Do you have to pay taxes on earnings you make online?

I’ll make this short and sweet: YES! If you are a United States (whether living in the US or around the world), you owe taxes on any money you make, whether it be online, offline, or in some alternate universe that the IRS has an ability to track (and they will be able to track it, I promise).

Contrary to what your best friend’s cousin’s sister-in-law’s friend Bob may have said, money made online isn’t different from money made anywhere else. In fact, the only difference between the money that you make online and the money you might make from a US business is that the online company (ie: Envato) won’t be sending you a 1099 at the end of the year – which means it’s your responsibility to record those earnings.The fact is that you are responsible (by law) to report and pay taxes on all income, regardless of its source.

I think freelancing is a pretty sweet gig. But there are some things about it that are not so sweet. Taxes/finances probably ranks at the top of this list. With no large company taking your hand, asking you to fill out forms, and reminding you when tax season is, freelancers are completely on their own in navigating a very confusing world of rules and paperwork.

So Where Do I Start?

If you’ve earned more than $600 during the year on freelance projects or through your small business, you are required to report that as self-employment income in the United States. Here are two tips for getting organized for the 2009 tax year that will save you a lot of frustration and hours of preparation next tax season!

Set Up an Easy Filing System to Find Your Deductions

Just about anything you buy to perform your freelance work is a deduction, but you’re only able to enter the details if you save your receipts!  Some people toss all of their receipts into a shoebox and sort them at the end of the year, but you can save time if you file them away in an organized way.

Accordion files work great for receipts and credit card statements you need to save for tax time, and so do plastic or checkbook register style coupon organizers.   Create common expense categories for your business, things like “subscriptions”, “office expenses”, “communications”.

Instead of sliding all receipts into one box or file, take an extra minute to put it into the appropriate category.  Keep business and personal receipts and credit card statements separate from each other.  The extra few minutes a week spent keeping your receipts and statements organized year long could save you hours at tax-time!

Keep Track of Your Money

Freelancers probably experience the most sporadic income of any industry!  Working for yourself typically means you don’t have a set “pay day”; and can rarely expect to make the same amount each week.  This sporadically received income is all the more reason to keep a close eye on your money.

Each time you receive a payment from a client, record it in a notebook, spreadsheet or bookkeeping software. You’ll want to know the date the payment was received, the amount, and if there were fees associated with receiving the payment, record those as well.

It’s a good idea to save 15-20% of all income for taxes – but check with an accountant for the exact amount and how you should be paying it if you’re not sure.   It’s also a little easier to track your money if you set yourself up with a regular “pay day”.  You may receive payments on Monday and Wednesday and three on Thursday, but rather than taking the money out as fast as it comes in; you might find leaving your earnings in a bank account or Paypal account until a specific day of the week makes managing and tracking your money easier.  You may still never know exactly how much you’ll make on your designated “pay day” in advance; but at least it is a step in the right direction as far as money management is concerned.

Common Questions for Freelancers

Where do I start?

Do some research and find a tax pro. Seriously, spend the money on an accountant (ask one of your clients – if they’re a large enough business, maybe you can haggle and get them to let you “borrow” their accountant for the afternoon!) It is the most worthwhile investment you can make: Firstly, freelance taxes are a mess and a half. You really want someone who does this all day everyday on your side. Secondly, tax laws can change, sometimes even within a few years. Hire an accountant who will keep up with these laws for you. Thirdly, a good accountant can help you compare your exemption options and help you get more money back from the government than you would have on your own. Fourthly, you don’t want to get audited. Really.

How much can I expect to pay?

If you made under XXXXXXXXXX, nothing. If you made more than that, 15% goes to a self-employment tax (aka social security). 15% more is a federal tax. So, in total, you can expect to pay about 30%. Now remember…that’s 30% of what you made AFTER you take out expenses. More info on that below.
How much you owe your state will depend on where you live. California has no specific self-employment tax that applies to me, so I can expect to have to pay a few hundred dollars annually—very little, compared to the federal taxes.

How often should I be paying taxes?

Like everybody else, you’ll file your taxes annually. But, unlike everybody else, you’re not getting taxes taken out of each paycheck, so you should plan to send the IRS an estimated amount of taxes quarterly. These important dates are April 15, June 15, September 15, and January 15. (For January taxes, cut off your income/expenses on December 31).

Um, really?

Yes really. Unless you relish the idea of having to pay thousands of dollars every April. Are you a dedicated enough person to keep all that money on-hand in your bank account, yet not spend a cent of it? Yeah, neither am I. Do yourself a favor and estimate your taxes every quarter.

How do I pay these quarterly taxes?

Go to www.irs.gov and download a 1040-EF form. Fill out Voucher 3. Talk to your tax pro, and use some of the suggested exemptions below to estimate how much your income minus expenses amounted to. Calculate 30% of that number, and mail a check in that amount to the IRS. (Photocopy the form and the check for your own records).

Do I have to?

Yes. Even if you’ve slipped through the cracks and not paid taxes for a while (as it’s sometimes easy for people working independently to do), there’s a VERY good chance that you are eventually going to get royally screwed. Or IRSally screwed. The point of this post is not to shame you or chide you into staying paid up. You should simply know better.

Types of Exemptions

Okay, let’s talk some silver lining here. Because if you’re like me, your head is spinning at the idea of losing 30% of your income. Since you’re self-employed, anything that you spend on your business is deductible. My accountant’s words of wisdom were:

“Every time you take out your wallet, ask yourself how the money you’re spending relates to your business. Get in that habit, and you’ll be amazed at how much money you save. ANYTHING that moves your business forward is deductible.”

Supplies and Equipment:

There’s the big expenses (new computers, new software, printers, etc), and there’s small expenses (printer ink, paper, pens)…any of these things that you use for your business counts. So let’s say you’re looking to buy a new video camera: if you use it to record a few promotional vlogs, or you get paid to film a friend’s wedding, guess what? Business expense.

Monthly bills

Cell phones. Internet. Use them to run your business? Then heck yes they’re deductible. Some situations even allow you to deduct a portion of your rent and utilities—but these rules can be sticky and you should definitely talk to your tax pro about it first. The basic rule of thumb is that you must have a space used solely for work (ie. not your bedroom or living room), and it must have a closable door. Figure out the portion of your floor plan that this room occupies, and that’s the portion of your utilities/rent you can deduct.

Transportation

Anytime you drive to meet a client, or pick up supplies, write down your mileage! You can take that off too. There are two basic ways that this works:
A. Standard mileage rate: a certain number of cents per mile
or B. Actual expenses: including auto insurance, gas, repairs, etc.
Which one will work best for you? If you’re haven’t purchased a new car, it’s most likely that you’ll get more money back on option A. Talk to your tax pro to be sure.

Research

This one’s quite possibly my favorite: because if I buy something at the grocery store that has good design, it can count as research for my business. I KNOW RIGHT. I’m totally buying more pretty package products. The best way I would suggest to keep track of this is to separate out your products at the check stand into two bills. Otherwise, you’re going to have a mess keeping track of everything. Of course, other things can count as research write-offs: every time your purchase something, ask yourself if this thing is research in any way. My unprofessional advice though is to NOT go overboard. It’s way less of a mess to only claim things you really can prove are research than to get audited in the end. Most sucky.

Self-promotion

The cost of business cards, your website, etc etc. This one’s pretty simple to remember, since it obviously and directly relates to your business.

Outsourcing

If you hire someone else to help you complete a job for your business, the amount you pay them with is deductible. Just make sure that they provide you with an invoice. Make a note of what check number you pay them with (DON’T pay with cash…you always want to have documentation of your payment).

Things that are NOT business deductibles

These are often called personal (or in official tax lingo, itemized) expenses, and my knowledge in this field is quite hazy. But a few basics for freelancers in this category are: charity and tithing, car registration, health/dental/renters insurance. They only count if they add up to more than $5,000 annually. So, keep track of them: but don’t expect to use them to get out of more taxes.

The folks over at Freelance Switch have posted a great resource for 10 Tax Deductions that Freelancers Can Make

Some additional deductions include:
Unpaid invoices
Niche research
Meetings at the coffee shop
Job hunting
PayPal fees
Virtual assistants and other freelancers
Your home expenses
Cellphone and Skype
Professional advice
Payments to non-profits

Making it Happen

So, all those deductibles sound pretty awesome, right? Right. But in order to get them, you have to be willing to put in a little work on your own. Okay, it’s kind of a lot of work. But I think you’d agree that the money saved could be well worth the effort.

First Step – Get organized

This means a lot of different things for a lot of different people. If many of your expenses are business related, you should really consider having two bank accounts and/or credit cards: one personal and one business. It will help immensely with keeping things straight.

Get a system going.

Figure out your best system for keeping track of your expenses. Excel, Quicken, GoogleDocs, and Mint.com are a few options. Just make sure that there’s a way to denote your expenses, that it’s something you can keep up with on a daily basis, and (especially if it’s electronic) back it up periodically.

Keep your records, and your receipts.

Generally, you only need write-ups of your purchases. But in case the IRS decides to come after you, you will need your receipts to prove that everything is as you claimed it to be. If you don’t already have one, start a binder for 2009 where you can easily drop in pertinent receipts for each month. Get in the habit of printing out records of online transactions. It doesn’t have to be super organized and tediously documented: you most likely won’t need these receipts. But it’s much much MUCH better to be safe than sorry.

Should I charge my clients taxes up front?

Well, you’re responsible for paying taxes in the end. And your clients are accustomed to paying taxes on everything else. It only makes sense to let them know you’re a responsible person to hire. A seemingly tricky question is whether you charge your state taxes or your client’s state taxes. Since you are the one responsible for paying the government, it’s necessary to go by your state’s tax laws.

Got a tax tip to share? How do you handle your taxes? What ways have you found that work best? Do you have any stories of bad experiences you’ve had filing taxes?