Tax planning strategies fall into four basic categories: accelerating or deferring income and accelerating or deferring deductions. Pushing more income into the current year through a combination of income acceleration and deduction deferral techniques means increasing this year's tax; while 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.
Freelance professionals face two separate tax rates on their business income: the regular income tax at graduated rates and the self-employment tax. Both taxes can be managed using the planning tactics outlined below.
Planning for 2012 and 2013We know with certainty what the tax rates for 2012 are. But the exact tax rates that will be in effect for 2013 is somewhat uncertain. As the law is currently written, all the tax rates will change for 2013. There's two proposals currently in Congress to keep the tax rates the same or increase only for the top two tax brackets. But so far those bills have not passed into law. Accordingly, entrepreneurs may want to plan out their 2012 taxes with an eye towards the presumably higher tax rates that are scheduled to go into effect in 2013. And this means that traditional tax planning techniques need to be reversed. For example freelancers may want to accelerate income into 2012 to lock in a known tax rate now instead of an uncertain or possibly higher tax rate next year. Similarly freelancers may want to defer deductions until later years so those deductions will offset income taxed at presumably higher rates.
The self-employment tax rate also is scheduled to revert in 2013 back to the normal 15.3% rate. For 2012 there's a temporary reduction in the self-employment tax to a rate of 13.3%. For 2012, not only will the rate revert to 15.3%, but the Social Security wage base is increasing from $110,100 (2012) to $113,700 (2013). Accordingly, accelerating additional self-employment income into 2012 can benefit by booking income taxed at lower rates both for the income tax and the self-employment tax.
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.
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.
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 next year. But to be able to utilize this tactic, you will need to have placed the equipment in service this 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.
Deduction Deferral Strategies for the Self-Employed
- Put off investments in computers and other equipment until next year.
- Stock up on supplies and other office necessities next year.
- Consider paying bonuses to your employees in January instead of December.
Review your Books and your Bookkeeping SystemReview 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 PlanSelf-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 Choice of Business EntityFreelancers 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 other 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 now to respond to the possibility of higher tax rates in 2013 and beyond.