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Columns by June Walker: IPs Face Unique Tax Challenges Tax Deductions Are There For The Taking You Say You're Self-Employed -- Will the IRS? Do You Have a Business or a Hobby? Proving That You're a Business Keeping Records -- It's Not Just for Taxes Three Ways to Expand Your Business Deductions Can I Deduct Disneyland and Other Questions Mixing Business with Pleasure and Other Gray Areas Getting There is Half the Battle Getting Credit and Taking Allowances Advertising: Do It, Then Deduct It The Subtle Art of Advertising Deductions Billy Bridesnapper's Start-up Saga Giving Gifts, Taking Deductions
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Tax Basics for the Self-employed, Part I IPs Face Unique Tax ChallengesAmerica is alive with distinctive people -- computer analysts, astrologers, personal trainers, writers, realtors, creators of intellectual property, solo performers on the stage and in the business world. Each is unique. Yet despite their uniqueness all these people have one thing in common: they are IPs. You may call them by another name -- self-employed, sole proprietor, freelancer, independent contractor -- but to the taxing authorities all these descriptions mean the same thing. And all are required by these taxing authorities to follow the same specific rules. My calculations suggest that more than 20 million Americans, or 12 percent of the workforce, are self-employed. In the area where I live (Santa Fe), the figure is probably over 20 percent. These workers are, with a few exceptions, talented and spirited people, motivated and deeply interested in their work. Despite their number, the tax laws are written without independent contractors in mind. And as for their needs, the mahogany-office accountants don't have a clue. After meeting with most accountants, self-employed people stagger out glassy-eyed, their minds a jumble of irrelevant and often incorrect advice. They deserve better. They are bright, intuitive people whose talents often outweigh their practical sense. Eventually they will add solid business ability and sharp financial judgment to their array of skills. I have found, however, in almost 20 years of advising self-employed people, that you've got to start with the basics. I suggest you start with four: income, deductions, taxes, and the basic questions -- are you really self-employed and are you in business? As far as the government is concerned, you can't just think you're self-employed, you must be able to prove it. If you can't, you're taxed on a different basis -- which almost always costs you more money. The IRS lists 20 factors that determine whether you're an employee or independent contractor. Your status boils down to whether the following criteria are fulfilled:
...then you are probably self-employed. To put these in specific terms:
...then you're on the right track toward being self-employed. But that's not all. The IRS also requires you to show that your self-employment is a business, not a hobby supported by an inheritance from Grandma. If it's really a business, the object must be to make a profit. That doesn't mean that you actually have to make a profit, but there must be a reasonable expectation of one. It could be a big chance of making a small profit or a small chance of making a big profit. Careful, though: the IRS says "elements of personal pleasure or recreation" may indicate the lack of a profit motive. So don't enjoy your work too much! Just keep in mind that the more you treat your activity as a business, the more likely the IRS will see it as one: portray a strong commitment to your business, advertise and -- most important -- keep accurate records. The easiest way to begin recordkeeping is to record your income. What is self-employment income?Sales commissions, consultant fees, craft sales, any payment to you for a service you performed or a product you made is self-employment income. Most self-employed use a cash basis method. That means it's income when you get paid -- not when you invoice. The total that you receive is called gross income. After you subtract expenses you're left with your net income. You pay taxes on net income. Banks lend or deny loans based upon net income. Employees receive W-2 forms, which show the year's wages as well as any taxes or employee benefits withheld or paid during the year. IPs do not receive W-2 forms. Every IP must keep a record of his or her own income. Depending upon their business and that of the person for whom they provide a service or sell a product, some freelancers may receive one or more income statements called a Form 1099. Your only concern with this form -- if you receive one -- is that it accurately reflect your income from the source providing it. At the end of the year, when Gail's Gallery sends a Form 1099 to you stating that you earned $2,400 in "Nonemployee compensation," a copy also goes to the IRS. If you actually received only $1,400 from Gail, you will need to be able to prove the error to the IRS. The gallery's mistake shows how foolish it would be to rely on the recordkeeping of others for your financial survival! One typo can mess up your life. People for whom you work make mistakes -- the bookkeeper had a bad day, the computer program had a glitch. Real estate salespersons paid by commission and authors paid through their agents have been burned because of someone else's error and their own lack of records. Keep in mind that if you're self-employed and are subject to a routine IRS audit, the auditor will want to see bank statements. If you reported gross income of $20,000, the government wants to see that $20,000 was deposited. If instead your bank statements show $25,000 deposited, you'd better have a good explanation for the extra $5,000 -- and a note from Mom saying she loaned it to you will not do. On the other hand, if your bank statements show only $15,000 deposited, you are not putting all your income into the account, which could lead the IRS to question your bookkeeping accuracy. So either too much or too little leads to more thorough IRS scrutiny. What should you do with income once it's received?Well, for starters, don't hide it. That's fraud, plain and simple. If you receive payment by check, deposit the entire amount into your checking account. Do not split the check. If you need $100 cash, deposit the whole check, and then write out a check to yourself for $100. If you receive a cash payment, deposit it. Note the source of the money on your deposit slip. If any stub, piece of paper, or other printed data came with the payment, attach it to your copy of the deposit slip. Log your income. The log can be simply a sheet of loose-leaf paper on which you write: DATE RECEIVED | FROM WHOM | AMOUNT | DATE DEPOSITED Or you can customize it: DATE | GIGS-CHECK | GIGS-CASH | TEACHING | PERSONAL NON-INCOME You can use a different color ink for each client; gifts from Mom can be in capital letteres; you can highlight all cash deposits. Anything that works for you is fine -- the simpler the better -- as long as your timely-kept record of what you received, when, and from whom corresponds to your bank deposits. So, if Mom did lend you $5,000, or if Mom lent you $3,000 and you made $2,000 in cash income from teaching, then your income log will show just that to the IRS. Money from non-income sources -- store rebates, old debt repayments, gifts, checks cashed for a friend -- may end up in your checking account. If you can't prove where they came from, the IRS will say it's income. Keep an income log. (c) 2000 June Walker. All rights reserved. We'd love to hear your feedback about this column, or put you in touch with June Walker if you like. You may also like to see her biography. |
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