How to Manage Your Taxes as a Freelance Developer or Startup

Being self-employed as a freelance developer or running your own startup comes with many perks—you get to be your own boss, set your own hours, and work on projects you‘re passionate about. However, it also means taking on additional responsibilities, including handling your own taxes.

For many freelancers and entrepreneurs, managing taxes is one of the most daunting and confusing aspects of running a business. But with some basic knowledge and careful planning, you can stay on top of your tax obligations and even put yourself in a better financial position. Here‘s what you need to know.

Understand Your Tax Obligations

When you‘re self-employed, you‘re responsible for paying several types of taxes:

Income tax: You must pay federal, and sometimes state and local, taxes on your net business income (revenue minus expenses). The amount you owe depends on your total income and your tax bracket.

Self-employment tax: This is how self-employed people pay Social Security and Medicare taxes. The self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare).

Estimated taxes: Since taxes aren‘t automatically withheld from your pay as a freelancer, you may need to make quarterly estimated tax payments to avoid underpayment penalties.

Business taxes: Depending on your business structure and location, you may owe additional taxes, such as sales tax, gross receipts tax, or franchise tax.

Choose the Right Business Structure

One of the first tax decisions you‘ll make is choosing a legal structure for your business. The most common options for freelancers and startups are:

Sole proprietorship: This is the default if you do business in your own name. It‘s simple to set up, but offers no legal separation between you and your business.

Limited liability company (LLC): An LLC provides some legal protection for your personal assets and allows you to choose how you‘ll be taxed. Single-member LLCs are taxed like sole proprietorships, while multi-member LLCs are taxed as partnerships by default.

S corporation: An S corp is a special tax status that can help you save on self-employment taxes. You must pay yourself a reasonable salary, but additional profits are taxed only at the income tax rate, not the self-employment tax rate.

There‘s no one-size-fits-all answer, so evaluate the pros and cons of each option and consult with a tax professional to determine the best structure for your situation.

Track Your Income and Expenses

Accurate recordkeeping is essential for filing your taxes and claiming deductions. Keep track of all your business revenue, whether it‘s from freelance projects, product sales, or other sources. Also maintain records of your business expenses, such as:

• Website hosting and domain fees
• Computer hardware and software
• Office rent and utilities
• Advertising and marketing costs
• Business travel
• Vehicle mileage for business purposes
• Subcontractor payments
• Health insurance premiums
• Retirement account contributions
• Professional membership dues
• Educational expenses to improve your skills

There are many apps and accounting software programs that can help automate your bookkeeping. Just be sure to keep detailed records and receipts in case of an audit.

Make Estimated Tax Payments

If you expect to owe at least $1,000 in taxes for the year, you should make quarterly estimated tax payments to avoid penalties. For 2021, the due dates are April 15, June 15, September 15, and January 18, 2022.

To calculate your estimated taxes, estimate your net income and multiply it by your marginal tax rate (based on your tax bracket). Then add your estimated self-employment tax. Divide the total by four to determine how much to pay each quarter.

If your income fluctuates or is unpredictable, you can use the annualized income method to make unequal payments each quarter. There are also safe harbor rules that let you avoid penalties if you pay 100% of last year‘s tax (110% if your adjusted gross income was over $150,000).

Take Advantage of Tax Deductions

Business expenses you incur to run your business are generally tax deductible. The key is that they must be "ordinary and necessary" costs for your industry. Some of the most valuable deductions for freelancers and startups include:

Home office deduction: If you use part of your home regularly and exclusively for business, you can deduct a portion of your mortgage interest, property taxes, utilities, and repairs.

Vehicle expenses: If you use your car for business, you can deduct the costs using either the standard mileage rate (56 cents per mile in 2021) or your actual vehicle expenses.

Depreciation: If you buy equipment or property for your business that will last more than a year, you can usually deduct the cost over time through depreciation.

Startup costs: You can deduct up to $5,000 in startup costs, such as market research and advertising, in your first year of business. Any additional costs must be amortized over 15 years.

Retirement savings: Contributions to a self-employed retirement plan, like a SEP IRA or solo 401(k), are tax deductible and can help you build long-term savings.

Be sure to keep proper documentation of your expenses in case you‘re audited. And remember, not all deductions are obvious—it‘s worth consulting a tax professional to ensure you‘re not missing anything.

Consider Hiring a Tax Professional

Taxes for freelancers and small business owners can quickly get complicated, especially as your business grows. According to a survey by the National Association for the Self-Employed, nearly 75% of self-employed taxpayers use a professional tax preparer or tax software.

Working with an experienced CPA or enrolled agent can give you peace of mind, help you take advantage of all the deductions you‘re eligible for, and free up your time to focus on your business. Look for a professional who specializes in self-employed taxes and is familiar with your industry.

You can also use tax preparation software like TurboTax Self-Employed or QuickBooks Self-Employed, which offer step-by-step guidance, expert advice, and audit support. But even if you prepare your own return, it‘s a good idea to have it reviewed by a professional at least occasionally.

Plan Ahead for Tax Season

The key to managing your taxes as a freelance developer or startup is to plan ahead and stay organized throughout the year. Here are a few tips:

• Set aside money for taxes as you earn income, so you‘re not scrambling at tax time. A good rule of thumb is to save 25-30% of your net income.
• Pay your estimated taxes on time to avoid penalties and interest.
• Keep your business and personal finances separate by using different bank accounts and credit cards. This makes tracking expenses much easier.
• Stay on top of changes in tax laws, deductions, and credits that could affect your business. The tax code is always evolving.
• Consider using accounting software to automate your recordkeeping, invoicing, and financial reporting. Good options include FreshBooks, Xero, and Wave.
• Take the time to understand your tax obligations and develop a system for meeting them. A little planning can save you a lot of headaches down the road.

By being proactive about your taxes, you can minimize your tax liability, avoid costly mistakes, and set your freelance business or startup up for long-term success. It may seem daunting at first, but with the right knowledge and tools, managing your taxes can be a lot less taxing than you think.