A well-crafted question gets a better answer.

An article that I wrote recently for

http://nationalpsychologist.com/ brought me many requests from psychologists for my expense list. Some also sent questions. The most frequently-asked question was this one, as expressed here by Dr. David from Santa Clara, CA.

How do I know if I'm paying too much year after year? Thank you.


Hello David,

Your question is similar to my asking you, how do I know if I handle personal relationships well? You wouldn't have enough information to give me an answer.

Am I referring to my relationship with my mother, my kids, my husband, my friends? Do we fight a lot? Have other people noticed and commented? What specific things are on my mind about this? Do I just feel that things aren't right? How long have I felt this way?

With taxes, as in any situation, you need to know the particulars in order to make the right choices, or give correct answers.

I would start by looking at David's last three tax returns. If they were not available, I'd ask what his gross income was last year and what was his net income for that year. Based on his answer I'd ask the next question and then the next.

Dr. David's question is often asked by indies in all professions. You might want to check out this on my website -- How To Ask A Question.

June

What's the difference between a tax bracket and a tax rate?

We are all hearing a lot of hype about tax cuts and tax hikes for the middle class, for the rich, for everybody, for nobody.

But, has any pundit or pol explained how taxes work? No. No more than anyone explains what is a small business?

So here's something with which to regale your friends at the next cocktail or tea party -- a little tax savvy.

What’s your tax bracket? It's the same thing as your marginal tax rate. As your taxable income increases so does your federal income tax rate. The rate at which you end up is called your tax bracket. Another term for tax bracket is marginal tax rate.

Tax bracket and marginal tax rate both mean the percentage at which your next dollar of income is taxed. If you’re in a 15% tax bracket, for instance, on the next $100 of taxable income you will pay $15 in income tax. If in a 28% bracket, then $28 of the next $100 taxable income will go to the Feds.

Advancing to a higher tax bracket does not mean that all your taxable income is taxed at the higher rate. It means that any income from that point on is taxed at that rate.

Gross income, age and filing status -- married, single, widow(er), etc. -- determine whether you must file a tax return.

Taxable income is what's left after all deductions have been subtracted. Taxable income determines the rate at which tax is paid

Let's look at Gary Graphic -- single, owns a house, gives a lot to charity.

Gary grossed $250,000 in his design business [Wow! that's a lot.] After deducting business expenses his net income for the design business was $195,000.

Among the deductions from the $195,000 were Gary's self-employed pension contribution, mortgage interest, real estate taxes, and charitable contributions. After all subtractions he had $100,000 taxable income.

Here's how his tax is calculated:
The first $ 8,350 …… is taxed at 10% = $ 835
the next $ 25,600 ….. is taxed at 15% = $ 3,840
the next $ 48,300 ….. is taxed at 25% = $12,075
the last $ 17,750 ...... is taxed at 28% = $ 4,970
Total Income: $100,000 Total Tax: = $21,720

Gary is in a 28% tax bracket. That is his marginal tax rate.

Gary's real tax rate -- we tax pros call it his effective tax rate -- is: just about 22%. Meaning that about 22% of Gary's taxable income went toward federal income taxes.

How did I get that: Divide 21,720 by 100,000

Keep in mind that in this example Gary started with $250,000 income. The tax talk about taxing the rich who make more than $250,000 is not about Gary or most of you unless you are one of the top 3% earners in the country.

If Danworth Design's taxable income were a half million dollars his federal income tax would be $152,684. That is a little more than 30% of his taxable income.

End of today's tax lesson.

June Walker

What's a small business?

Indies, you know that I frequently tell you that you are a business. That you must think like a business. That you must have an indie-business mindset. You also know that your business is small. Your business may be you and only you. You may call yourself a "small business" because you are.

There’s lots being said right now about tax credits, tax hikes, what’s good and what’s bad for small business.

Well, what exactly is a small business?

I think it will come as no surprise, that there is no "exactly." Let me give you some examples from our ever-present source: The IRS.

If Caitlin Caterer, who has three women working for her, or Lorenzo Landscaper, who has a couple guys help him out, were looking to take advantage of the "health care credit for small business," they’d qualify because, for this tax credit, small business is defined as any business having 25 or fewer employees.

If graphic designer Victor Visual wanted to carry-back the business loss he had this year in order to recoup some of the taxes he paid in previous years he’d be allowed to do that as long as his small business had gross income of not more than $5,000,000 per year over the last three years (yup, that’s five million dollars). Doesn’t matter how many employees Victor has as long as he didn't gross five million dollars.

If Sid System wanted to set up a medical savings account for the two techies who are his employees he’d be allowed to do that. Why? Because for the Archer medical savings plan the definition of small business is 50 employees or less.

And then there’s a whole lot of other “definitions” of small business. And this is where size really counts.

Based on the North American Industry Classification System (NAICS) the following are considered small businesses if their income is equal to or less than:
agricultural industries ---------------- $750,000.
heavy construction industries ----- $33,500,000.
trade contractors -------------------- $14,000,000.
retail and service industries -------- $7,000,000.

Or their number of employees is equal to or less than:
for most manufacturing and mining industries -- 500. employees
for all wholesale trade industries ----------------- 100. employees

(For complete list of size standards, see the Small Business Administration's Table of Small Business Size Standards.)

So indies, please be careful when people with an agenda throw around terms that have different meanings.

According to the IRS, in 2007 [most recent statistics available] 94% of businesses were S-corporations, partnerships, and sole proprietorships. I don’t want to boggle your mind but all those business entities pay taxes at the individual tax rates. Yes, that is so.

I’m a sole proprietor. I pay tax at an individual rate. If I hook up with another accountant and we form a partnership and split the profit, then we each pay tax at an individual rate. The same would be true if we formed an S-corp.

Randy Neugebauer, a Republican who represents the 19th District of Texas, as a guest blogger of Townhall.com, wrote on July 29, 2010, that "Ninety-four percent of small businesses will face higher taxes under the Democrats' plan."

Randy is using 94% to confuse us. You and I are part of the 94% of small businesses out there. So is just about everyone who visits my site. And! Most of us do not have at least $250,000 in taxable income.

I see Randy as intentionally muddying the water. Some may say it’s a lie. The Democratic plan is to keep individual tax rates as low as they currently are, except for those individuals with taxable income over $250,000.

Unless Mr. Neugebauer refers to small businesses such as retail manufactures with gross receipts of $7-million or trade contractors with a gross of $14-million he is deliberately misleading indies.

Indies send me lots of questions about the fear-instilling emails they receive that threaten tax hikes that will wipe them out. Don’t listen to that propaganda. Tell your indie colleagues not to be terrorized by this intentional misrepresentation. Get more information.

June Walker

Tax & Marriage

Hi June,

I attended your session at CFC last year. I'm a Chicago graphic designer (sole prop) and have been in business for 10 years. I recently got married and am wondering if you have any specific advice regarding how to approach taxes now that I'm married (I checked your website but didn't see anything relating exactly).

Thanks for any insight you can offer!
lidia


Hello Lidia,

First, let me wish you joy and happiness and good wishes on your marriage.

Assuming you and your husband do not work together in your design business then marriage has no impact on your sole proprietorship graphic design business tax, per se.

However, being married may have a profound impact on your overall tax. For instance, a married couple with taxable income of $100,000 will pay less tax than a single person with $100,000 taxable income. Yet, two single people each with $50,000 taxable income may pay less tax than a married couple with $100,000 taxable income.

As I explained here Taxes: Which ones and how much do I pay? and here Estimated Taxes your tax is based on yours and your husband's entire income and deductions. That includes earned income, investment income, medical deductions, etc.

-- June

Oh, the hype ... lies ... and edited video tapes

June --

I am a writer that is still having a time finding a tax person with your indie point of view. But the good bookkeeping I have learned from you has been a plus. Can I get your updated version of biz expenses?

Also, I am hearing that massive tax increases are coming in January 2011. Can you please post what these tax increases are on your blog as you can? This would really help in my monthly bookkeeping.

Thank you, Donna
Lakewood, NM


Hello Donna,

Thanks for letting me know that my advice is a help. Expense list sent a while ago so on to your question.

So many indies write me and say that they heard such-and-such but they don't tell me where they heard such-and-such. Aunt Tillie? A CPA? The yoga teacher's husband?

And I must tell you that just about all the such-and-such is hogwash. As is what you heard.

Anecdotally, I have seen taxes go down for my clients. The refundable and non-refundable credits available have increased. The reading I must do to keep up on the new tax breaks is daunting.

And, it's not just my experience. The Center on Budget and Policy Priorities says that: "This is the second-lowest percentage in the past 50 years."

I am so pleased that you asked before acting. And, as my husband the former reporter always says: Check your sources then check them again.

Best,
June

Net profit is subject to tax.

June --

I have a question. I teach Metal Clay classes (making fine silver jewelry from silver in clay form). I charge $85 fee which includes $35 for supplies. What portion of this do I have to pay tax on as income. I am assuming I would just claim $50 as income but I wanted to be sure.

Edith


Edith --

An indie claims all income she receives. That's gross income.

Then she deducts all expenses.

What remains is net income or profit or loss. It is that amount on which you are subject to tax.

Here are more posts on income .

-- June

IRS owes you money. A BIG BUT as to whether you'll get it or not.

Hi June,

I have been a software developer for 15 years in Oklahoma City, Oklahoma. Loved your book and I have a question about the statute of limitations for refunds that maybe you can address in your blog.

Here is a direct quote from the tax code section 6511:
"Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid."

It clearly states "within 3 years from the time the return was filed". There is no use of language such as "timely filed" or "due date" etc. My interpretation of this would be as follows: I file my 2003 return on April 15th 2009. I can take a refund until April 15th 2012. After all, the IRS can assess taxes against that return until April 15th 2012! Obviously, the IRS does not see it this way, but I cannot get anyone on their side to give me a reasonable explanation as to how they arrived at their application of Section 6511. In this case the code isn't acting as code should from a developer's perspective :).

Perhaps you have some insight, like a related section that provides guidance which I may be missing?

Thanks,
Matthew


Well, Matthew. Don't know how insightful I can be. But, I can explain it.

Correct, no matter how late you filed your tax return, you may file a claim for refund for up to three years after you have filed your tax return. But -- BIG BUT -- that doesn't mean you can get the money owed you!

Here's how it works:

*** To be considered for a refund you must file a claim for refund within three years from the date you filed your return.

*** How much of your refund that you may receive depends on whether you filed your return on time or not.

*** Amount of refund received also depends on when you paid the taxes for the year for which you are claiming the refund.

If you filed your return on time, meaning due date plus extensions, then your refund can be up to any amount as long as it was paid during the tax year plus the three years after that.
For example:
If you file your 2007 tax return on October 15, 2008 and you file a claim for refund on October 15, 2011 your refund may not be more than the taxes paid and applicable credits for 2007. The taxes for 2007 must have been paid during 2007, 2008, 2009, 2010 through October 15, 2011.

If you filed your return after the due date plus extensions then your refund can be up to any amount owed you as long as the taxes were paid during the two years prior to filing the refund claim:
For example:
If you file your 2007 tax return on October 16, 2008 -- a day after the deadline -- and you file a claim for refund on October 15, 2011 -- same day as my previous example -- your refund may not be more than the taxes you paid for 2007. But, [this is the BIG BUT] only those taxes paid from October 17, 2009 through October 16, 2011 are eligible for refund..

If you want to read how the IRS explains this, see IRS Publication 556 pages 13 through 15 and IRS Code Section 6511 -1B(2)a.

Since most people pay taxes for a particular year in that year or a little into the next it pretty much means: forget about filing for a refund if you didn't file your tax return on time.

The exception: You receive a notice from the IRS a year or so after filing. You pay additional tax then find out you didn't really owe that tax and you file a claim to get the additional tax refunded.

Best,
June

Plan on 30% to 40% of net income going for taxes.

June, thanks for your response, Cruising Both Ways . In reply, I absolutely knew I would owe money to the IRS but this year seems to be particularly outrageous. I have no problem paying my taxes (as I have done for my entire working life - the last nine on cruise ships)...as long as it seems within reason.

I made $21,000 last year and only $8,000 of that was from 1099s from the cruise ship job. The remaining income was from my land based job I worked for 9 months and from which all my taxes were deducted.

What I find unbelievable is that I owe $1,800 in taxes!!! And how is it that I am being taxed on income ($11,000 from my land based job) that I've already paid taxes on?

How can someone who makes so little money owe so much? My tax guy said it's because of my land job that I owe so much as it put me in a higher tax bracket. What??? I made $21,000!!! That's nothing! I just can't believe that someone living close to the poverty level would be liable for so much. So, in essence, doesn't $1,800 on $8,000 seem a bit much?

Thanks for your time.

Regards,
Paige



Dear Paige,

I understand your incredulity. Let me explain. Although I may make it clear I can't make you feel better. Wish I could.

Income tax is calculated on entire income. Wages, dividends, alimony, net self-employment income, jury duty pay, etc. are all added together. Were someone to receive a lot of dividends [not this year, of course] or alimony, no tax would have been withheld on that income. If no estimateds had been paid tax would be owed at year-end.

Let's say you made $20,000 in salary but your withholding were incorrectly set for a $10,000 income. You'd owe taxes at year-end. Or conversely were you over withheld as if you were earning $40,000 a year -- you'd get a refund at year-end.

In your case, nothing was withheld on your $8,000 freelance income. If your income tax rate is 7 1/2 % then you'd owe $600 income tax on the $8,000 income.

In addition to that you must pay Medicare and social security tax on your freelance income. That's approximately 15%. $8,000 times 15% = $1,200.

Add them up you get: $600 + $1,200 = $1800.

As a general rule of thumb, I suggest that indies plan to pay 30% to 40% of their net self-employed income on taxes.

Here's more info on taxes .

Best,
June

Is this what they mean by "do the math?"

In response to my post To deduct or not to deduct. Jamie sent back the following really good question:

Thanks for responding June.

In regard to your comment about it being a confusing question, let me explain. Say my business grosses $100,000 a year. After payroll, vendor bills, utilities, supplies, and other business related expenses, I'm left with $40,000.

The government is going to say "Okay, you have $40,000 left over. We're going to take a percentage of that." My concern is choosing between lowering my taxable income, and saving the money that I make.

So if I buy tissue paper for my office bathroom, should I be conservative and get the cheaper brand? Or should I buy the name brand because any money I would have saved getting the cheaper brand will be taxed by the government?

Or if there is a business convention coming up and the entire trip costs $3000, should I take the trip and not get taxed on the $3000? Or should I "save money" but still get taxed on it by the government?

I guess it's like a catch 22: If you spend more of your income, you may not have much left over for other interests. But if you're "saving money" by not spending it on legitimate business deductions, then the IRS will take a larger percentage of the unspent money.

I hope this made some sense. If it does, then my question is: Is it wiser to spend more through your business to reduce your taxable income than to try to save money and get taxed on the unspent money?

Thank you.
Jamie.


OK, all you indies. Follow this for I hope it will give you insight into answering your own questions because I think Jamie could answer his own question were he to simplify it.

What if I said to Jamie: Would you want me to give you $100 to deposit into your savings account or would you prefer I give you a percentage of $100 for you savings account?

Or if I gave Jamie, or you, the following choices, which would be the better pick? Keep in mind that you pay approximately 30% of your net income to taxes or reduce your tax by 30% of every business deduction.

OK, Jamie. You've got $200 in your pocket.

First choice: Spend $200 on a large supply of soft expensive toilet tissue. You save $60 in taxes. You put the $60 into your savings account.

Second choice: Spend $100 on a large supply of scratchy cheap toilet tissue. You save $30 in taxes. You put $130 -- that's the $30 tax savings + the $100 you did not spend -- into your savings account.

The smart shopper or the smart indie-business chooses to buy the less expensive toilet tissue -- the second choice -- unless there is a business reason to buy the more expensive toilet tissue. The Hilton buys the more expensive the Heartbreak Hotel buys the cheaper.

Jamie mentions a $3,000 conference. You do the arithmetic. If you choose to attend the conference there better be a really good business reason why that conference will make your business more successful or more productive because if you go it's $2000 out of your pocket. [Did you get the correct answer?]

OK. Math lesson over. By the way, I used to tutor math in the old days back when they thought girls could count but weren't quite up to multiplication and division.

Cheers,
June

Unemployment Compensation

"W-2 people" is my shorthand for employees who receive wages or a salary.

Someone can be both an employee and self-employed. For instance, someone works 9 to 5 for the local pet shop and is pet sitter by night and weekends.

I have received many questions from former W-2 people about receiving unemployment compensation and how it impacts self-employment. And vice versa. Here are two typical emails followed by my response.


Hi -
I have an odd question... I was laid off from a tv station in June 2007.. got unemployment for 20 weeks - when it ran in December of 2007 I was still unable to find full time work but did pick up
several short term (independent contract) gigs last year.

I got notice that unemployment insurance was extended in June 2008 but since I had some short term projects I didn't enroll. When those projects dried up - I did enroll and am back on Unemployment Insurance extended for the next 20 weeks.

My question is: When I do my taxes for 2008, if I file as a self-employed will that create a problem with the current unemployment that I am collecting?

Just not sure what to do.
Dee


June --

I am from Portland, Maine. I am a graphic designer/editor. Just started as an indie.

My question is with regard to unemployment insurance, taxes and self-proprietorship. When I was laid off last year, I began to collect unemployment insurance. This year, I have started an indie biz as a freelance designer/editor. I have a small amount of money coming in, but it does not cover my start-up and operating expenses.

Can I continue to collect my unemployment insurance payments while I get the biz off the ground?

What are the tax implications of this?

My unemployment benefits will run out before the end of the year. Is it possible/advisable to postpone payments from clients until the benefits run out, and if so, how do I report it on quarterly estimated tax payments?

Michael
Portland, Me


Unemployment Compensation -- let's call it UC -- is a benefit provided by both the federal and state governments. That means that the Feds as well as each state has a say in how it is regulated.

The intention of UC is help W-2 people who are temporarily unemployed due to work-related circumstances which are beyond their control.

Typically state laws require that someone requesting UC meet the following conditions:
** is not currently employed
** is able to work
** is available for work
** is actively seeking work

If you are self-employed you are you own employer. That means that even though you may not be making any money you are working. You are currently employed by yourself. So you are not currently unemployed.

An odd job to pick up some money does not make you a self-employed in business. Read these posts being self-employed for more info.

Your circumstances and your state's laws determine which conditions must be met.

For instance, if yours is a temporary layoff from your job and you have a reasonable expectation of being recalled, you may not be required to seek work.

If the work you did is no longer in demand, and you are not trained to do anything else, the state agency may provide you with vocational training and your work search requirements may be waived so that you may collect unemployment while going to school.

And, some states will pay UC while you start a business of your own.

Call or log onto your state agency and get an explanation of the benefit requirements. Know before you act so that you don't mess up.

Tax treatment for indies, whether on or off self-employment, is the same. One does not alter the other.

June

What % of my income for taxes?

June --

I work and live in San Diego CA, I am a mortgage loan processor and just started as an independent processor. I get paid per loan closed. No hourly pay. I get $400 for each loan I close and was promised at least 10 loans per month. So if I make about $2000 every other week, how much should I take from that check to put aside to pay for my Federal State Tax, Social Security taxes and possibly self employment tax?

I will have several deductions at the end of the year for working such as my transportation, office supplies, cell phone, use a room from home as my office etc.

I thought I should put aside at least 25%, am I thinking right?

Look forward to your answer.

Thank you, Rose
San Diego, CA



Hello Rose,

You need to put aside between 30% and 40%. Take a look at this column on my website for an explanation Taxes: Which ones and how much do I pay?.

-- June

Artist Tax Problems

Hello Ms. Walker,

Me and my husband are self-employed artists.

The question that I have for you doesn't really belong to the self employed category, though. Here it is: I have a trust that sends me 1099's. This year, the 1099B said that my proceeds from an exchange,(a trust merger) gave me a net proceed of 80,000.

When I plugged this number into TurboTax, there wasn't any spot for "exchange", so I listed it as a "sale": it said I would owe $5000! Did I do this right? Are exchanges "sales"? I'm just not sure if I'm doing this right, and, ironically, I don't have the money to pay an accountant. I'm an artist, I do my own taxes, I get $300 a month from the trust, and I made $0 in 2007 (I moved to Mexico, where I can live more cheaply). I

I know this is totally not what your site is about, so thank you for listening. It's hard in Mexico to find someone face to face who knows about US taxes. If you have any other site/person to send me to, please please do so! I've been trying to read as much as I can online to figure it out.

Best wishes from Baja California Sur


Hello Baja California,

Your dilemma is not unique to you. Many artists have tax questions about the non-indie part of life and don't have the resources to hire a tax pro.

Here's a little general tax info about income statements received at year end from different sources:

An employee must get a W-2.
A self-employed may receive a 1099-MISC.
An investor with interest or dividend income receives a 1099-INT or 1099 -DIV.
An investor who sells a stock or other product receives a 1099-B.
A partner in a partnership receives a K-1.
A trust beneficiary [one who receives money from the trust] receives a K-1.

Your first step should be to go the source. By the source I mean the accountant who prepares the trust tax return. Unless yours is an unusual situation, you should not be receiving 1099s from the trust. You should receive a K-1.

You don't say what kind of artist you are but for my purpose I'll think of you as an accomplished watercolorist. Just as putting a paintbrush into the hand of your neighbor doesn't make him a skilled painter, nor does putting you at the keyboard of TurboTax make you proficient or even skillful in taxes. Over and over in my writing I warn about the inexperienced using tax programs.

A 1099-B is sent when there is a sale. If you receive a 1099-B showing a sale of $2,000 you might have a gain or you might have a loss. If you bought the stock for $500 you would have a $1,500 gain. If you bought the stock for $3,000 you would have a $1,000 loss.

An exchange is just that, one thing is exchanged for another. In your case maybe one trust for another trust. For instance if a $50,000 trust is exchanged for a different $50,000 trust there is no gain nor loss. Thats's why you need to call whoever is handling the trust. If you get no help there call the IRS directly at 800.829-1040. [The # may differ when calling from Mexico. If it is, please let me know.] Don't be afraid of contacting the IRS. The new IRS is friendly and often helpful. Don't use a tax program for this situation.

Best,
June

Indies: Do it right.

June –

I am a nuclear engineer from Knoxville, Tennessee. I just started December 3, 2007. I would like to start off without calling attention to the IRS.

I assume I need to pay quarterly estimated taxes but am not sure how to estimate them.

When was the last update of your book, Self-employed Tax Solutions?

If I use Schedule C must I also fill out the SE Form?

Your help would be appreciated.

Thanks,
Max


Hi Max,

I am not sure what you mean by “without calling attention to the IRS.” And if you mean you don’t want to call attention to yourself in the eyes of the IRS, I am still unsure.

Every new indie -- such as you – needs to get as much information about self-employment income, expenses and taxes as possible. Your goal should be to pay the least tax legitimately possible and to avoid missed deadlines and payments so that you don’t get stuck paying penalties and interest.

As in nuclear energy, the aim is economy, simplicity and doing it right. Rather than thinking of your task as an indie in terms of keeping the government off your back or out of your business affairs, think in terms of avoiding mistakes and delays that would cause problems and overpayment of taxes – in other words, learn how to do it right.

Here is my post on how to calculate and pay Estimated Taxes .

Yes, a Schedule C: Profit or Loss from Business, and a Form SE: Self-employment Tax, are part of your tax return.

My book, Self-employed Tax Solutions, just went into its 6th printing. My purpose in writing it is to give indies an understanding of how the IRS looks at self-employment and also to give them a basic foundation in income, taxes, expenses, and recordkeeping. The book does that and will always do that.

Other than an adjustment to the treatment of start-up costs the tax laws have not changed since the book was published in 2005. As you may know from reading my material or attending one of my seminars I advise indies to have a professional prepare their returns. So, when I say that the tax laws haven’t changed I mean, for example, that the method of recording and calculating business miles remains the same. Yes, the per mile amount allowed by the IRS changes every year. That is something your tax pro knows or you can look up on the IRS site. But, what your tax pro probably has not told you, nor has it changed, is that you should write down your odometer reading in your calendar on New Year’s Eve before you go out to party.

Get the idea? Hope that helps.

Best,
June

Self-employed in more than one state

June --

I have 14 yrs as a contract electrical engineer (electronic hardware designs).

You touched upon this topic at June's Blog but you didn't get into the detail I'm curious about. I am self employed and live in CT. For the first time, I might take a client company in the neighboring state (MA). For my previous long term client located here in CT, I worked from my home office and visited their facility (3 hrs round trip) maybe about 15 days out of a year.

If I work in a similar manner for a company out of state, what criteria should be used to determine how I report income to each state. Would I only report MA income for the days I traveled to MA, and the rest is CT income? Of course, the full income from this client would be reported on their 1099 showing they're an MA company, possibly without a CT facility.

Also, while hired under contract by a local office here in CT, I had to go to their corporate office in another state to work for a few weeks. I reported all income as CT income that year. Was that reasonable?

Brian
Windham, CT



Hello Brian,

All your net self-employed income -- and all your other income as well -- is taxable to the state in which you live. That's your "resident" state. In your case, Connecticut.

Here's how it works ... or here's what the non-resident states want you to do:
If you work in other states -- that means actually work there not just go there to pick up the work -- then you are working in a non-resident state. You must pay tax to the non-resident state on the income made in that state. If you pay income tax to the non-resident state you will get a credit on your resident state tax return for the tax paid to the non-resident state.

If your income can easily be identified as done in one state rather than the other, then allocate by actual income. Or, figure your income in each state by # of days worked to # of days worked in the non-resident state.

Here's an example:
As an engineer you grossed $100,000 self-employed income. $80,000 earned in resident state, CT; $20,000 was earned in non-resident state, MA.

You had $40,000 expenses which left you a net income of $60,000.

Since 20% of your gross income was from MA, then 20% of your net $12,000 is taxable to MA.

If your expenses were such that they could be easily identifiable to each state then your portioning of income would be actual rather than as a percent.

Best, June

First Year Freelance Writer

Hi June,

I started working as a full-time freelance writer in January 2007, and since then I haven't paid any taxes. (I did pay my income taxes in April, but that was based on my normal full-time job from 2006.)

I've missed three periods of paying estimated taxes, and now I'm not sure if/when I should pay them or if I am exempt because it's my first year as a self-employed freelancer.

I know I probably need to pay a penalty to the IRS but I'm not even sure how to do that.

Will general tax software be able to help me with this?

I really want to get back on track with all of my taxes and all caught up. Any help you have on how to do this would be much appreciated.

Thanks, Stephanie New York, NY


Hello Stephanie,

First: You are not exempt from taxes because this is your first year of freelancing. Now who could have told you that?!

Read this Estimated Taxes to get an overview of how estimated taxes work. Then read my other blog posts on estimated taxes if you need more info.

I do not think that tax software does a good job for indies. Most programs are geared for employees or else small businesses that make widgets. Independent professionals are a unique breed and need special tax treatment by a pro who understands tax law as it applies to the self-employed. Educate yourself about what is and is not deductible. Read my posts on how to pick a tax pro and you'll be headed in the right direction. If you want more information, my book, Self-employed Tax Solutions, will give you a solid understanding of the basics.

Best,
June

It’s December – Do you know what your taxes are?

It's December, yet there is still time for indies to take a few steps that will make tax-filing season less distressing.

Which steps to take and the order they are taken depend on where you are and where you’re headed. So before you can better your tax situation, you need perspective on your current tax outlook. The way to get this perspective is to compare your expectations or planning for the year to what has actually happened.

If you've made more money than you’d expected or planned for, you may want to reduce your income with more business deductions or pension contributions.

On the other hand, if your income is lower than projected, maybe you can bring in income earlier than you expected or defer some deductions until next year when you’re determined to make more money.

The very first step: Start now! Get your tax papers together. More time means more complete records, fewer missed deductions, and the opportunity to discuss tax strategy with your tax pro. In stead of waiting until the hour has struck, ask her for a review now and get a projected tax total. If you hesitate because of the cost of the consultation, think about this: the more you get done now the less you and she will have to do later. Overall cost may be the same, or even less! And if it does cost you a little more it’s worth it if it helps to improve your total tax picture – and accounting fees are a deductible business expense.

Once you have an idea of your tax position, you can take steps to change it.

Too High Income
If your income is higher than expected or your deductions are skimpier than you’d like, here are some tips.

Look for more business deductions. Are there expenses or purchases planned for the future that you can make now? What about the scanner or desk you really need? The computer that you intended to buy next year?

Fine, you say, but I don’t have the cash for a major purchase. Well, there’s a way around that. Charge your purchase to a bank credit card. For instance, a $2,000 piece of equipment purchased with a bank credit card before the end of the year gets you a $2,000 deduction for this year even if you make no payment on it until next year. Keep in mind, however, that it has to be a bank credit card like MasterCard or Visa -- not a store credit card.

If you’re a cash basis taxpayer, which most of you are, a check written on or before December 31st for a legitimate business expense is a deduction for this year.

Of course, never spend just for the tax break You won’t get a dollar for dollar tax savings. Here’s a general rule: Unless you are in a very high tax bracket, a $1,000 business deduction will save you about $300 to $400 in federal income and self-employment taxes and state tax.

I use the term pension plan and retirement account interchangeably. For an artist or writer with no plan of ever retiring I call it a freedom account because it allows the freedom to change ideas and plans in the future.

So it’s time to re-evaluate your pension plan. The pension laws and regulations have had a complete makeover. You may be able to decrease your tax significantly by starting a pension or changing the kind you have. Be sure to investigate a relatively new pension plan that goes by several names -- the UNI-K, the Solo-K, the one-person-K. It’s easy to set up, flexible and, if established with the right brokerage house, inexpensive . Careful though: some brokers and investment people who don’t usually work with self-employeds may not be familiar with the UNI-K. They will try to steer you to the corporate world 401-K, which is the wrong plan for indies. Make sure that your tax or financial professional has a grasp of pensions that work well for indies.


Not Enough Income
On the flip side, what if you had a bad year and made less money than expected? One of the nasty side effects of a bad-income year is that you may be entitled to deductions that get you no tax breaks. Those deductions would come in handy next year when your IT business takes of or you've finally been accepted to the regional juried show, and your income increases.

Here are some possible moves to make in the face of a downer income year.

Delay purchases if you can. This is one of the advantages of understanding your tax situation before filing deadline – not that tax matters should determine all your decisions, but that taxes should be factored into them. If you can wait until next year when there’s a promise of more income, wait.

If you have to purchase a piece of equipment now because the sale ends on December 25, buy it now. According to IRS rules you don’t have to take the deduction in the current year if the equipment was not available for use, So if the set up of the scanner or computer must wait until the holidays are over and the guests leave then it is not available for use and so it is not a deduction until next year.

Do everything you can to get your income up. Offer discounts, have a sale, make an extra effort to get the money owed you, pester the gallery owners or consignment shops or laid-back-clients that have been slow in paying or who normally pay after the first of the year.

I said earlier to take a look at your pension if you’re having a good year. And if you’re having the opposite kind of year, look just as hard. Several pension plans require a contribution. You may not need to make a contribution in the current year because you don’t need to reduce your income. And in a low-income year you may not have the funds to make a pension contribution. The solution may be to change to a different type of pension plan. And now, before the year is out, is the time to discuss that with your tax pro.

This month you will see a lot of last minute tax tips posts and columns. Most of them will tell you the same old stuff: Clean out your closet and give the clothing to charity for a big write-off. It is a good idea to free up some closet space and do a good thing with your discards. But that is not going to have a big impact – if any – on your tax situation. picture. So, start now to develop your 2007 tax picture and you'll have a better perspective into 2008.

In future posts I’ll mention tax tips from other folks that are worthwhile. Keep an eye out for them.

June Walker

How does an indie pay social security tax?

June --

I am self-employed with no employees, however I am interested in paying something into the system toward social security benefits for myself in the future. What tax form do I fill out to get started?

Jane from Baltimore, MD


Hello Jane,

Every self-employed who has a net profit of $400 or more pays into social security when she files her tax return.The amount is figued on Schedule SE: Self-Employment Tax. Social security is part of self-employment [SE] tax.

-- June

How much should I charge?

June --

I have been a Web Developer / ASP.NET Programmer / Writer / Educator for 4 years.

I agreed to a rate before researching the real cost of taxes etc... is there a rule of thumb for consulting so I don't make this mistake again?

For example, should I add 35% to my minimum rate to ensure that I take home what I need?

Thanks.
David, M.Ed. from Seattle


Hello David,

I think you are asking two different questions.

I will ignore taxes for a moment and look at how much an indie should charge. Let's say you were making $50 per hour as an employee. All your work expenses would be covered and so $50 per hour meant $50 an hour -- less taxes -- into your pocket.

Now, as an indie you have many expenses that you must pay and they must be figured into your hourly fee. Not only do you need to look at things like the costs of a computer purchase and publications you read and the costs of running a home office, but what about hours on the phone with your computer guru who is helping you after your computer crash? What about your time or someone else's time cleaning your home office? Your time doing your own bookkeeping? Your time on the web getting answers to tax questions?

Most new indies -- that is, those without experience who have no history on which to judge their rates -- severely undercharge. They usually should double or triple their fees. When they give a fee of $500 for a project they think would take them 10 hours, they should have charged $1,000 or $1,500. Most often the project takes at least twice as long as they thought and they didn't figure in things like the two hours at Best Buy exchanging the modem they just bought.

The market and your reputation may limit how much you can charge but it is important to know your actual costs and to strive to charge what works for you. Especially at the start of your indie business it is important to keep a log of time spent on each client as well as on "general" time -- that's the bookkeeping, cleaning, errand running kind of stuff.

Your other question about fees and taxes: Plan on 1/3 to 40% of your net profit going toward taxes. Read more here Taxes: Which ones and how much do I pay?

Best,
June

SE Tax and Partnerships

Hi,

My husband currently receives a 1099 & is self-employed as a territorial sales rep.

He pays alot on self-employment [SE] tax. We are thinking about opening up a retail store in which we would be partners in an LLC.

Does The Small Business and Work Opportunity Tax Act of 2007 mean that we would not need to file for SE tax on this small business? If I am understanding it incorrectly & we still do need to file SE tax, is there some way we can combine his territorial sales rep work in which he already pays SE tax with the small retail business, so that we are not paying SE tax on two related businesses?


Also, does the Small Business and Work Opportunity Tax Act of 2007 eliminate the double taxation that occurs with husband & wife partnership llc's?

Thanks, Eileen


Hello Eileen,


Wow! You are mixing up apples, potatoes and Fruit Loops.

First of all, there is nothing in the Small Business and Work Opportunity Tax Act of 2007 that eliminates SE tax. To make sure there was no hidden paragraph that I missed I called the IRS to confirm. If you found something that says it's been eliminated, please send it to me.

Second: There is not now nor was there ever a double taxation of SE tax. Read What is Self-employment (SE) Tax? on this blog.

In a partnership SE tax is paid on the net profit. For instance, if you and a friend were 50/50 partners then each of you would pay SE tax on half the profit. A husband and wife partnership would also split the profit and pay SE tax on his and her share.

By the way, a partnership is the least tax advantageous business structure for a husband and wife business. A better way: One spouse as owner, the other as an employee.

Best,
June

What is Self-employment (SE) Tax?

While income tax is paid on any kind of taxable income, self-employment (SE) tax is paid only by people who work for themselves. SE tax is social security and Medicare tax for self-employeds and is paid on a self-employed’s net earnings.

Net earnings – think of it as net profit. It's what you have left after subtracting all business expenses from your gross self-employed income.

You must pay self-employment tax if net earnings from self-employment are $400 or more. The SE tax rate is 15.3% and is made up of two components: 12.4% social security tax plus 2.9% Medicare tax.

Social security benefits are available to self-employed persons just as they are to wage earners. Your payments of SE tax contribute to your coverage under the social security system which provides you with retirement, disability, and survivor benefits.

Medicare coverage provides hospital insurance benefits.

There is a cap on the amount of earned income on which you must pay social security tax. The cap for 2009 and 2010 is $106,800.

That means that you do not pay social security tax on income over $106,800. If you were to make $106,800 as an employee and also have an indie venture with a $20,000 profit, you would pay no social security tax on the $20,000 profit because you had already paid the maximum social security tax for 2009 or 2010 via withholding on your wages.

If you had a job and were also self-employed you would pay social security tax on both wages and profit until you met the $106,800 limit.

If you earn $106,800 in 2009 or 2010 you will pay the same amount of social security tax as Max Millionaire who earns $1,000,000. Hmmmm... do you see an opportunity here for filling the social security coffer?

There is no cap on Medicare tax. You pay 2.9% Medicare tax on all earned income.

{revised 1/31/10}