Disclaimer: This article should not be construed as advice for tax management or investment decisions.
Neither the author of this article, nor freeCodeCamp, are professionals in these areas. The discussion below is a matter of personal opinion only and you should discuss such matters with a licensed professional.
If you’re thinking about starting up your own development business, then you likely have a lot of questions and concerns. You’re most likely worried about where you will get clients, how you will market yourself, how you will get through the downtimes, and so on.
Unfortunately, many who are new to the freelance world (as well as many who just never bother to pay attention to such things) don’t consider the importance of properly managing their taxes.
This is a big, big, big (big) mistake for quite a few reasons. The impact of not considering your taxes is simple - you’ll wind up working far harder than you need to in order to have any money at the end of the day. In other words, you may end up looking like this:
Developers who focus on keeping more of what they make, by contrast, can look like this:
If you’re reading this article then I’m assuming that you’re not opposed to prosperity and that you would rather look like the latter than the former. If you are opposed to prosperity then…...well…..ok.
I’ve previously written for freeCodeCamp on how freelance developers can manage their taxes. That article was more cursory in nature and didn’t dive into some specifics.
Also, there have been changes to the U.S. tax code since I published it. Given this, I felt it was time to take an in-depth and up-to-date dive into the topic.
One important thing to understand is that this article is related to taxes in the United States only. If you prefer to take in information through video, then I’ve prepared this
If you’re like I am, and you prefer to absorb via reading, then read on.
I’m going to dive into several topics in this article. Below is a roadmap of this discussion. To jump to a particular section, simply click its link.
Table of Contents
- Why one should be mindful of their taxes (jump to section)
- One of your biggest expenses, if not the biggest, is your taxes (jump to section)
- Today’s “income inequality” discussion misses the point that opportunity is given to freelancers & small business owners (jump to section)
- By being mindful of your taxes, you can greatly improve your financial standing (jump to section)
- Concepts to understand in order to get your taxes under control (jump to section)
- Understanding the differences between revenue and income (jump to section)
- How employees and business owners are taxed differently (jump to section)
- Understanding the different types of taxes one must pay & graduated brackets (jump to section)
- Taxes paid v. taxes paid in during the year (jump to section)
- How your business structure impacts your tax bill (jump to section)
- Understanding the Qualified Business Deduction (jump to section)
- Working as an independent contractor (jump to section)
- Sole proprietorships (jump to section)
- LLC taxation (jump to section)
- S Corporation taxation (jump to section)
- Picking the right entity for your situation (jump to section)
- The importance of taking, and maximizing, deductions (jump to section)
- Missing an expense amounts to donating money to the government (jump to section)
- Expenses that can be deducted (jump to section)
- Maximizing retirement plans to save on taxes (jump to section)
- Making payments during the year as a business owner/freelance developer (jump to section)
- Where you choose to live impacts your tax bill (jump to section)
- Closing thoughts (jump to section)
So, let’s get to it!
Why freelance developers and other business owners must be mindful of their taxes
If you’re thinking of going the freelance route, or have already done so, then I’m assuming that at least part of your motivation was making more money and/or having work flexibility.
Well, if you want either of those things then it is vital that you pay attention to your taxes.
The reasons for this are three-fold. First, as many don’t realize, your taxes are one of your largest expenses and it’s hard to get ahead when your large expenses aren’t under control.
Second, you’re missing a massive financial opportunity that is being presented to you if you ignore this area.
Finally, the numbers don’t lie as to how being mindful of your taxes can improve your financial standing. Let’s look at each of these in turn.
Most people, including business owners, fail to realize that taxes are one of their biggest expenses
One of the biggest things that people experience stress over is money. This is especially true for freelance workers and small business owners, as they do not have the consistency of a paycheck from an employer.
It goes without saying that one of the most important aspects of good financial health is keeping your expenses low. The big problem comes when you're looking at expenses you can reduce. Your analysis typically does not involve thinking about taxes.
For virtually everyone out there, trying to get ahead by reducing various expenses without thinking of tax reduction is akin to trying to lose weight by ordering a diet soda along with your triple value meal, with extra chicken nuggets, from McDonald’s. It doesn’t work very well.
Let’s look at what I mean.
Suppose, for example, that you live in San Francisco (you’ll see why I’m using S.F. as an example shortly) and you make $110,000 a year working for yourself. Also, assume that this is your only source of income.
Now assume that you haven’t paid any attention to tax reduction (meaning you’re like the majority of freelancers out there).
By the end of the year, you’ll have paid $32,838 in taxes (source: Free Income Tax Calculator), meaning that you only actually kept $77,162 of the money that you worked hard for. The breakdown of this is as follows:
A freelancer in this situation will have paid roughly $2,736 per month in taxes. Now think of how many people you know that get a roommate to save on rent, who look for ways to save a few bucks on things such as their Netflix account or groceries, but make no effort to get their tax bill down. This is why I made the McDonald’s comparison above.
Why did I pick San Francisco and a $110,000 income for my example? Simple...it’s a real-life scenario. A friend came to visit my wife and me a few months ago and she lives in San Francisco. Several comments were made about struggling to “get ahead.”
When I asked her what her two largest expenses were, the first she mentioned was rent. The second was an expense which amounted to $8,000 per year. In other words, she was looking for ways to save money but not even considering one of the biggest, and easiest, savings she could've made.
If you want to truly get ahead, then you need to understand what your largest expenses are. And for most it is their tax bill.
Many who mention “income inequality” miss the point that the tax code provides enormous opportunities for everyday developers or other business owners
I’m sure the heading to this section is going to lead to a few negative reactions to this article. Consider a few things, however, before dismissing my statement.
First, it is important to recognize a common complaint that today’s tax code “favors the rich.” This is, in fact, not accurate. The tax code does not favor individuals or those with wealth. What it favors is certain activities.
An average person can engage in these activities in the exact same way that someone who is wealthy does. The specifics which I will be getting into later in this article will show why this is the case.
The big thing to remember right now is that the tax code is set up to favor those who start/run businesses and who invest. This means that if you have not structured your “freelance gig” as a business and are not investing, then you are throwing money away.
Someone making $110,000 per year in San Francisco, like the example person above, will pay $32,838 per year in taxes if they do not take advantage of any of the provisions in the tax code which are readily accessible to them.
If, however, they take advantage of opportunities available in the tax code, they can lower their annual tax bill to a little over $15,000. In other words, running your business and making choices in a way that is mindful of tax reduction, can save you $17,838 per year.
The common belief that being mindful about taxes is something that “rich people do” is not accurate. People do not pay attention to their taxes because they are rich – they are rich, in part, because they pay attention to their taxes.
If you are starting a business as a way of growing your income, then it is crucial that you consider this fact.
Being mindful about taxes can greatly improve a freelance developer’s financial standing
The above discussion is meant to drive home one important point – the fact that being mindful about your taxes, as a freelance developer, is one of the fastest ways to improve your financial standing.
Keeping more of what you earn means more money in your pocket without having to increase your overall income. Conversely, not focusing on your taxes means that you are paying extra money, each time you get paid, to government entities.
This means that you don't have as much money as you could, and you often think you need more customers to have more cash. You then get those customers and pay excess taxes out of each of those customer payments as well.
In other words, you’re trying to get ahead by pushing a boulder up a very steep hill, like this guy:
Good luck with that. Now let’s move on to steps you can take to get your taxes under control. The first part of that process is understanding some different concepts under the U.S. tax code.
Concepts which freelance developers must understand in order to properly manage their taxes
There are several concepts you need to understand before you can get your tax bill under control. I got into some of these in my previous tax article (linked to in the intro section to this guide).
The things we need to look at are:
- the difference between revenue and income
- how employees and business owners are taxed differently
- the different levels of taxation that exist in the United States
- the concept of graduated tax brackets, and
- the difference between withholding of tax payments and taxes actually paid.
Understanding each of these is important to determining how your choices impact your overall tax bill and help you strategize going forward.
It is important to understand a few core concepts before diving into managing your taxes. I’ll keep it to tax concepts for now, and not get into one of my much, much, much (much) larger rants on the need to learn as much about business as possible.
We’re going over these tax concepts first because, for understandable reasons, most people see their taxes as something that has traditionally been taken out of their paychecks and they’ve never really worried about it. Also, many self-employed people have never taken the time to truly consider their tax structure.
So, let’s look at the differences between revenue and income, how business owners and employees are taxed differently, the different types of taxes you have to pay in the U.S., and the difference between what you pay in each year vs. what you actually pay.
Freelance developers, as well as other business owners, pay taxes on their income, not their revenue
Calculating your income is simple when you're working as an employee. You receive a salary or an hourly wage and the total amount of that compensation is reported on your W2 at the end of the year.
This is different when you are self-employed. The amount of money that comes into your business’ account during the year is not what you actually earn. This is because your business has expenses which you had to incur to earn that money. What’s left over after your expenses, which is your profit, is what you will consider your income for tax purposes.
Suppose Jane Developer gets paid $5,000 to build a website or application for a local business. She gets sixty percent ($3,000) up front and the rest ($2,000) thirty days later when she completes the project. Jane’s revenue is $5,000 over this period.
Now suppose that she spent $200 on advertising for her development business, $50 on liability insurance, and $50 on business related software subscriptions. Jane’s profitor net income is $4,700, broken down as follows:
I’m taking the time to explain this because I have talked to way, way, way too many self-employed people that answer the question of what they made by reciting their revenue number.
These same people then put that number on their taxes as their income. So under the example above, many would report their income as $5,000 and not $4,700. If they are paying taxes of fifteen percent, then these people would be paying $750 in taxes ($5k x 15%) as opposed to the $705 they should have paid ($4.7k x 15%).
Understanding the difference between revenue and income is crucial to not over-reporting your earnings to the IRS and paying taxes on money you didn’t actually make.
How a developer is taxed will depend on whether they are an employee, a “true” freelancer, or a business owner (you want to be a business owner)
The U.S. tax structure is extremely complicated. This is why an entire industry exists in this country just to help people deal with it. It has also been called “the only law which requires people to pay professionals to ensure that they do not break it.”
How this tax structure will apply to you, as a developer, depends on several things. First, is the difference between how employees and “independent contractors'' are taxed and, second, how businesses are taxed. As for how businesses are taxed, that is further divided into understanding how different types of businesses fall under the system.
I’ll get into specifics, with examples, later in this article. For now, here is a quick overview of how you can expect to be taxed based on your status as an employee, a contractor, a business owner, and so on.
On a side note (and this will show you the types of topics I geek out on), if you’re interested in how the U.S. tax system, and the boondoggle* of an industry that supports it, came to be, then I suggested reading chapter 3 of “Business Adventures” by John Brooks (Link goes to Amazon).
*boondoggle - work or activity that is wasteful or pointless but gives the appearance of having value.
If you are a developer working in a job, then you will receive a salary from your employer. You will pay federal, state, and local taxes on one hundred percent of this salary (a breakdown of each of these tax types is given later in this article).
The federal tax component of your obligation will include your income tax as well as your FICA (Federal Insurance Contribution Act) payments. These FICA payments constitute your contribution to Social Security and Medicare.
Since all of your income is reported on your paycheck, and your employer handles the bookkeeping, reporting your income to the government at the end of the year is straightforward.
Some “freelancers” choose to work as independent contractors. These are people who do not start a formal business and instead receive a 1099 at the end of the year from the people for whom they do work.
These individuals will fill out a “Schedule C” form when completing their taxes. Their income is determined by adding up all money (revenue) received from customers and subtracting out their expenses.
Most independent contractors will pay federal income taxes on the first eighty percent of their profits (more on this below) and they will also pay self-employment taxes (the equivalent of FICA) on their net income. Whether you pay state and local taxes on your profit will depend, in part, where you live.
If you don’t wish to form a formal legal entity to conduct business (more on this in a moment), but you wish to have a legally recognized business name, then you may get a business license and start a sole proprietorship (the licensing/paperwork for this type of structure will vary from locale to locale). This will allow you to operate under a business name, have a business level bank account, and so on.
You will fill out a Schedule C at the end of the year, similar to an independent contractor, and you will have a similar tax structure. From a tax/finance standpoint, being a sole proprietor and an independent contractor are similar.
Another option is to form a formal legal entity through which you will do business. This comes with many benefits (such as liability protection) which are beyond the scope of this article.
Practically speaking, most will form a Limited Liability Company (LLC) and some may choose to elect to have the LLC taxed as an “S Corporation.” This latter option means that you own an LLC but, for tax purposes only, it is considered an S Corporation by the IRS.
If you are operating an LLC, without the S election, then the profits of the business “flow through” to you. In other words, if the business has $100,000 in profits then you will report those profits on your personal tax return as the LLC itself does not pay taxes.
Most developers going this route will pay federal income tax on eighty percent of those profits (again, more on this below) and self-employment tax on all of the profits.
If you are taking the S election, then you must pay yourself a “reasonable salary” as an employee of the company. This salary will be taxed as would the paycheck of any W2 employee. The profits remaining for the S corporation will flow through to your personal tax return.
Most developers would pay federal income tax on eighty percent of these profits and would not be required to pay self-employment tax on them. Whether the owner of an LLC or an S Corp pays state and local taxes will depend on where they live.
If you are working for yourself, then it is important that you speak with tax and/or legal professionals to determine which of these business structures best fits your goals. Each structure comes with its own benefits as well as its own additional expenses and complications.
Developers should understand the different types and brackets of taxes which may apply to them and/or their business
We just discussed the different types of business structures you may be using in your freelance gig. The next “core concept” to go over is the different levels of tax structure which exist in the United States.
Once we’ve done this, then, a little later in this article, we’ll put the two together and show how different business structures are impacted by these tax tiers.
There are different levels of taxation of which freelance developers should be aware
If you are operating as a self-employed individual then there are three core levels of taxes which you need to be aware of (there are actually others but they are beyond the scope of this discussion).
These taxes are those paid to the federal government, those paid to the state, and those paid to your locality. Let’s look at each of these in turn.
Taxes paid to the federal government are those which most people think of when they refer to “paying taxes.” These taxes, however, consist of two components.
The first is federal income tax. This is a tax, collected by the government, which is based on your income. The higher your income, then the higher the tax.
The second component of federal taxes consist of FICA and Medicare contributions. As mentioned above, this is your contribution to programs such as Social Security and Medicare.
For the 2021 tax year (these calculations change year to year), FICA and Medicare contributions, after oversimplifying it a bit, consist of 6.2 percent of your first $142,800 of income and 1.45 percent of total income. The 6.2 percent contribution goes towards Social Security and the latter goes towards Medicare.
So, in simple terms, someone making $100,000 per year, without proper planning, will pay $7,650 in FICA and Medicare taxes in addition to their federal income tax.
In addition to federal taxes, you may also have to pay taxes to state and local governments. This will vary by locale.
If you're living in City “X”, in the state of “Y”, may have to file a state tax return with Y through state tax authorities while also filing a city return through X’s tax authorities.
Some states, however, do not have state income tax of any type. Others only apply state income tax to certain business activities while others have a state tax which applies to everyone.
The same is true for localities. If you live in an area with several levels of taxation, then you will need to file tax returns for each level of government.
Self-employed developers should have an understanding of tax brackets
Quite a few people hear about “tax brackets” in the U.S. tax code and don’t have a true understanding of how they work.
For example, if someone is told that they’re “going to be in the 32% bracket for this year” then there’s a good chance they’ll take that to mean that their federal income tax will be equal to 32 percent of their income. This is not the case. This is because federal income tax brackets are “graduated.” Let’s look at what this means.
For the 2021 tax year, there are seven different tax brackets for a single filer in the United States. A tax payer’s income will be subject to taxation in each of these brackets.
For example, the first $9,950 you earn, after deductions (deductions are covered later in this article) is subject to a ten percent federal income tax.
Any income between $9,950 and $40,525 is subject to twelve percent federal income tax. This means someone earning $40,525, after deductions, would be taxed as follows:
As shown in this table, someone earning $40,525 after deductions will pay federal income tax totaling $4,664, or roughly 11.5 percent of their income. Such an individual would be referred to as being “in the 12 percent bracket” because that is the highest bracket under which a portion of their income is taxed.
It does not mean, however, that all of their income was taxed at that rate. So when you hear people like me complaining about extremely high tax brackets, we’re really only complaining about the rate at which an upper tier of income is taxed.
For an FYI, below is a breakdown of the IRS 2021 brackets for a single individual.
$0 to $9,950
$9,950 – $40,525
$995 + 12% of the amount over $9,950
$40,525 – $86,375
$4,664 + 22% of the amount over $40,525
$86,376 – $164,925
$14,751 + 24% of the amount over $86,375
$164,926 – $209,425
$33,603 + 32% of the amount over $164,925
$209,426 – $523,600
$47,843 + 35% of the amount over $209,425
$523,601 or more
$157,804.25 + 37% of the amount over $523,600
This wraps up the section of this article on the types of taxes (federal, state, and local) that many pay as well as an explanation of graduated tax brackets.
The last quick point to cover, before getting into specifics on minimizing your taxes, is to understand the differences between taxes paid and payments sent to the government during the year.
Freelancers need to be aware of the difference between taxes paid and payments made during the year
I have spoken with many people who have not considered the difference between tax payments they make during the year and the taxes they actually pay for the year.
This is crucial for freelance developers, and anyone who is self-employed, as failing to make proper payments during the year can result in penalties from the IRS.
Let’s take a look at the difference between taxes paid in and actual taxes paid and then we’ll look at how you go about paying your taxes as a freelancer.
If you’ve had a job, then you’re familiar with your employer withholding taxes from your paycheck. These taxes are then sent to the federal government. At the end of the year, when you prepare your tax return, you determine the amount of tax to be paid to the government based on your income. The payments made, through your paycheck withholdings, are then applied to this amount.
If your withholdings exceed the tax to be paid then you receive a refund for the difference. If the taxes to be paid exceed the amount of your withholdings, then you owe the IRS the balance.
Before discussing how you pay your taxes during the year, as a freelance developer, it is important to understand one thing about receiving a “tax refund.”
I know many people who get excited at the end of the year because they will be receiving a refund. These individuals often see this refund as some type of windfall being given to them by the government. What they do not understand is that it is their money! It is simply a refund of the overpayment made toward their taxes. In other words, by paying in too much during the year, they were essentially loaning their money to the government interest free and getting the surplus back at the end.
While I do not like to owe money at the end of the year, it certainly is not good financial management to loan money to anyone interest free. This is why I try to structure my affairs in a way where I either have no balance, or a small one that avoids a penalty, at year end. This way I have more money during the year.
If you are a freelance/self-employed developer then you are not having taxes withheld from your pay during the year if you receive a 1099, if you are a sole proprietor, or if you operate an LLC which has not made the S Corporation election. This is because you are being paid directly by your customers.
If you do not make regular payments to the government during the year, and if you underpay your taxes by a sufficient enough amount, you may be assessed a penalty from the IRS in addition to any taxes you owe.
In order to ensure that you are not hit with a penalty, you need to make quarterly payments to the government using form 1040es. While the form provides a calculator of how much your quarterly payments need to be, in order to avoid a penalty, this does not mean you will still not owe the IRS money at the end of the year. It is crucial that you discuss your estimated payments with a tax professional.
How quarterly tax payments are calculated, and the application of penalties, can become quite a lengthy discussion which goes beyond the scope of this article. My strong suggestion is that you be aware of this issue, ensure that your payments are made, and that you discuss your situation with a tax accountant.
The payment of taxes during the year works differently from self-employed developers who have formed an LLC and have opted to have it taxed as an S corporation. This is because, as explained above, the owner of an S corporation must pay themselves a “reasonable salary.” Any profits in excess of that salary are then distributed to the owners.
The payment of the salary, however, means that the owners of the business are receiving a paycheck from which taxes can be withheld.
Remember that the owner of an S corporation must pay federal income tax on both their wages and their profits. So, while the taxes on the wages will be withheld on your check, you still need to make sure you are paying in enough to cover the taxes on your profits.
In our business, we handle this by having additional federal income tax, in addition to what would already be withheld, taken out of our paycheck. Again, discuss your situation with a tax professional to figure out your best course of action.
Now that all of that is out of the way, let’s take a look at the tax consequences associated with the different business structures available to a freelancer.
How a freelance developer’s business structure will impact their tax liability
The way in which you structure your business activities is going to impact the extent to which you pay various taxes.
Generally speaking, you will either be working as an independent contractor, who receives a 1099 at the end of the year (typically a bad idea), a “sole proprietor,” as the owner of a Limited Liability Company (known as an “LLC”), or you may choose to be taxed as an S corporation.
There are different levels of complexity that come along with each of these structures, just as there are different benefits with each. To understand how this impacts what you will pay the tax man, let’s dive into how a typical company employee is taxed and then how freelancers can be taxed under each of the business structures I just mentioned.
First, however, we will need to understand the rules surrounding what is known as the “Qualified Business Income” deduction. This is also known as the “QBI” deduction.
The Tax Cut & Jobs Act of 2017 created the Qualified Business Income deduction
The Qualified Business Income deduction was created under the 2017 Tax Cuts & Jobs Act. This deduction allows a self-employed individual to avoid federal income tax on the first twenty percent of their business income as long as their total income is below $164,900. Yes…….I know that sounds confusing. Let’s break it down a bit.
If your total income is below $164,900 for 2021, then the first twenty percent of any income which came from “qualified business activities'' will not be subject to federal income tax. To more easily explain how this works, let’s look at how this can apply to two different situations.
Suppose Joe Developer is working as a freelancer and is able to deduct qualified business income. Joe’s entire income is from his freelancing activities and his total profit for 2021 was $150,000. Joe will only pay federal income tax on $120,000 worth of income as he is not taxed on the first twenty percent of his $150k in profits.
Now suppose that Jill Developer has freelancing income of $30,000, a salary of $100,000 from a full-time job, and another $20,000 of profit from rental units she owns. Jill’s total income is also $150,000.
Jill, however, will be taxed on $144,000 of income as only the $30k was related to a “qualified business.” Thus, only the $30,000 is subject to the Qualified Business Income deduction. If Jill’s total income had been over $164,900 then she may not have been able to deduct her QBI at all.
Now let’s look at how the QBI, and other tax related issues, apply to having a job, having a business, and how the form of your business impacts tax obligations.
Developers who work as W2 employees will likely pay a higher amount in taxes than a freelancer
When someone takes a job working for a company then they will be considered a “W2 employee.” This means that the employer will issue a W2 at the end of the year, to the employee. The employer will withhold federal income taxes and FICA (explained above) from the employee’s paycheck.
One of the biggest downsides of being a W2 employee is that the income that flows from it is the most taxed income someone can earn. This is because they are responsible for federal income tax on all of their income. They are also responsible for Social Security taxes for all of the first $142,800 which they earned for 2021 (this limit adjusts each year). Finally, they are also responsible for Medicare taxes on all of their income.
It’s pretty hard to get ahead in life when someone is automatically taking a slice of everything you make. This is the situation which W2 employees find themselves in. Fortunately, those who go the freelance route have options. Let’s look at each of these in turn.
Freelance developers, who do not form a business, may be able to reduce their tax obligations.
A freelance developer, who does not form a business, will receive a 1099 at the end of the year. Depending on whether their freelancing activities are continuous and ongoing, they may be able to consider themselves a “sole proprietor,” which is explained below. Sole proprietors are eligible for the Qualified Business Income deduction explained above.
The key to whether someone, who has not formally formed a business, can consider themselves a sole proprietor is whether their activity is continuous and ongoing. Let’s explain this with a few examples.
Suppose Joe Developer has a full-time job but takes a single side project which will take six months to complete and he does not form a business. He is paid $100,000 for this side project and receives a 1099 at the end of the year.
During this time, he takes no other projects, does not attempt to gain other projects, and ceases “freelance” work once his one project is completed.
Most likely, Joe’s activities are not “continuous and ongoing” and were, instead, a one-time activity. Likely, Joe would not be able to call himself a sole proprietor and would have to pay federal income on the entire $100,000 as an independent contractor.
Now suppose Jill Developer took small projects throughout the year and earned $30,000 from her side hustle. She was continuously looking for more work and/or performing work for different customers.
Because Jill’s activity is “continuous” she would likely be able to take the QBI deduction. This means she would only pay federal income tax on $24,000 of the money she earned ($30k-20%).
One thing that is important to remember for both Joe and Jill, is that both independent contractors and sole proprietors must pay “self-employment” tax on all of their business income.
Self-employment tax is the equivalent of FICA/Medicare payments. So, in other words, Jill would pay slightly less federal income tax than a W2 employee due to the QBI deduction and would pay the same level of self-employment tax that a W2 employee would pay in FICA/Medicare taxes. Joe would be at the same level of taxation as a W2 employee in all regards.
As these examples show, if you go the freelance route then you can see tax benefits (mainly the QBI deduction) as long as you are not simply completing a “one off” project but are, instead, engaging in continuous activity.
Forming a formal sole proprietorship can yield tax benefits for freelance developers
A sole proprietor is someone who is self-employed but does not start a formal business entity, such as an LLC or a corporation. This is an individual who obtains a local business license and registers a trade name (depending on the rules and laws of their particular locale).
Income earned through this business is reported on Schedule “C” of their personal tax return and is eligible for the Qualified Business Deduction. As with an independent contractor, a sole proprietor will pay self-employment tax on all their profit.
One of the benefits for forming a formal business is that it clears up ambiguity regarding whether you can consider yourself a sole proprietor.
In the example above, Joe developer likely could not classify himself as a sole proprietor as he was not engaged in continuous business activity and had not formed a business by obtaining a business license and registering a trade name.
By forming a business, you can more comfortably call yourself a sole proprietor (generally speaking) and ensure that you receive the benefits of the Qualified Business Income deduction.
Acquiring a business license and trade name is often inexpensive in the grand scheme of things. There’s a good chance that it’s worth it to do so.
Freelance programmers have the option of forming an LLC
Another option for a freelance programmer is to start a Limited Liability Company. This is a company which is considered to be a separate entity from the owner.
There are many benefits which come with forming an LLC. These benefits include quite a few things which are beyond the scope of this article, such as liability protection, the ability to bring in partners with ease.
When you start an LLC, you will form the entity through your given state’s Secretary of State Office. You will also need to check your state’s requirements regarding business licensing and so on.
The LLC will have its own bank account and customers will be billed through the LLC. The owners of the company can withdraw money from the business in the form of “distributions.”
The LLC will, itself, pay no taxes during the year. It will report its revenue and expenses to the IRS via tax form 1065. At the end of each year, the owners of the business will receive a form known as a K-1. The owner will be responsible for any taxes on their respective share of the LLC’s profits.
Freelance developers who operate as an LLC will be able to take the Qualified Business Income deduction explained above. They will also be fully responsible for self-employment on their share of the LLC’s profits. Let’s look at how this works in practice by way of example.
Jill Developer and Joe Programmer start an LLC together and start taking customers. Jill owns sixty percent of the business and Joe owns forty percent. The business earned $100,000 in profit for 2021. Jill’s share of the business’ income is $60,000 (sixty percent) and Joe’s is $40,000 (forty percent).
Since the Qualified Business Income deduction applies, $48,000 ($60k-20%) of Jill’s income will be subject to federal income tax. $32,000 ($40k-20%) of Joe’s income will be subject to federal income tax. Each will be responsible for self-employment tax on their entire share of the company’s profits.
A single individual can also start an LLC – it does not have to take the form of a partnership. For tax purposes, however, a single member LLC is referred to as a “disregarded entity” and the single owner will file a Schedule C as if they were a sole proprietor.
For federal tax purposes, this will have little difference as the tax consequences of being a sole proprietor and an LLC are essentially the same. However, there may be differences in terms of state taxation and it is important to remember that there are non-tax benefits, such as liability protection, which can come from forming a single member LLC.
Self-employed developers can save federal income tax and self-employment tax by taking the “S Corp election”
Another option for self-employed developers is to form an LLC and opt to be taxed as if it were an “S” Corporation.
Under this scenario, the business is an LLC but, for tax purposes only, is treated by the IRS as if it were an S corporation. This provides the owner with the benefits of owning an LLC but also comes with some additional tax benefits – the main benefit being that the company’s profits are not subject to self-employment taxes.
Let’s look at how an S Corp election achieves this and how you can make the election when you start your business.
When an LLC opts to be taxed as an S Corporation, the owners must pay themselves a “reasonable salary.” This salary comes on a paycheck to the owner and the paycheck is taxed the same as it would be for any other W2 employee.
After that, however, the owner(s) start to receive multiple tax benefits. First, if you're a self-employed developer then the company’s profits would be considered Qualified Business Income, meaning you can take the QBI deduction.
Second, the profits of the company are not subject to self-employment taxes. This means that an S Corporation election can result in multiple benefits.
Suppose Jill Developer wants to go the freelance route. She starts an LLC and opts to be taxed as an S Corporation. Jill determines that a “reasonable salary” for a developer of her skill level is $60,000 per year. The S Corporation pays Jill her $60,000 salary. The Corporation also has profits of $50,000 in excess of the $60,000 salary. This means that Jill has a total income of $110,000 ($60k salary + $50k profit).
However, only $100,000 of this will be subject to federal income tax. The $60k salary is taxable, and because of the twenty percent QBI deduction, only $40k of the profit is subject to federal income tax. Also, the $50k in profit is exempt from self-employment tax.
So, while a sole proprietor or LLC owner would pay self-employment tax on the full $110,000 of income, Jill will only pay self-employment tax on her “reasonable salary.”
Forming an LLC is typically accomplished through the Secretary of State. To be treated as an S Corporation, the LLC will need to complete and send IRS form 2553 to the Internal Revenue Service.
It is important to note that form 2553 can only be sent to the IRS within seventy-five days of the start of your tax year. This means if you just started the LLC, you have seventy-five days from the date of the founding to make the election. Otherwise, you have to wait until the next tax year starts to be treated as an S Corporation.
If you miss this deadline, you will have until seventy-five days after the start of the next tax year to make the election effective for that year.
The benefits of an S Corporation exceed those of a sole proprietorship or LLC. An S Corporation, however, does come with additional burdens and things to consider. It’s important to weigh all the pros and cons when deciding which business entity is right for you.
Developers should pick the business structure which bests fits their situation
After going through all the options above, it may seem like forming an LLC with S Corporation status is the obvious choice. That is the structure which offers the most possible tax advantages.
It is important to remember, however, that each level of tax savings is also going to come with additional levels of red tape and expense.
On one end, forming a sole proprietorship is straightforward, as getting a business license and trade name are often inexpensive and low cost. On the other end of the spectrum is S Corporation status – this involves paying yourself a “reasonable salary,” which means managing payroll filings and other regulatory hurdles. It’s important that you pick the structure that best fits your situation.
Again, you should discuss any decision as to how you should structure your enterprise needs with a tax professional (which I am not). My personal, non-professional opinion, is that the more you're intending to grow your business the more it makes sense to take your business structure up a notch.
In our company, the taxes we save justify paying for Quickbooks Payroll Service and the time involved in managing payroll. In other words, the benefits outweigh the costs.
If, however, you are only taking a project here and there, then you will need to weigh potential tax savings against the time and expense of a given structure.
At the end of the day, how to structure your business is a personal choice. Understanding how the choices impact your taxes, however, is important to planning your business and trying to get ahead in this world.
Now that we’ve looked at how the structure of your business will impact your tax obligations, let’s look at the importance of taking, and maximizing, your various deductions.
Freelance & self-employed developers must understand the importance of tax deductions & utilize them
A big part of minimizing your tax obligations is to make sure that you're utilizing all possible deductions.
The extent to which I talk with people, on a regular basis, who aren’t maximizing their deductions is astounding to me personally. These people are leaving large amounts of money on the table while simultaneously complaining about not being able to “get ahead.”
This section of this tax guide is going to be dedicated to discussing the importance of deductions.
First, we’ll look at how not utilizing your deductions amounts to donating money to the government.
Second, we’ll look at various expenses which can be deducted from your taxable income at the end of the year.
Finally, we’ll look at how proper retirement planning can impact your tax bill. Before diving into these topics, however, I believe it is important to explain the concept of a “deduction.”
Many people are familiar with the concept of a tax deduction. Most, however, don’t understand that a deduction is not a dollar-for-dollar credit. Instead, deductions reduce income which, in turn, reduces your tax bill.
Earlier in this guide we looked at how the higher your income is, the more you pay in taxes. If, for example, you are in the twenty-four percent tax bracket for 2021, then the last dollar you earn will result in a twenty-four-cent tax obligation.
We also looked at the fact that freelancers pay taxes on their profits and not on their revenue. This means that if you have one hundred dollars of revenue, and ten dollars of business-related expenses, then you only pay taxes on ninety dollars of income ($100 revenue - $10 expenses).
Putting these concepts together, we see that if you are in the twenty-four percent bracket, then your tax obligation would be $21.60 on that last $90 (24% * $90). So, by deducting $10 in business expenses from $100 in revenue, you save $2.40 in taxes ($24 - $21.60).
In other words, anything you deduct as an expense means a reduction in the income that you must pay taxes on. It is, therefore, important that you understand which business expenses are deductible and that you report them to your accountant/on your tax return.
Developers are essentially donating money to the government if they fail to deduct their business expenses
I talk to way, way, way, way……way too many small business owners (including developers) who don’t do a good job of making sure they claim all their business expenses as deductions at the end of the year. This amounts to unnecessarily donating money to the federal government.
Think of it like this – if you don’t write off an expense, which was deductible, then you must pay taxes on that money. Let’s look at this by way of example.
Jill Developer brings in $100,000 in revenue in her freelance business. She deducts $20,000 for services which are necessary to her business (AWS, and so on). This brings her taxable income (the amount she will pay taxes on) down to $80,000.
However, as part of her work, she regularly drives to meet with customers. Over the course of the year, she incurs $2,000 worth of work-related mileage on her car. She does not deduct this mileage as an expense (more on this below).
This means that Jill paid $2,000 for her work mileage and paid $440 in unnecessary taxes by not writing it off. This amounts to Jill letting the government keep $440 of her money unnecessarily. Here’s a tip for Jill if she wants to get ahead in life: don’t do that.
It’s common for self-employed individuals to be unsure of what, and what is not, deductible as a business expense. A rule that I live by in our business is to err on the side of assuming that something is deductible and then asking our accountant about it.
If you don’t report an expense to your accountant, then they have no way of knowing the expense even existed. This can result in deductible expenses being missed.
If, instead, you let your accountant know about everything and then let them exclude non-deductible expenses, you ensure that you don’t miss any deductions.
In other words, make sure your accountant knows about all your expenses. This will help to prevent you from donating money to the government.
Common expenses which developers can deduct from their taxes at the end of the year
The discussion above, hopefully, drives home the point of making sure that you deduct all your business expenses. Unfortunately, many freelancers don’t deduct any of their expenses.
So, let’s devote a bit of this guide to understanding the more common deductions which you should be claiming as well as some of the less obvious/lesser-known ones.
First, there are things which can clearly be classified as business expenses. If you are paying for a service such as AWS, for example, it can be deducted from your revenue as an expense.
If you are renting an office of any sort, or if you pay for a post office box that is solely dedicated to your business, then these expenses will generally be tax deductible.
Likewise, expenses related to an office, such as utilities, are clearly a business expense.
Unfortunately, many developers miss out on some of the lesser known/considered deductions.
The first commonly missed business expense is work-related mileage. For the 2021 tax year, self-employed individuals can deduct up to fifty-six cents per mile for work-related driving. This is meant to cover the cost of gas, depreciation on your car, insurance, and so on.
Examples of “driving for work,” can include driving to meet with a customer, driving for a dinner meeting with a potential client, driving to Best Buy to purchase work-related equipment, and so on.
Work mileage does not include driving from your house to your office (that is your daily commute) and vice versa.
If you are a sole proprietor, then you will deduct the mileage on your Schedule C. Under the Tax Cut & Jobs Act of 2017, however, mileage on a personal vehicle became non-deductible for an LLC owner. But if you have elected for S Corporation treatment of your LLC, it is still possible to claim the mileage deduction.
This is accomplished by having the S Corporation (the company) reimburse the employee (you) at the rate of fifty-six cents per mile for the use of a personal vehicle. This is not taxable to the individual (you) and is deducted from the S Corporation income which flows through to the individual (you).
So, in a nutshell, if you are a sole proprietor then you can deduct your mileage. If you own an LLC with an S Corporation election, you can deduct your mileage by having the company reimburse you for the mileage expense.
A second commonly missed deduction is the use of a personal cell phone. If you have a separate cell phone, that is in the name of the business only, then the cost of it is clearly deductible.
But what if you use your personal phone for work purposes? The answer is that you can write off the portion of your bill that can be apportioned to work. So, if forty percent of your personal cell phone usage is work related, then you can claim this as an expense on your Schedule C if you are a sole proprietor. If you own an LLC or S Corporation then your business can reimburse you for that forty percent. It would be deductible to the business and non-taxable to the individual.
So, sticking with the forty percent example, if your cell bill is $100 per month then you would reduce your taxable income by $480 [12 months * ($100 - $40)]. This is one of the more commonly missed deductions.
Third, work-related equipment purchases are also deductible. Importantly, so are personal purchases with a work purpose. If you buy a laptop, for example, that is solely for use in your freelance business then you can deduct the entire cost of it (you may be required to depreciate it over time – that’s a question for your accountant).
But what about a laptop that is used for both work and personal purposes? Like with a cell phone, you can deduct the portion of it that is “work related.” So, if you pay $1,000 for a laptop and sixty percent of its use is work related, you can deduct $600 from your taxes.
Another commonly missed expense is the one for non-extravagant work travel. This can include airfare, nights in a hotel, and meals for business related travel.
The key point of this deduction is that the travel must be non-extravagant and primarily for work. In other words, if the trip is a vacation in disguise, then you can’t deduct these expenses. If you can meet the standard of “primarily for work,” however, then these expenses became fully deductible under the Tax Cuts & Jobs Act.
The foregoing are just a few examples of deductions which are often missed. Talk with your accountant to see what other opportunities for deduction you may be missing.
Freelance developers can minimize their tax burden by maximizing retirement plans
One of the big things people in the U.S. are missing out on is the ability to partially fund their retirement through tax savings. Whenever I meet someone who isn’t maxing out their 401(k) through their employer, I just shake my head to be honest.
Fortunately, if you are a developer taking the freelance route (which I assume is why you’re reading this guide), then you’re not going to make that mistake.
To see how you can build wealth, and save money at the same time, let’s look at what you can be doing with an IRA or a SIMPLE (short for “Savings Incentive Match Plan for Employees”).
Before looking at an IRA and a SIMPLE, let’s understand how the IRS treats retirement plans in general.
Contributions made to retirement accounts are tax deductible. This means that you will not pay federal income tax on income used to fund these accounts. For 2021, the most an individual could contribute to an IRA was $6,000. The limit on a SIMPLE for that same time was $13,000.
It is important to note that there are low-income limits in terms of being able to take both. If you have a Modified Gross Income of less than $76,000 then you can still contribute to both an IRA and a SIMPLE. You will not be able to reap the full tax benefits, however, if your income is over $66,000. So, let’s take a look at how these work.
An IRA is an “Individual Retirement Account.” As just mentioned, you can contribute up to $6,000 per year for 2021 (this number changes each year).
The amount you contribute to your IRA is deducted from your taxes at the end of the year. You then invest the money in an investment vehicle of your choice. Any gains in that investment, and dividends paid on the investment, are [MBD2] not taxed.
When the person reaches 59 ½ years old, they may then withdraw money from the IRA to live on. Those withdrawals are taxed as “regular income” at the time of withdrawal.
Suggested Reading: Unshakeable by Tony Robbins (Link goes to Amazon)
Let’s look at how an IRA works in practice. Jill Developer has a taxable income of $80,000 in freelance business for 2021, after taking her QBI deduction. Her federal income tax obligation for the year is going to be $13,348 and her top bracket is twenty-two percent. That’s a lot in taxes.
Now suppose Jill had contributed $6,000 to her IRA. This would drop her taxable income to $74,000 and her tax obligation would have been reduced to $12,028 due to her lower taxable income. This means Jill would have saved $1,320 in taxes.
Further, this means that contributing $6,000 to an IRA only cost Jill $4,680 ($6k contributed - $1,320 tax savings). So, at the end of the day, Jill wound up with $6,000 in retirement savings, which will grow tax free, at a cost of only $4,680. What’s even more beautiful is that any individual can contribute to an IRA.
Another option is to create a SIMPLE if you have an LLC that is being taxed as an S Corporation. A SIMPLE is a type of plan which allows employers to contribute to the retirements of their employees. It is like a 401(k) but is for smaller businesses.
As stated above, if you are being taxed as an S Corporation you are both the business owner and an employee of the business. This means that you can create a SIMPLE.
Under this type of plan, the employee (you) could contribute $13,000 to their retirement for the 2021 tax year. The employee can deduct this amount from their taxable income. The company (which you own) can then match contributions of the employee (which is you) for up to three percent of the employee’s salary. This match is deductible from the company’s profits.
Now let’s look at a Simple in action. Remember Jill Developer? Well….she’s back. Jill has started an LLC and has elected to be taxed as an S Corporation. The company pays Jill her “reasonable salary” of $60,000. It also has profits which, after her QBI deduction, give her a total taxable income of $132,000 (salary plus profits). Jill’s federal income tax obligation is $25,701.
Now, let’s suppose that Jill had contributed to a SIMPLE. She could have contributed $13,000 as an individual and the company (which she owns) would contribute $1,800 (three percent of her salary). Once all the numbers are crunched, Jill will have received $14,800 in retirement contributions at a real cost of $11,623, after factoring in tax savings.
The moral of the story for either an IRA or a SIMPLE is that a self-employed developer can partially fund their retirement, and build wealth, through tax savings.
How small business owners and freelance developers can make their tax payments during the year
Tax withholding is simple when you are a W2 employee. You go to work, you get a paycheck, and your employer withholds any necessary taxes from that paycheck.
When you are working for yourself, however, making your tax payments during the year becomes your responsibility.
Not paying in enough during the year can result in a large bill when you file your tax return. It can also result in a potential penalty. Conversely, paying in too much can mean that you are loaning your money to the government interest free – not a good idea.
Before we get into how self-employed developers can make their tax payments during the year, let’s look at tax withholding as a general concept, and the consequences of paying in too little, or too much, during the course of such a year.
Federal tax payments made during the year (whether through payments you make or withholding from a paycheck) goes to the IRS, and the US government uses that money to fund its current operations (along with money it borrows to finance the deficit – but that’s a different discussion).
At the end of the year, you file a tax return which calculates how much tax you owe for the year, as explained throughout this guide.
If, during the year, you paid in more than the amount shown as required on your tax return, you will receive a “refund” equal to the amount which you overpaid. Conversely, if you paid in less than the amount shown as required on your tax return, then you must pay the balance to the government.
There are consequences for failing to pay in enough tax during the year. If an individual owes more than $1,000 in tax at the end of the year, then they will face a penalty unless their payments during the year amounted to at least ninety percent of the total year’s tax or if the tax they paid during the year was equal to the total tax paid the prior year.
If a penalty is assessed, then interest will apply to that penalty until it is paid. Yes, this seems convoluted. Let’s look at a few examples to see how this works in practice.
Jill Developer earned “x” as a freelancer in 2021. When she completes her tax return, it shows that her total tax obligation for the year was $10,000. Jill only paid $8,500 in tax payments during the year. This means she has a balance of $1,500.
Because this balance is more than $1,000, Jill may owe a penalty. Now Jill must look at her 2020 tax return. If her total 2020 tax obligation is $8,500 or less, she will not owe a penalty. This is due to the fact that her 2021 payments were equal or greater than her total 2020 tax obligation. If her 2020 return shows a tax obligation of more than $8,500 then she will owe a penalty.
Now suppose Jill’s 2021 tax obligation is $20,000. Further, suppose her 2021 tax payments only equal $18,500. Jill has a balance of $1,500. Again, Jill may owe a penalty due to this $1,500 balance. In 2020, Jill’s tax obligation was $30,000. While Jill owes more than $1,000, and has 2021 payments that were less than her 2020 obligation, she will not owe a penalty for 2021. This is due to the fact that her 2021 payments were more than ninety percent of her total tax obligation for the year.
There are potential consequences that come with paying too much in tax payments during the year as well. These consequences are the fact that doing so amounts to loaning money to the government interest free.
In other words, making excess payments during the year, just so you can get money back without any interest, at the end of the year, isn’t exactly the road to financial success.
As you’ve probably gathered from reading this guide, smart tax management is one of the keys to “getting ahead” financially. Loaning money out for free is not smart. It is also pretty common for people, who get excited about having a refund at the end of the year, to be the ones who didn’t manage their taxes correctly and paid too much as a result.
Consider the following example. Joe Developer had a total tax obligation of $15,000 for 2020. This means that Joe did not need to pay more than $15,000 during 2021 in order to avoid a penalty.
Although Joe’s business wasn’t considerably growing in 2021, he still paid in $20,000. Furthermore, Joe did not structure his business as an S Corporation (see the discussion above). So, this means that for 2021, Joe loaned $5,000 to the government interest free. He also paid unnecessary self-employment tax by not taking the S Corporation election.
Joe just doesn’t understand why he can’t get ahead with his finances, but never stops to think that his tax management may be a culprit. Unfortunately, there are a lot of people like Joe out there.
Now that we’ve discussed the problems with paying too little, and too much, tax during the year, let’s discuss how a freelance developer can make their tax payments during the year.
If you are self-employed, there are multiple ways in which you can make your tax payments during the year.
First, if your business is being treated as an S Corporation, then you will receive a paycheck as you are an employee of the business as well as the owner. Taxes will be withheld from these paychecks, as they are with any other employee’s check.
If you are not being taxed as an employee, then you must make estimated tax payments each quarter. Let’s look at each of these in turn.
If you are receiving a paycheck from your business, then the taxes withheld will only be based on the amount of the paycheck. This can leave you with a large tax obligation, at the end of the year, which stems from the business’ profits.
One option for dealing with this is to have additional money held out of each check, on top of what would be held out normally. These extra withholdings can serve to deal with the taxes due on your profits. If you do not wish to have extra money held out of each paycheck, then you can make quarterly estimated tax payments (more on this below).
If you are not receiving a paycheck, then you must make estimated tax payments to the IRS during the year. These estimated payments can be made by sending a check, along with Form 1040-ES, to the IRS. Payments can also be made directly through the IRS website.
How much you should be paying during the year is an issue which I would suggest discussing with a tax professional. Again, paying too little can result in a penalty while paying too much can result in you loaning money to the government interest free.
How to best manage your payments during the year is going to depend on your specific situation and it is strongly suggested that you make your decisions in consultation with a CPA.
Where you choose to live will impact your overall tax bill
As mentioned earlier, there are several layers of taxation in the U.S. These include various federal taxes (which have been the main focus of this article). But these also include state and local taxes. Such state and local taxes can include taxes paid to the state you live/work in as well as the city you live/work in. These state and local taxes can vary wildly.
Since, as I’ve been repeating over and over, consideration of your taxes is important to your financial wellbeing, it is important to understand that where you choose to live will impact your tax burden.
I’ll spare you a long discussion (as this guide is long enough already), about the various tax structures in different states. The biggest thing to consider is this: some states have no state income tax, some states have an income tax where self-employed people are highly favored, and other states have a high state income tax.
Nevada, for example, is a state in which there is no state income tax on individuals. Ohio has a state income tax, but self-employed individuals enjoy several exemptions. Living in California will result in paying a high state income tax.
Life is about choices, and these include the choice of where you live. If you are choosing to live and work in a place with a high cost of living, and a high tax structure, then getting ahead is going to be highly difficult.
Earlier in this guide I mentioned a friend from San Francisco who didn’t realize that her taxes were her second largest expense. Well, she lives in California where housing prices are sky high, and taxes are sky high. I live in Ohio, where housing is cheaper and state income is largely waived for self-employed persons such as myself. Where you live matters.
If you’ve been reading this guide, then I’m assuming that you have a desire to save on your tax bill. Being mindful of your taxes is one of the most powerful things you can do when it comes to getting ahead financially.
By starting a business, structuring it appropriately, and being mindful of where you live, you can greatly improve your financial standing.
If you feel like you are struggling financially, then ask yourself these two questions:
- Are you actively trying to reduce your tax bill?
- Are you willing to move to a state with a lower cost of living?
Unless you answer “yes” to each of these questions, and then act on them, the first thing to do when it comes to your finances is to have a harsh discussion with the person in the mirror.
Just food for thought.
I am a front-end developer and the founder of Modern Website Design. I enjoy writing on business-related issues and am passionate about entrepreneurship. To keep up with more of my ramblings, follow me on Twitter.