countless hours gathering data manually.

Use Tax Deductions and Credits to Save Money

As an independent contractor, you’re eligible to deduct a range of products and services that support your work. In most cases, you can deduct the following expenses, which are captured in Schedule C of your tax filing:

• Computer
• Cell phone and plan
• Software costs
• Internet
• Meals (only half deductible)
• Home office space
• Home office furnishings and supplies (e.g. desk, chair, computer stand, keyboard, mouse, extra monitor, printer, etc.)
• Rent for an office space (including coworking spaces)
• Marketing, which can include subscriptions to networking groups, business cards, website upkeep, ads, etc.

Home office deduction for freelancers

The home office space deduction is calculated using the 8829 form by taking the the percentage of your house that is used for business and dividing it by the total square footage. So if you use 100 feet out of a 1,000 square foot house, your “business use percentage” is 10%.

Once you have this percentage, add up all of your home office related expenses (rent, mortgage interest, home insurance, home office repairs), and multiply them by your business use percentage.

Make sure you keep your home related expenses separate from your other business expenses to make it easy when you file.

Qualified Business Income (QBI) deduction

The Qualified Business Income (QBI) deduction was added when the 2017 tax laws passed to give small business owners a matching decrease in taxes to what corporations received, a decrease in rates from 35% to 21%.

In general, the deduction is 20% of your net income, and is not affected by whether you take the standard deduction or not. There are some nuances to the total deduction, but tax software will calculate it for you. It’s just important to know that you are getting it.

Covid tax credits and updates

There have been several tax credits and programs offered throughout the pandemic to help people cope with financial struggles, but there are changes to how those credits might affect your taxes for 2021. Here’s what you need to know:

• Child Tax Credit—This credit was increased for 2021, but a portion was paid during the year, which will likely decrease tax refunds for those that used it.
• EIP 3—If you didn’t receive the third federal stimulus check, you may be able to claim it on your 2021 tax return. Keep in mind that there are income limits!
• PPP Loans—The IRS announced that all forgiven PPP loans are not considered taxable income.

Estimating Your Taxes

Self Employment taxes are one of the most important pieces of tax preparation for freelancers and small-business owners. When you are a W2 employee, you pay half of your employment (FICA) taxes and your employer pays the other half. And that it is all withheld from your paycheck, so employees never have to worry about employment taxes.

When you are self-employed, not only do you have to pay both halves of the tax (you are the employer and employee), you also have to make the payments on your own behalf.

Quarterly tax estimated payments

In general, you must make estimated tax payments using the 1040-ES form if you anticipate owing $1,000 or more at the time that you file your taxes. IRS penalties for late payments are .5% of the balance per month. However, there are safe harbor exceptions that will waive penalties if you paid enough tax during the year (90% of your total current tax or 100% of last year’s tax).

Making estimates can be confusing, but overall it’s much better to make some estimated payment than none at all. There are a lot of variables that go into how much you will owe. Your best bet is to work directly with an accountant to determine your estimates.

More information about estimated tax payments can be found here.

Benefits of Forming an LLC or Other Legal Entity

There are several benefits of setting up a legal entity, like an LLC or sole proprietorship, for your consulting business. From a tax perspective, your legal entity and your tax election are two separate decisions to be made. Your legal entity will be an LLC or C-Corp depending on what you choose, but LLCs are much more common and useful for freelancers.

And on the legal side, creating an LLC will separate your personal liability from your liability related to contracts with your clients or other parties that you do business with. This shield means that any situation that creates liability for you will be limited to your business. Your personal assets will not be at risk.

Your tax classification will be chosen when you set up the entity. You can choose to be taxed as a:

• Sole proprietor (disregarded entity), same as your personal taxes if you don’t create an LLC
• S-Corp, where you file a separate return that flows through to your taxes
• C-Corp, an entity that files and pays its own taxes

It’s important to work with an accountant or legal professional when setting up an entity. A filing mistake could result in costly penalties, and you could end up losing out on tax savings if you choose the incorrect strategy.

Retirement Planning for Freelancers

Just like tax withholdings and health benefits, retirement planning and contributions fall solely under your responsibility as the independent contractor, and not the client paying you. There are several options available and you should talk with your financial advisor or accountant to determine which is best for your situation.

Tackling Taxes

Once you have a solid understanding of the type of income you earn and set up a reliable recordkeeping system, you’re on the right track to handling your taxes like a pro. Remember to take advantage of deductions and credits to save money, and consider creating a legal entity if you plan to make freelancing your long-term setup. And as always, consult with your accountant or tax professional if you have any questions. 

Do you want to join our team of talented growth marketers and work with the most respected early-stage ventures, the fastest growing tech companies, and well-established Fortune 500 teams? Give us a shout at talent@rightsideup.co to get started.