One of the main reasons that developers choose not to go the freelance route is their fear of “business” issues. Perhaps the most intimidating of these issues is how to handle their federal income taxes. This is understandable, since many developers have no idea how the payment or application of taxes will work once they’re self-employed.

I’m writing this post to let you know that you don’t need to let that fear of the tax man prevent you from striking out on your own as a freelancer. Like anything else, you can learn what you need to know in order to deal with such issues. I’m going to talk about how we manage our taxes in our business so you can see that there are actually quite a few benefits to being a freelancer.

I’ve also recorded a video lecture on this that goes into even more detail here:

One BIG thing I want to make clear is that I’m not a licensed tax professional, nor am I holding myself out as one. I’m simply sharing what we do, upon the advice of our tax accountant, in our business. I’ll also break down what we do and why we do it. Let’s look at the following:

  1. Why there are tax advantages in being a freelancer
  2. How to utilize a “flow-through” entity
  3. How to handle reimbursement of mileage and other expenses
  4. What to do about reimbursement for equipment and other services

One thing you should understand is that an important goal of being in business is keeping as much of your revenue as possible. There’s no point in working if you’re not actually keeping any of the money you earn. One of the best ways to keep more of what you earn is through tax management. This is why going about things the right way can help you look like this:

While freelance developers who don’t pay attention to tax management can wind up having to ask for handouts just like this poor guy:

You should know that this article was written after speaking with our company’s tax accountant in regards to the legislation which was passed for the 2018 tax year. Upon the advice of our accountant, we are continuing to operate our business as an S Corporation for the reasons explained in this article.

Now let’s get to it.

Freelance developers can save on employment taxes by utilizing a “pass through” entity

There are several ways you can structure your freelance business. You can be a sole proprietor and file a “Schedule C.” This will have you breaking down your business revenue and expenses on your personal tax return.

You can also start a separate business entity, such as an LLC. An LLC will file its own tax return on which it will report revenue, expenses, and net income. The LLC, however, will not pay taxes itself even though it is a separate entity. The LLC’s net income will be reported on your personal tax return.

In our business, we formed an LLC and filed an “S Corp election” with the IRS by filing IRS Form 2553. This means that our LLC, for tax purposes only, is considered an “S Corp” by the IRS. The reason we did this is that it allows us to save on self-employment taxes.

Let’s look at what self-employment taxes are and how we save money using a flow through S Corp. This is going to sound complicated — but read through it and I’ll provide some tips to help simplify everything.

If you’ve gotten a paycheck from a job, then you’re used to paying 6.2% of your salary to the government for Social Security and Medicare. These are your employment taxes. Self-employed individuals still pay these taxes in the form of “self-employment tax.”

Say, for example, that you freelance as a sole proprietor and after expenses, you clear $100,000. When you file your taxes with the government, you’ll owe roughly $6,200 ($100k x 6.2%) in self-employment tax on top of your normal federal income taxes. You’ll pay this self-employment tax if you’re a sole proprietor, an independent contractor, or if you are an LLC with no S Corp election.

If you start an LLC and do the S Corp election as we did, then you will need to classify yourself as an employee of the business. You will run regular payroll and you must pay yourself a reasonable salary. You will have Social Security and Medicare taxes (6.2 percent) held out of your paychecks.

Any profit, on top of your salary, however, will be exempt from self-employment tax. This means that you will be saving an extra 6.2% of your profit. That profit will still be subject to regular income tax. Let’s put down some numbers to show how this works.

  • Say you’re an independent contractor or sole proprietor with $100,000 in profit (you get no salary because you’re not an employee). You will pay federal taxes on $100,000 plus $6,200 in self-employment taxes.
  • Say you own an LLC that did not make the S Corp election. You clear a profit of $100,000. Again, you would have no salary. Your tax obligations are the exact same as the independent contractor or sole proprietor.
  • Say you own an LLC with the S Corp election. You pay yourself a $60,000 salary and have $40,000 in additional profits. This is the same $100,000 as the individuals above. You would pay federal income tax on the entire $100,000. You would have 6.2 percent withheld from your salary for Social Security and Medicare. The $40,000 profit, however, is exempt from self-employment tax. This means you save $2,480 (6.2% x $40,000) over the other examples discussed above.

This S Corp election is one of the ways in which being a freelancer allows you to keep more of your money than if you simply got a job somewhere. If you get a developer job and take a salary, then you’ll pay the 6.2 percent tax on all of your earnings.

It’s very, very important to note that the recently passed tax legislation changed some of the ways in which “flow through entities” are taxed. After talking to our accountant, however, we are still taking the “S election” route in our businesses (as I stated in the note above). Again, I am not a tax professional or financial advisor of any type. It’s best to discuss your situation with a CPA.

I know the above process sounds complicated — starting an LLC, making the S Corp election, and managing payroll. But it’s not overly hard. Most states allow you to easily form an LLC online as we did. The S Corp election is a simple matter filling out IRS form 2553 and following its instructions. We manage our payroll through Intuit’s Payroll Service. We use their “full service” option which means that they file all the necessary paperwork, stemming from payroll regulations, for us.

As complicated as the process above sounds, it was actually pretty seamless for us. We have Intuit hold out some extra cash from our paychecks to cover the federal income tax which will be applied to our business profits. We then pay our accountant to handle everything for us at the end of the year. At the end of the day, we come out ahead by doing things this way — and it’s not much hassle at all.

Mileage driven for your business is tax deductible. For 2018, the IRS allows you to deduct this mileage at a rate of 54.5 cents per mile. To keep things simple, we track all of our work mileage and our LLC writes a reimbursement check each month.

If we drive 100 miles in a month for work then the LLC will write a check at the end of the month for $54.50. We don’t have to pay taxes on this money when it goes into our personal account, and the LLC takes it as an expense (which means that our flow-through income is lower).

It’s important to remember what constitutes “business mileage.” Every time you drive to and from a customer’s location, that’s for work. Driving to a networking function? That’s likely a work expense. Having lunch or dinner with other developers? That may well be a work-related networking event. These are just a few examples of how your mileage can add up.

And, by the way, money you spend at those networking functions may also be tax deductible. Make sure you track those expenses as well.

Freelance developers can often write off computers and other necessary equipment

Buying a new computer for work? Sounds like a work expense. Need to buy a scanner, some toner, or other similar equipment? That may be a work expense as well. The laptop I’m using to type this was purchased through our LLC/S Corp.

When you’re working for yourself as a freelancer, and have properly set up your business, you start to realize that there are a number of tax advantages in doing so. If the primary reason you’re buying something is for work, then there’s a good chance that it will be a write-off.

Conclusion

This was just a quick overview of some of the tax issues we deal with as a small business. Once you start running your business, you really will see that these things aren’t complicated. Don’t let apprehension over these types of issues prevent you from striking out on your own. Are you currently freelancing? What do you do to deal with tax issues? Let me know in the comments.

I owe thanks to James R. Cloyes, CPA for taking the time to speak with me regarding this article.

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