The vast majority of freelancers incur losses. A business profit increases your taxable income, and increases both your regular income tax and your Self-Employment Tax. The Self-Employment Tax, figured on Form 1040 Schedule SE (PDF), is 15.3% of your net profit and represents the Social Security and Medicare taxes owed on your business profit. As a freelancer, you are your own employer, so you pay both halves. Whereas, as an employee (on a W-2), you only pay half of the Social Security and Medicare taxes (7.65%), and your employer pays the other half.
Setting Aside Money
As a freelancer, you need to set aside money at least every quarter, or better yet every month, towards your Self-Employment Tax. For example:
Let’s say you anticipate having a net profit of around $1,000. Your Self-Employment Tax would be ($1,000 x 15.3%), or $153. If you divide that into four quarterly payments, you should be paying $38.25 every quarter to the IRS as an estimated tax payment.
You should also calculate your anticipated regular income tax. This tax is dependent upon what tax bracket you fall under. If you are in the 25% tax bracket, the additional income tax on your business profit would be ($1,000 x 25%) $250.
So, you should set aside $403 ($153 + $250) over the course of the year towards your estimated taxes. This mathematical example is over-simplified (the actual calculation of the income tax and the self-employment tax is a bit more complex), but this gives you a simplified way for budgeting for the federal taxes owed on freelance income.
Electronic Federal Tax Payments
I recommend all self-employed entrepreneurs to enroll in EFTPS, the Electronic Federal Tax Payment System. It takes some time to get set up with the EFTPS, but once you’re fully registered with the website, you can make estimated tax payments by phone or online, with the payment debited directly from your checking account..
Tax Planning with Business Losses
If the net profit figure on your Schedule C is a negative number, you have a business loss. Business losses reduce income and reduce income taxes. Business losses offset other income and reduce income tax only. Since there’s no net income, there won’t be any self-employment tax on your freelance business. Accordingly, taxes might be higher in a subsequent year, and so deductions might produce greater tax savings if they can be deferred.
Consider using section 179, which lets you take a deduction in lieu of depreciation for fixed assets. Since section 179 deductions cannot produce a loss or increase a loss, those deductions will carry over to the following year. Consider accelerating freelance income, if possible, into the loss year (again, since this is likely to be a low tax year).
Read on in the resources below for some tips on handling business losses from tax planning and audit defense perspectives.