It’s that special time of year—tax time! April 15 is right around the corner and you’re probably already receiving your tax documents such as W-2s and 1099s in the mail. An increasing number of workers are entrepreneurs, including those who freelance on the side and those who are self-employed.
If you find yourself collecting 1099s for freelance work you have performed or if you consider yourself a sole proprietor, there are several items to consider related to your federal income taxes.
Is It a Hobby or a Business?
The IRS defines an activity as a business when “it is carried on with the reasonable expectation of earning a profit.” I’m a CPA, but several years ago I decided I also wanted to be a writer. I attend writer’s conferences and incur business expenses such as travel costs, conference fees, dues, and so on. For the first few years, my losses exceeded any profit from my writing business. If this pattern of losses without income continued, the IRS could question whether my writing is a hobby instead of a business for tax purposes. The government wouldn’t allow me to continue using these losses to offset other income if my activities were actually a hobby.
However, I did achieve a profit in the third year of my writing business. Also, I have a website, business cards, and I actively pursue a profit from these activities. If an activity achieves a profit for three out of the past five years, the IRS typically deems it a for-profit business endeavor.
Best Practices for Recordkeeping
Now that you have established whether your activity is a business, what are the best ways to track income and receipts for tax purposes? First, it’s important to keep personal and business expenses separate. I highly recommend opening a separate bank account for business transactions. If you’re going to use credit, apply for a separate credit card for business transactions instead of using a personal card. Be sure to keep all business receipts, either in paper or electronic format!
If you use your car for business purposes, you can deduct a portion of the cost on your tax return. There are two methods to determine the amount of expense to use as a deduction: the standard mileage rate or the actual expense method. Personally, I prefer the standard mileage rate because I find it easier to track business mileage than maintaining receipts for the actual expenses such as gas, oil, repairs, tires, insurance, registration fees and licenses.
The standard mileage rate just changed as of January 1, 2015. The new mileage rate is 67.5 cents per mile. If you use this standard mileage rate method, be sure to track your business miles in some type of log. If chosen for an audit, the IRS will most likely ask for this documentation. I use an Excel spreadsheet that operates like a calendar where I track the number of business miles I drive each day.
Home Office Deduction
In 2013, the IRS introduced a new simplified method for the home office deduction. Instead of tracking each expense related to maintaining your home and applying a percentage based on the square footage used for business, the simplified method allows for a $5 per square foot deduction up to 300 square feet. With this method, there’s no depreciation deduction recapture when you sell your home. You can find out more information in Publication 587, Business Use of Your Home.
Regardless of the method used, remember that any home office space you plan to deduct for business purposes must be regularly and exclusively used for business. This means it’s not temporary space and it’s not a combined space that’s also used for personal activities.
Quarterly Tax Payments
As a sole proprietor, it’s important to make quarterly estimated payments throughout the year to pay estimated income and self-employment taxes. Generally, individuals should make estimated payments if they expect to owe taxes of $1,000 or more. The quarterly payment due dates are April 15, June 15, September 15, and January 15 (of the following year).
Quarterly payments can be filed on Form 1040-ES via mail or electronically through EFTPS.gov. The Electronic Federal Tax Payment System® tax payment service is provided free by the U.S. Department of the Treasury. After you’ve enrolled and received your credentials, you can pay any tax due to the Internal Revenue Service (IRS) using this system.
I hope this introduction to taxes for entrepreneurs is helpful as you enter the tax filing season. You can find out more in-depth information on any of these topics via the “Self-Employed Individuals Tax Center” on the IRS website.