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Freelancing and Taxes

A friend asked me about taxes and freelancing recently. This crops up often enough that I thought I’d share my answers with the rest of the world—well, really the US, as that’s where I pay my taxes. I’ve run freelancing business seminars that have covered this in the past, so this is going to be the encapsulated version.

Note that I’m not an attorney or an accountant, just someone who’s had to deal with this a lot over the years. This is complicated stuff and can vary from state to state, so for expert advice, I recommend contacting one of each in your area.

Any money you make from freelancing is subject to self-employment tax (assuming you’re not incorporated, but more about that in a minute). The self-employment tax in the US is 15.3%. According to Wikipedia: “Half of the hypothetical self-employment tax is allowed as a deduction against self-employment income so only 92.35% of the self-employment income is taxable at 15.30%, an effective tax rate of about 14.13%.”

For regular employees (W-2 folks), the employer covers half of the employee’s payroll taxes (Social Security, Medicare, and FICA). That’s half the self-employment tax rate, or 7.65%. W-2 employees split the taxes with the employer, but the self-employed have to pay both halves of that. This means that you effectively take a 7.65% penalty to be self-employed.

On top of that, like everyone else, you have your standard income tax bracket, which depends on how much you make during the year and how you file. Most folks fall into the 15% bracket, or really $1,565.00 plus 15% of the amount over 15,650. (That’s 10% on the first chunk and 15% after that.)

When planning your budget, though, you need to make sure you put away that tax money aside, because you won’t have the enforced discipline of your employer withholding the taxes from your paycheck like they do for W-2 employees. Instead, you’ll end up having to pay quarterly estimates (look for the 1040-ES forms) to make sure you don’t get nailed with a penalty at the end of the year.

If you wind up making more than, say, $35k in a year, it might be worth it to incorporate as an LLC or S-corp. You then hire yourself and pay yourself a small but reasonable salary. That way you only pay the payroll taxes (that total 15.3%) on the salary you earn, while the rest only gets taxed at the standard income tax rates.

I run my business as an S-corp and have saved thousands of dollars every year that way. This does limit your social security funding, which may come back to hurt you later, but that’s only true if social security doesn’t change a great deal between now and when you’re old enough to collect it.

Incorporation comes with a pile of paperwork you have to deal with on a monthly basis, but it also provides you with a layer of personal protection should someone somehow wind up trying to sue you over your work. Also, for a number of good reasons, some large businesses prefer to hire corporations for contract positions rather than individuals. Others insist on it.

One of the secrets to success at freelancing is recognizing it for what it is: a business. If you want to do well at it, treat it that way and get professional advice to help you make the most out of it. Good luck!

Comments 16

  1. I did the S-Corp thing myself. I went right to Lansing and filed on my own, then had a SCORE counselor help me with the S-Corp filing. Total cost for me $60 and I just paid my renewal for $25. Its a lot easier (depending on your state) than you might think to have your own corporation.

  2. I did the S-Corp thing myself. I went right to Lansing and filed on my own, then had a SCORE counselor help me with the S-Corp filing. Total cost for me $60 and I just paid my renewal for $25. Its a lot easier (depending on your state) than you might think to have your own corporation.

  3. I have one observation and a question.

    First, the observation: Federal Self-employment tax is divided into two components, Social Security and Medicare/Medicaid. The SS component makes up about 12.4%, while the MM component is 2.9%. I realize that your post is aimed at freelancers (which I take to mean people who freelance exclusively) but since lots of writers (me included) have day jobs in addition to our writing, I wanted to mention that only the first $102K of income is subject to the 12.4% tax for SS. So, if a writer’s day job paid him or her $102K or more, and SS tax is withheld from that pay (as is usually the case), then their liability for the 12.4% SS tax on their income earned from writing (on Schedule SE) would be zero. They’d still have to pay the 2.9% on their writing earnings, however.

    Now, the question:

    Can you walk me through how incorporating as a pass-through tax entity decreases your ultimate tax burden? Imagine you’re an LLC or a Sub-chapter S corporation and have gross revenue of 50,000. You employ yourself through the LLC and and pay yourself a salary of say $25K. That leaves 25K in profit (we’ll assume no other deductions for the sake of ease of analysis) which you would note on Schedule C and Schedule SE. Barring the example I described above, you’d pay the 12.4% and 2.9% on that amount.

    So good deal. Instead of paying that amount on the whole 50K, you only pay it on the 25K profit to the LLC. The rest is just ordinary income to me. The problem with this (I think) is that the LLC or S-Corp itself should be paying half the SS and MM taxes for its employee (just as any employer would) and the other half should be getting withheld from the employee’s (your) salary as part of normal withholding. If all of that is happening, there is no gain in after tax income from incorporating. It’s the same either way.

    Maybe I’m missing it, though. Let me know.

  4. I have one observation and a question.

    First, the observation: Federal Self-employment tax is divided into two components, Social Security and Medicare/Medicaid. The SS component makes up about 12.4%, while the MM component is 2.9%. I realize that your post is aimed at freelancers (which I take to mean people who freelance exclusively) but since lots of writers (me included) have day jobs in addition to our writing, I wanted to mention that only the first $102K of income is subject to the 12.4% tax for SS. So, if a writer’s day job paid him or her $102K or more, and SS tax is withheld from that pay (as is usually the case), then their liability for the 12.4% SS tax on their income earned from writing (on Schedule SE) would be zero. They’d still have to pay the 2.9% on their writing earnings, however.

    Now, the question:

    Can you walk me through how incorporating as a pass-through tax entity decreases your ultimate tax burden? Imagine you’re an LLC or a Sub-chapter S corporation and have gross revenue of 50,000. You employ yourself through the LLC and and pay yourself a salary of say $25K. That leaves 25K in profit (we’ll assume no other deductions for the sake of ease of analysis) which you would note on Schedule C and Schedule SE. Barring the example I described above, you’d pay the 12.4% and 2.9% on that amount.

    So good deal. Instead of paying that amount on the whole 50K, you only pay it on the 25K profit to the LLC. The rest is just ordinary income to me. The problem with this (I think) is that the LLC or S-Corp itself should be paying half the SS and MM taxes for its employee (just as any employer would) and the other half should be getting withheld from the employee’s (your) salary as part of normal withholding. If all of that is happening, there is no gain in after tax income from incorporating. It’s the same either way.

    Maybe I’m missing it, though. Let me know.

  5. Good points, Paul. You’re absolutely correct about the upper cap on the SS part of the tax. One of the often-proposed solutions to making SS more liquid is removing that cap, although that hasn’t happened yet.

    As I understand it, having just looked up a bit more about LLCs, you’re right that all that income gets taxed the same either way. However, with the S-corp, all profits (over and above salaries, of course) and losses flow through to the shareholders, and any profits are not subject to payroll tax or corporate tax.

    So, on that $50k, the S-corp hires you at $25k, and you essentially pay the self-employment tax on that. (Think of it as your withholding, plus the payroll tax if you like, but it amounts to the same.) However, the $25k you take as dividends, draws, or whatever you like to call it is not subject to that tax. On that $25k, you’d save $3,825 in taxes.

  6. Post
    Author

    Good points, Paul. You’re absolutely correct about the upper cap on the SS part of the tax. One of the often-proposed solutions to making SS more liquid is removing that cap, although that hasn’t happened yet.

    As I understand it, having just looked up a bit more about LLCs, you’re right that all that income gets taxed the same either way. However, with the S-corp, all profits (over and above salaries, of course) and losses flow through to the shareholders, and any profits are not subject to payroll tax or corporate tax.

    So, on that $50k, the S-corp hires you at $25k, and you essentially pay the self-employment tax on that. (Think of it as your withholding, plus the payroll tax if you like, but it amounts to the same.) However, the $25k you take as dividends, draws, or whatever you like to call it is not subject to that tax. On that $25k, you’d save $3,825 in taxes.

  7. Hey, that’s news to me. I assumed the S-Corp rules would be the same as those of the LLC (and I think, and I’m out of my element a bit here, that if one is the equivalent of a “limited partner” in the LLC, even though it is not a partnership, then the profits are not subject to Self Employment taxes).

    Live and learn. Thanks, Matt.

  8. Hey, that’s news to me. I assumed the S-Corp rules would be the same as those of the LLC (and I think, and I’m out of my element a bit here, that if one is the equivalent of a “limited partner” in the LLC, even though it is not a partnership, then the profits are not subject to Self Employment taxes).

    Live and learn. Thanks, Matt.

  9. I would chime in to remind everyone to keep in mind those out of state state taxes…I get dinged for Rhode Island every year…grrr….

  10. I would chime in to remind everyone to keep in mind those out of state state taxes…I get dinged for Rhode Island every year…grrr….

  11. When I first saw the title of your article I thought it said “Freelancing and Texas”. LOL. Good article.

    Rob

  12. When I first saw the title of your article I thought it said “Freelancing and Texas”. LOL. Good article.

    Rob

  13. I’ve just started being self-employed, so this is all new and scary to me. Do you know what the minimum is for filing a 1040-ES? I don’t think I’m making enough to worry much about taxes … yet.

    1. You have to pay self-employment tax if you make $400 or more from such activities. If you expect to owe $1,000 or more when your taxes are due, you need to do quarterly estimates. However, if you have a day job, the easiest way to handle this is to ask your employer to increase the regular withholding from your paycheck. As long as you don’t owe more than that $1k (from all you’re doing) at the end of the year, you’re set.

      This is another benefit of running an S-corp. I don’t bother with quarterly estimates. However, that also means I don’t have a mechanism to put anything away for the end of the year, and if you’re not careful with that you can end up getting dinged with a huge bill come April 15.

  14. I’ve just started being self-employed, so this is all new and scary to me. Do you know what the minimum is for filing a 1040-ES? I don’t think I’m making enough to worry much about taxes … yet.

    1. Post
      Author

      You have to pay self-employment tax if you make $400 or more from such activities. If you expect to owe $1,000 or more when your taxes are due, you need to do quarterly estimates. However, if you have a day job, the easiest way to handle this is to ask your employer to increase the regular withholding from your paycheck. As long as you don’t owe more than that $1k (from all you’re doing) at the end of the year, you’re set.

      This is another benefit of running an S-corp. I don’t bother with quarterly estimates. However, that also means I don’t have a mechanism to put anything away for the end of the year, and if you’re not careful with that you can end up getting dinged with a huge bill come April 15.

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