If you are a freelancer or run a small business, then you probably file a Schedule C when putting together your 1099. This form is used to account for all income generated from your business and deductible expenses. Thus, it is important to get this right – so as to avoid an audit but also to maximize your tax advantages.
As should be no surprise, there are many factors to consider. But to simply things, I have 4 tips to keep in mind:
Estimated Payments: As an independent contractor, you will not have any automatic withholding of federal income taxes and self-employment taxes (such as for Social Security and Medicare). Rather, you will need to do this on a quarterly basis through a process called estimated payments. If you fail to do this, there will be penalties. Although, the biggest problem could be that you will not have set aside enough cash to pay your taxes on April 15th.
For more regarding estimated payments, you can check out the following post.
Deductions: Be thorough. There are lots of opportunities to reduce your taxable income. Just some of the items include:
- Professional service fees
- License fees
- Memberships to professional organizations
- Credit card fees (such as for processing transactions)
- Business-related gifts
But here are some more details on other potential deductions:
- Car Expenses: These can be a great source of tax savings. But there are two approaches – that is, using a standard mileage rate or to use the actual expenses. It’s a good idea to test out both.
- Depreciation: If you purchase something — like a computer — that will last more than a year, you will probably need to depreciate — or expense — the value over time. This is known as depreciation. Now the rules can get tricky, which means it’s an area where getting expert advice can be very helpful. But the IRS has rule 179 that allows you to deduct up to $25,000 for depreciable expenses (for 2014).
- Home Office Deduction: The perception is that this is a sure-fire way to get audited. But the reality is much different. So long as you use the room for only business and the activity is ongoing, you will be fine.
Regardless of the deductions you elect, it’s a good idea to get an accounting system, such as QuickBooks or Xero. Using such an application will make the tax process much easier (at MasterCFO, we can help you out with this).
Also, make sure you get receipts for everything. It’s the best defense against an IRS audit.
Retirement Plan: This can be a great way to reduce your taxes – and it’s a good way to help provide for a more financially secure future. One option is to fund an IRA. But the IRS also has other programs for the self-employed, such as a SIMPLE IRA, SEP IRA or a solo 401(K).
Hobby: A business may not really be a business at all. Instead, it may just be a hobby. In this case, the IRS will make your life absolutely miserable – and you could be on the hook for paying prior deductions, including penalties and interest. It could be devastating.
Yet there is one clear-cut rule to make sure your business is not classified as a hobby: make sure you generate profits for three out of every five years.