Freelancers and other self-employed entrepreneurs have several tax planning strategies available to them before the year is over. The following strategies can help entrepreneurs mitigate the cost of certain taxes in order to optimize their tax situation between the current year and future years.
These tax planning strategies fall into four basic categories: accelerating or deferring income and accelerating or deferring deductions. Accelerating income means trying to earn more income this year, especially income that might otherwise have been received the year following. Deferring income means to postpone the payout of income to a future year, instead of receiving that same income in the current year. Similarly, accelerating deductions means spending money on expenses that will generate a tax deduction in the current year. Deferring deductions means holding off on spending money on tax-deductible expenses until the next year or years following.
Accelerating income and/or deferring deductions functions to increase the amount of income that's taxed in the current year; this may be a useful strategy if your income falls in a lower tax bracket this year compared to the next. Deferring income and/or accelerating deductions functions to decrease the amount of income that's taxed in the current year; this may be a useful strategy if your income falls in a higher tax bracket this year compared to the next.
These four tactics revolve around the proper timing of paid income, and of deductions for tax related purposes. The timing of income and deductions depends on a person's accounting method. According to the IRS, "Most individuals and many small businesses use the cash method of accounting," and so this article focuses on the rules for cash method taxpayers. Under the cash method of accounting, "you include in your gross income all items of income you actually or constructively receive during the tax year." Similarly, "you deduct expenses in the tax year in which you actually pay them.... However, you may not be able to deduct an expense paid in advance. Instead, you may be required to capitalize certain costs." (All quotations are from Publication 538, Accounting Periods and Methods.)
Strategies that Involve the Timing of Income
Self-employed persons will report income that is actually or constructively received during the year. Constructively received means income that "is credited to your account or made available to you without restriction. You need not have possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations" (Publication 538). For example, if you receive checks in the mail in late December, and hold on to them and don't deposit the checks until January, the income is still constructively received in December. Keeping these rules in mind, we can look at some general strategies for timing the receipt of income.
Income Acceleration Strategies for the Self-Employed
- Ask clients to pay now. Call or write to clients who are behind in paying your invoices. Not only does this accelerate income, but it also cleans up your accounts receivable.
- Ask for larger up-front payments for projects that will span this year and next.
Pushing more income into the current year works well if you anticipate being in a lower tax bracket this year as compared to next year. For example, if you're in the 15% tax bracket this year and next year you expect to be in the 25% bracket, accelerating income to this year could result in that income being taxed at a lower rate.
Besides the regular income tax, you will also want to keep an eye on the self-employment tax. The self-employment tax consists of two separate taxes for Social Security and for Medicare. The Social Security portion of the tax has a maximum. The 12.4% Social Security tax stops once net self-employment income exceeds $113,700 (for 2013). For 2014, the maximum amount will be $117,000. Self-employed persons may want to consider accelerating income if they are going to be over the Social Security ceiling, since that additional income won't be subject to the 12.4% Social Security tax.
Be aware there's a new additional Medicare tax of 0.9% (on top of the 2.9% Medicare tax that's included as part of the self-employment tax). This Medicare surtax applies once net self-employment income reaches $200,000 for single or head of household filers, $250,000 for married couples filing jointly, and $125,000 for married couples filing jointly. Also, I should point out that for joint filers, the additional Medicare tax is assessed on the combined Medicare wages and net self-employment income for both spouses. If you are considering an income acceleration strategy, you may want to try to avoid accelerating too much income such that you would push yourself over the threshold to where the additional Medicare tax would apply.
Income Deferral Strategies for the Self-Employed
- Send out collection letters in January instead of December to push some income into next year.
- Ask for smaller up-front payments for projects that span this year and next.
Income deferral strategies attempt to push income that might otherwise be earned this year into the following year. Deferring income works well if you anticipate being in a lower tax bracket the following year. For example, suppose you are in the 25% bracket this year, and expect to be in the 15% bracket next year. By deferring income to the following year, a taxpayer in the situation would push income into a lower tax rate.
Self-employed persons whose incomes will be near the thresholds for the additional Medicare tax may want to consider a deferring income if that will keep them below the threshold for both this year and the next year.
Pushing more income into the current year through a combination of income acceleration and deduction deferral techniques means increasing this year's tax. Income deferral and deduction acceleration techniques means decreasing this year's tax and pushing that tax impact to the following year. Which strategies are right for your business depends in part on whether you think your taxes might be higher next year compared to the current year.
Strategies that Involve the Timing of Deductions
Self-employed persons report deductions that are actually paid for during the year. Now some deductions can be paid after the year ends, notably, contributions to an IRA can be made until April 15th, and SEP-IRA contributions can be made until April 15th or until October 15th with an extension. For all other deductions, however, the expenses would have to be paid for during the calendar year.
Self-employed persons may want to accelerate deductions into the current year. Doing so can reduce both the income tax and the self-employment tax.
Deduction Acceleration Strategies for the Self-Employed
- Buy equipment this year instead of next year. Computers, software, vehicles, furniture and other types of equipment are either depreciated over multiple years (a form of deduction deferral) or can be expensed immediately using the section 179 deduction or special bonus depreciation (both are types of deduction acceleration). Which method you use can be decided when you file your tax return. To be able to utilize this tactic, you will need to have placed the equipment in service the current year.
- Stock up on office supplies. If you need few extra deductions this year to tweak your tax bill lower, this is a good place to start.
- Consider paying bonuses to your employees this year.
- Consider paying the 4th quarter payroll taxes in December rather than in January.
Deduction Deferral Strategies for the Self-Employed
- Put off investments in computers and other equipment until next year.
- Wait until next year to stock up on supplies and other office necessities.
- Consider paying bonuses to your employees in January instead of December.
Review your Books and your Bookkeeping System
Review the financial health of your business with your accountant. Many accountants will help you analyze your profit and loss statement and balance sheet to identify year-end tax strategies that are appropriate for your business. The nice thing about this step: once you have an up to date set of books, preparing your tax return will take a lot less work.
Entrepreneurs should also evaluate whether their current accounting system is sufficient for their needs. If not, there are plenty of small business accounting software options available if your current system doesn't have all the features you need.
Review your Retirement Plan
Self-employed people have several options when it comes to retirement plans: SEP-IRAs, SIMPLE IRAs, and 401(k) plans. The important thing to remember is that SIMPLE and 401(k) plans need to be established or set up during the calendar year, even if the plan is funded retroactively next year. (SIMPLE plans need to be established before October 1, while 401(k) plans need to be established by December 31st.) Review your current plan to see if the plan and your funding levels are appropriate for your needs for the year to come.
Review your Choice of Business Entity
Freelancers often work for themselves without any formal business structure, what we call being "unincorporated." That might be just fine for your needs. But there are other possibilities as well, such as forming a corporation, partnership, limited liability company, or another formal structure. There's no one-size fits all answer. And entrepreneurs who are working under one type of structure may want to review whether a different business structure might be more advantageous.
Each business structure has its own tax advantages and disadvantages. It may be especially strategic to review your business structure to respond to the higher tax rates and new types of taxes that began in 2013.
Review Estimated Tax Payments
You'll want to set up a plan for tax payments due next year. This includes the 4th estimated tax payment due by January 15th, the extension payment (if any) due by April 15, and the first estimated tax payment for next year which is also due on April 15. Get a preliminary idea of what your tax liabilities will be for this year so you have an idea of how much you'll need to set aside for this year's and next year's taxes.