It’s a great day for anyone when you get that first paycheck, especially if it’s the first money you’ve earned from being self-employed. For the creative freelancer, there’s no clear path to getting that first client, but when the ball starts rolling you don’t want it to stop. It’s important and sometimes forgotten that being a freelance photographer, illustrator, or working musician is a business that requires the boring yet vital detail of paying and filing taxes. I’ve seen first hand some of the financial stumbles folks make in the early years of business, and it can take years to recover financially.
When I began earning money writing, my accountant prompted me into doing some research on tax issues that writers can face, and there’s a lot of information about expenses that should be considered before calling something a business expense.
Here’s a brief look at an aspiring writer’s tangle with the U.S. Tax Court —
Wright v. Commissioner, 31 T.C. 1264 (1958), affd. 274 F.2d 883 (6th Cir. 1960)
Here’s a quick summary — A couple flew to Japan to visit their son. Once there, they didn’t head home but continued on, and took a trip around the world. During the trip they kept a diary of their adventures and experiences.
When they returned home they edited the diary into a manuscript and failed at finding a publisher to take on the project. The couple reported the expenses of the around the world trip and all the costs involved in the of production of the manuscript as business expenses.
The Tax Court didn’t agree and concluded –
“The cost of a trip such as this, undertaken by petitioners for purely personal reasons, cannot be turned into and deducted as a business expense merely by writing in a diary en route with a mere hope (unjustified) that it might be published and bring in some income.
To allow the deduction of such expenditures to two people who have never been engaged in the business of writing and have no intention of attempting to earn a livelihood in the future in such business would be an invitation to many taxpayers to convert pleasure trips into business trips at the expense of the revenue.”
Since not all accountants are made equal, here’s a bit about Ms. Thompson from the Thompson Accounting website —
‘Megan Thompson is a Certified Public Accountant (CPA), Certified Valuation Analyst (CVA) and is Certified in Financial Forensics by the AICPA (CFF). She is a qualified expert witness and has experience in litigation support including the preparation of business valuations, analysis of income available for support, stock option and retirement plan allocations, separate property tracing, Moore/Marsden calculations and Pereira/Van Camp determinations.
In 2012, The California Society of CPAs (CalCPA) voted Ms.Thompson Young Emerging Professional (YEP) of the Year.’
I should say this up front — besides being an incredibly smart CPA, Megan is also my wife, so she has a big stake in my taxes being done correctly.
ETDC: At the end of the year freelancers and the self-employed get 1099s rather than W-2s. What’s the difference between 1099s and W-2s?
MT: You are technically “contract labor” which is why you would receive a 1099 instead of a W-2. A W-2 helps you out by forcing you to withhold taxes while a 1099 just reports how much you made.
Nothing is sent to the IRS or the state taxing authority , so you have to estimate how much you’re going to make for the year and how much you should be paying in taxes.
The benefit of being self-employed and receiving a 1099 is that you are able to deduct expenses you would not be able to deduct as a W-2 employee. You can reduce your taxable income by your business expenses which is an option that W-2 employees don’t really have (although there are ways W-2 employees can deduct expenses that I won’t go into here).
However you also have to pay Self-Employment tax which consists of Social Security and Medicare.
If you get 1099s instead of a W-2, how do you go about paying your taxes? What’s the process of paying estimates? How would you go about even calculating how much you need you need to pay?
If you are going to be paying estimates, your best option is to hire a CPA to review your information, calculate your estimated tax payments and provide you with vouchers so you can pay.
The IRS website is also a very good resource if you do not want to hire a tax professional. You can find a Form 1040-ES and follow the directions to pay your estimates. For state taxes you can look at your state taxing agency’s website and find state estimated tax forms to pay your estimates. There is also an option to pay your estimates online.
To calculate your estimates, you should look at how much total income less expenses you are going to make including any W-2, interest or other income you might have and determine what tax bracket you are going to be in at the end of the year.
This can be difficult if you are a freelancer and get paid sporadically for different projects but you can adjust your estimates throughout the year if this is a problem.
Depending on both your federal and state estimated tax percentages you should be sending quarterly estimates to the IRS and your state’s taxing agency.
Does the IRS have a hard distinction between hobby and business? Do some hobbies make more sense as businesses than others? Like a photographer versus someone selling crafts on Etsy?
The IRS has specific questions to determine business versus hobby —
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
Does an artist need to make money to call their work a business? Can it be all expenses, as long as there is intent to earn? Like a filmmaker who funds a film and enters festivals, but makes no income on the venture?
A business is generally considered to be for profit if it makes a profit in 3 of the last 5 years.
If it is not a for profit business it is considered a hobby and you can only deduct expenses up to the amount of income you earn. There are more specific rules and actually a lot of leniency for writers.
Here is a great article I found about taxes and the writer that explains everything in more detail —
For freelance artists, there can be a lot of expenses without much of an income. For writing and film, there can be a large cost in festivals and travel, and artists buying booth space at conventions and crafts fairs. What’s the advantage of reporting this income?
I’m sure it would be easy to not report it, but outside of the law requiring that you do, are there any benefits?
Most people think if you get cash and it’s not traceable, why report it? The real answer is that if the IRS finds out that you are not reporting your income technically this is fraud and you could be subject to fines and even jail time.
In the case of art on the side type jobs the explanation for not reporting the income would be that this is actually a hobby and not a job. You don’t need to report this income as long as your expenses are equal to or greater than what you made.
It makes sense to report when your income clearly exceeds your expenses. It is unlikely that the IRS will audit you but it is possible, and if you can’t prove that you had more expenses than income, you could owe money to the IRS.
If a freelance worker gets paid but at the end of the year doesn’t get a 1099 from a client, is that bad? Is it the workers responsibility to seek it out or does that fall on the client?
It is the client’s responsibility to issue a 1099. That being said, it is the worker’s responsibility to report all income that they have earned regardless of whether they have received a 1099 or not.
If you’ve commissioned artists for work this year – should you be issuing 1099s?
I guess the question would be whether you bought it for your business or bought it personally. If your company or you as a freelancer commissioned the artwork and will be claiming it as an expense, you’re technically supposed to issue a 1099. If you personally commissioned artwork to hang on your wall at home, you don’t.
As far as paper work goes, does a freelancer only need 1099s and a list of expenses before preparing a tax return?
If the freelancer has received 1099s for all earnings then yes, that is all he/she needs. If not, he/she needs to keep track of all income received throughout the year as well.
How would someone keep track of their income? Is it as easy as just writing it on a piece of paper or is there a ‘correct’ why to do it? Does the IRS have strict rules on it, or do they just take your word for it?
You could just write it all down on a piece of paper if that works best for you, however I would recommend using QuickBooks or some other bookkeeping software to keep track of your income and expenses if you have more than a few transactions. This software allows you to balance your checkbook and also print out forms that show your profit or loss.
If you have very little activity throughout the year you could also easily keep track on an Excel spreadsheet. You should keep all of your records including invoices and receipts.
The IRS will generally take your word for it but if you get audited, they are going to want to see supporting documents for all of your income and expenses.
I’ve heard that photography is a difficult hobby to claim as a business. There’s potential for profit, and there is work out there for photographers. Why would it be hard to report it as a business?
Photography is one of the classic examples of a hobby that taxpayers try to claim as a business. While there are certainly professional photographers, there are also several people who spend a lot of money on fancy photography equipment because they like taking pictures and then try to find a way to make this fun activity a tax deduction, even though they have no intention of ever making a profit.
At the same time if you are legitimately working as a photographer go ahead and deduct those cameras.
Let’s say a graphic designer has a regular W-2 paying job, but works freelance on the side, making roughly and extra $3,000 a year. Does this income just get reported on the regular individual tax return?
If the freelancer does not incorporate or start a partnership, he/she would report the income on his/her individual income tax return.
What’s the difference between reporting your contract income on your individual tax return’s Schedule C as opposed to having the business be a LLC or corporation? When should a self-employed artist (or anyone for that matter) become an LLC or corporation?
It really depends on each individual case. If you are earning royalties, technically you would be reporting them on the Schedule E rather than the Schedule C.
If you are making enough money to consider incorporating you should speak with a CPA and possibly a business attorney, preferably with some kind of entertainment background, to determine what would work best for your individual situation.
Of course that does not cover every issue the self-employed will face, but for the creative-type who is preparing to venture off into the world of freelance, it’s a good place to start.
This does not constitute legal advice. This should just be taken as a guide. Talk to a tax professional before making any decisions.