Tax Planning Strategies for Freelancers and Independent Contractors

Tax Planning Strategies for Freelancers and Independent Contractors

In recent years, the American job market has changed a lot as companies and employees are redefining the traditional employer-employee relationship.

Old, complicated processes are being replaced by more flexible and personalized options, made possible by new technology, mobile devices, and cloud computing.

In response to this transformation, there is a growing trend for people all over the world to engage in part-time work, second jobs, or so-called “gigs.”

People engaged in less structured forms of work, such as independent contractors or freelancers, often work on projects that can last from a few hours to several months and work for different employers at the same time.

Simply put, they sell their skills and knowledge to the highest-paying employer.

Talent networks, energy, and time have the opportunity to determine their income, which, when managed correctly, could have a positive impact on their financial condition, retirement, debt repayment, savings program, and tax obligations.

More and more people are shifting from regular full-time employment to independent contractors, regardless of age, career, or professional path.

We will focus on taxes and how freelance or contingent workers (collectively, “freelancers”) can legally minimize their expenses through tax planning strategies.

Importance of Tax Planning Strategies for Freelancers and Independent Contractors

Tax planning is important for freelancers and independent contractors in the following ways:

  • It minimizes tax liabilities and maximizes savings.
  • Tax planning helps with budgeting and financial stability.
  • It ensures compliance with tax laws and regulations.
  • It identifies deductions and credits for freelancers.
  • Tax planning helps to strategize for quarterly estimated tax payments.
  • It prepares for potential fluctuations in income.
  • Lastly, it optimizes retirement savings and investment strategies.

Tax Planning Strategies: An Overview of Tax Laws and Regulations

In the United States, the Internal Revenue Code (IRC) is the main body of tax laws and rules that apply to tax preparation. The code has collective rules about social security taxes, unemployment taxes, and self-employment taxes.

The four bigger areas within the code cover income taxes, which are imposed on American citizens, legal residents, and independent contractors, also called self-employed businesses.

Generally, everyone who is considered to be “in business” should pay income tax on a regular basis throughout the year, unless a tax year is one year long. Likewise, the foundational principle in U.S. law states that “income from whatever source derived is gross income.”

Different Types of Taxes for Freelancers and Independent Contractors

Here are some taxes that freelancers and independent contractors will pay, depending on the state:

  • Self-employment tax on net earnings.
  • Income tax on freelance earnings.
  • Estimated quarterly tax payments.
  • State income tax, if applicable.
  • Local business taxes or licenses.
  • Sales tax for goods or services sold.
  • Property tax on business assets, if owned.

7 Tax Planning Strategies for Freelancers and Independent Contractors

We are all set. Here are seven important tax strategies for independent contractors and freelancers:

1. Identifying Eligible Business Expenses

On a regular schedule, you should spend a little time adding up various subtotals and doing other bookkeeping tasks as necessary to track exactly how much you spent on each deductible expense during the year.

If something is a deductible business expense, remember to multiply it by (1- your marginal tax rate) to estimate its land-owning value.

Variable costs (like websites, equipment, home office, software, and direct advertising) are generally deductible, although what is deductible regarding cars is more limited.

Generally, fixed costs (like rent and utilities) can be partially deducted, but only if you use these items exclusively for your freelance work.

It is usually easier to argue tax law in your favor if you can provide documentation through a separate invoice or credit card statement that describes a business asset purchased.

2. Keeping Accurate Records

Keeping accurate records when you start as a freelancer is challenging, particularly when a more likely choice for a business owner, especially in its starting period, is to take control of the selling part of the business.

However, online tracking tools now make it easier for business owners to keep track of their expenses. And everything you record will help you maximize your tax deductions in the long run.

3. Utilizing Home Office Deductions

There are specific requirements a home office needs to meet in order to be eligible for home office deductions, including that the space must be used exclusively for business, that the space must be the primary place of business, and more.

While these rules are in place to prevent the exploitation of the home office deduction, they can sometimes be too restrictive for a work set-up that approaches, but does not strictly meet the rules.

Taxpayers can no longer qualify for home office deductions without having an official home office. However, if they do, then they can take a home office deduction, even if they rent, and also take standard employee business expense deductions.

If they don’t, then they are out of luck on both fronts. The home office deduction is a strategy that, while limited, can still provide a great deal of benefit. 

Unfortunately, if they want to rent their spare bedroom out on Airbnb, then they may be limited to taking either the standard employee business expense deduction or they may be limited to taking the home office deduction, but not both.

4. Maximizing deductions through retirement contributions

Retirement contributions are the best deductions because they have a double advantage: they minimize your current taxable income and help to secure your future. But to be able to contribute to retirement plans, you must have earned income.

It should be taken into account that while you can contribute to an IRA if you are earning an income from freelancing, you may not qualify for other retirement vehicles unless you have a combination of salaried work and income from freelancing.

For example, if you have an employer and are enrolled in a plan before your salaried work income drops below the limits, you are still able to contribute as if your previous salaried job were still in place.

Another alternative might be opening or activating a solo 401(k). If a freelancer has no full-time or part-time employees (the only exception is the spouse), and if she has only an informal job unrelated to the job as a freelancer, she will qualify. As a freelancer, you can also qualify for a reduced deduction under this plan.

5. Taking advantage of self-employment tax deductions

If you’re an independent contractor or  freelancer, you’re a self-employed individual. So what does that mean? Well, it means you have to pay federal and state income taxes, plus self-employment taxes (Social Security and Medicare), at a rate of 15.3%.

That might sound high, but there’s a bit of relief in the form of deductions, which allow you to subtract certain eligible expenses from your taxable income. This includes a full 50% of the self-employment tax.

6. Timing income and expenses for optimal tax savings

Independent contractors and freelancers are unique in that they often receive lump-sum payments for work completed rather than regular paychecks. To mitigate the tax event that results, planning can be key. 

Knowing how much income you expect to make can help you plan how you utilize deductions, credits, and write-offs. This data can also help you make the decision to file as an individual or as a business, should you choose to incorporate.

One way to lower taxable income is to postpone sending out invoices until the next tax year, to delay the income. However, by doing so, there may be repercussions, such as a late fee by the client for a missed deadline.

If such a strategy is employed, the freelancer may want to charge a higher fee to reflect the client’s costs.

Another strategy to consider is that credit card expenses could be an advantage by allowing the freelancer to front-load the costs for a particular tax year of deductions that would be incurred the following tax year.

This allows the freelancer to accelerate expenses and delay income, if possible, to take advantage of the tax savings earlier.

7. Search for Available Tax Credits

There are legal tax credits and deductions out there. Some people qualify for the Earned Income Tax Credit (EITC), which the IRS describes as “a benefit for working people with low to moderate income.

To qualify, you must meet certain requirements and file a tax return.” Self-employed people use Schedule C to report their business-related income and deductions. A tax credit reduces the amount of income tax that you may have to pay. A deduction reduces the total sales.

Some of the self-employed expenses that you can deduct on Schedule C include business travel, a home office, office supplies, utilities, the business part of your cell phone, banking fees, advertising, meals purchased while doing business, accounting fees, employment taxes, insurance, depreciation on equipment or vehicles, and vehicle loan interest. 

Carry over these business expenses on your Schedule C. Also, keep a record of your business investments that lost value, so you can take the capital loss.

Conclusion: Tax Planning Strategies for Freelancers and Independent Contractors

Tax planning is an important part of your business strategy and tax returns for freelancers and small business owners. But don’t worry about overlooking important steps. 

When taxpayers first choose professional tax preparers, they may ask how qualified they are and what areas of tax planning and preparation they specialize in. The answers should include more than basic accounting and bookkeeping.

Tax preparers should have an in-depth knowledge of the tax laws. Even if the preparer is not a lawyer or a CPA, that person should know the tax code inside and out.

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