The Freelance/Self-Employed
Myth and Reality

Hallelujah! So you finally gained your independence and you're out working on your own.

The Freelance/Self-Employed Myth:

Better hours. Choose your own clients. More money. Time with your family and friends. You can do it better than your former employer. Greater happiness. Personal fulfillment. And just think of the tax savings!

The Freelance/Self-Employed Reality:

You've got to do it all — by yourself! For some, the details are so overwhelming, they can't get past the business problems to let their genius shine! Others simply breeze through all the administrative nonsense. And nonsense it is! There are so many things for a businessperson to know and do that I sometimes wonder how they ever have time to work.

We'll skip the questions about doing it better, happiness and fulfillment. You'll have to decide those issues. But read on...

Expenses — or, It Went Thataway!

Being self-employed, you may take deductions for all your business expenses — but only if you can prove you paid for them. So recordkeeping is critical.

It helps to know what business expenses qualify.

Meals and Entertainment

Don't waste much energy building up expenses in this area unless you're prepared to do it right. This area is always a target of audits and is one of the most abused of all expenses. Make sure that each receipt (or notation in your appointment book or business diary) has ALL FIVE of the following components: 

• Who — Name and company (spouses' and dates' meals may not necessarily be deductible). 
• Business purpose of meal/program — was this to sell, buy, learn? 
• Business relationship — was this a potential client, a source of information or contacts, a supplier — why is this business? NOTE: Contrary to what the IRS might like to have you believe, even if you don't sell anything to a potential client or prospect, you ARE entitled to the deduction. Even the best salesfolk rarely have a 100 percent close rate! 
• Time — either during a business meeting or right before or after a business function is acceptable, as are expenses accrued during a business event (a week-long trade show, for example). 
• Place — make sure the receipt shows the name and address of the entertainment facility or restaurant. The IRS is used to people dummying these up, so annotate all receipts properly if the address is not pre-printed on them — preferably, at the end of each day or when preparing your weekly (YES, WEEKLY) bookkeeping.

Beware the IRS: Taking certain deductions can be like waving a red flag in front of a bull.

Cash Expenses With No Receipt Available

Have you ever tried to get a receipt out of a pay phone or parking meter — or even a valet, for tips? They're not very cooperative, are they? So how do you prove you spent that money? And is it worth the bother?

Some parts of the country have toll roads. In other areas, you can't park without paying costly lot fees or feeding meters. Adding up all these costs, you might be spending over $1,000 per year on parking meters (only $4 per day). Add in payphones and tips, and you've found about $2,000 or more in legitimate business expenses. OK, it's worth it!

Proving it? Easy, just keep a diary or appointment book. Write in the amounts spent each day — then add them up at the end of the year (or sooner, if possible).

Office in Home Deduction

Taking this deduction can be like waving a red flag in front of a bull — if you can avoid it, don't use it. Especially if you own your home and expect to sell it in the next couple of years. (Speak to a good tax professional and DON'T argue fairness!) Using Form 8829 will increase your chances of being audited. (Not using Form 8829 while taking rent and/or utility deductions can almost guarantee an audit if your business address is your home address.)

Essentially, to qualify to deduct office in home expenses, you must be meeting with clients, customers, or business associates in your home. Or you must maintain storage for inventory in your home. Or the majority of your work must be done at home.

In other words, a consultant who does all the work in a company's facilities does not qualify. Nor does a plumber (unless s/he only repairs plumbing at home) or an emergency-room physician. Forget about someone doing seminars and presentations for a living — unless all 2,000 people meet in your home. Granted, there are variations. This area will be litigated for a long time to come!

There are lots more legitimate expenses, but we're limited on space and time. So if there are specific kinds of expenses you want to see discussed in Tax Bytes, please drop me a note with EXPENSES as the heading.

To be in business for yourself, you must look and act like a business. You've got to have all the licenses and certifications, you must have personally made an investment in the business.

Are you really a freelance worker or an employee sans coverage?

To be in business for yourself, you must look and act like a business. You've got to have all the licenses and certifications standard for your profession and for your city, county, parish, state, province or other government division (resale license, city business license, teaching license, professional certificate, contractor's license, truck driver's license...).

You don't have to have a business name. But if you are Steve Johnson Consulting, instead of plain old Steve Johnson, you might look at filing a fictitious name (if required in your area) or your bank may not want to accept your deposits. Be sure to open a separate business account.

It's wise to have business cards. Create a brochure or flyer that identifies your products or services. You must be available to the general public (or your industry) to offer your goods and services. If you only work for one client for an extended period of time, you may find the IRS regarding you as an employee for income tax purposes (see consequences below).

Having a Federal Identification Number for your business lends some legitimacy to your claim. Also, you can provide that number to clients for tax purposes instead of your Social Security number. (Wouldn't you like to limit the number of people who can emulate you by having your SSN, driver licenses, date of birth, mother's maiden name?)

Another consideration: Do you have an investment in your business, equipment, etc? If your client provides all the tools, the work location, the supplies and utilities, you are an employee. On the other hand, if you pay rent, buy equipment and supplies, pay for your own training... you get the picture.

Make sure you have a contract — spell out the terms and length of the engagement or job. Carry the necessary insurances — professional liability, bonds, workers' compensation, etc. Pay your own business expenses. Build enough into each contract to cover anticipated costs, including travel.

There are a total of twenty common law factors. Speak to your tax professional about them and the relative importance of each factor to your own business or industry.

What if you turn out NOT to be a freelancer — or,
Who Cares Anyway?

Well, being self-employed, you may deduct all your business expenses without having to itemize deductions. You take the expenses on Schedule C and only pay taxes on the business profits.

If you turn out to be an employee, you'll have to itemize everything (Schedule A). That means, for a single person with $40,000 in billings, you won't get any benefit for the first $5,800 of your business expenses ($5,000 for the standard deduction you would have gotten anyway, plus $800 for the 2% of adjusted gross income you cannot deduct). That costs you $1,624 (in a 28% IRS tax bracket) plus penalties and interest. (Yes, there is a consequence on self-employment taxes, but if you did it right, you would have had about $20,000 worth of business expenses, so it would balance out the FICA/Medicare on $40K — we freelancers must think of these things!)

Moral of the Story

Know thyself. And make sure you cover your behind so the IRS agrees with your identity.

WEB RESOURCES:

The Official IRS Site
Government-run source for forms and information.

The Digital Daily
A surprisingly cool news page from the IRS.

1040.com
One stop source for tax information and forms.

Tax Software
Comprehensive list of links to available programs.

The Tax Prophet
Columns by attorney Robert L. Sommers from the San Francisco Examiner.

MsMoney articles

More Public Tax Articles

More Professional Tax Articles


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Copyright © 2000-2001, Eva Rosenberg
Previously Published,
Reprinted and Revised 3/15/01