People in their 20’s and 30’s are making big financial decisions every day: buying houses and cars, quitting jobs to open small businesses and solo practices, having kids, etc. These types of decisions bring a lot of considerations, which rely on the expertise of tax professionals, real estate agents, lawyers, mortgage brokers, insurance professionals, and more.

With that in mind, I am proud to introduce the first of what I hope will be many Young Scrappy Interviews with helpful professionals! 

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I’ve gotten a lot of questions recently from freelancers and small business owners about how to stay on top of those pesky business functions: paying taxes, tracking expenses, etc. 

To help me answer some of these questions, I called Tamara Richards, a good friend of mine and huge tax nerd. Tamara has been a CPA for 7 years, has a Master’s in Taxation, and is a Certified Treasury Professional. While her career started in corporate taxation, she shifted focus to tax consulting for non-profit organizations and small business.

Michelle: Let’s start with the basics. How does the tax situation for an entrepreneur or freelancer differ from someone who is a full-time employee?

Tamara: Well the big one is that when you’re an entrepreneur or freelancer, you’re no longer having your employer take out a portion of your income to go towards your taxes. A lot of people aren’t aware that the amount that comes out of your paycheck when you’re paid as an employee is based on an IRS formula. Thanks to this formula, at the end of the year, all else equal, you shouldn’t owe that much.

But when you’re self-employed, there is no easy formula. Your expenses across different industries will be drastically different, so there’s no one formula that works for everybody. You really have to track your own income and expenses, and then save for the end of the year.

To make things more equal, since the IRS requires W-2 withholding for employees, it also requires self-employed people to make quarterly tax payments. A lot of people don’t take that into consideration and are surprised by how much that ends up costing. Most don’t realize that when you’re a W-2 employee, your employee pays half the cost of Medicare and Social Security, but when you’re self-employed, you pay all of it. So your effective tax rate itself is different than when you were an employee, too.

Michelle: It seems like a big part of this equation involves that process of tracking your own income and expenses. Based on clients you’ve worked with, what are some best practices for making this happen?

Tamara: Well, rather than diving into what to do, I think it’s good to start with what not to do. What I usually see is one of two things. First, people start their self-employment without keeping track of expenses. They track income but not expenses, because they think they don’t have all that many. They say, “I work out of my house, I use my own computer, I don’t travel, so I don’t have a lot of expenses…” But really, there are expenses, and there are things you can deduct to lower your tax liability. When it comes to tax time, those people are hit with a huge liability, and they decide it’s not worth it and they end their business. It’s year one, and they just can’t handle the huge tax payment, so they shut the business down, start looking for a job, etc.

Then, you’ve got the other people who keep track of expenses, but they just do it in a spreadsheet, or they keep track of things that don’t make sense for their business, because they googled something real quick and read a blog post or found some standard list of things to track. And then it comes to tax time and they realize they forgot a relevant expense, or they’ve been tracking too much and it’s become overwhelming. So make sure that you’re tracking the things that actually make sense for your business– and make sense for tax time. If you do those things, calculating your liability can be simple.

A lot of people or businesses also start by keeping track of expenses, but it becomes overwhelming and they stop. So that requires hiring someone to dig through all their receipts and bank accounts at the end of the year. That’s a big hit in CPA fees, especially when you’re just starting out.

Michelle: So then in your experience, what’s the best way to track income and expenses without getting overwhelmed?

Tamara: Well, I’d recommend that you start with QuickBooks. Even if you’re small, or just starting out, they have a self-employed software that’s pretty cheap, like 5-7 bucks a month. I don’t mean to sound like a commercial, but they’ve been in the business a long time, so they have a lot of really simple tools out there. For example, QuickBooks Self-Employed automatically calculates your total quarterly tax payment so you don’t have to think about it; it’s already there for you. Then as your business grows, if you start out as self-employed and you decided to take on a partner or incorporate, then you can upgrade to a different version of the software. The system grows with you, which is good because I see a lot of clients where their accounting system has outgrown their business structure.

Michelle: And this system is easy to use? I mean, it’s the same people who do Mint and TurboTax, right?

Tamara: Yeah, the system is pretty intuitive – and it is the same people that do Mint and TurboTax. Which is great because at the end of the year, it’s easy to export it into TurboTax. You can also give QuickBooks account access to your accountant or tax professional, and that makes things so much easier for everyone involved.

Michelle: So what I’m hearing is, “Down with spreadsheets, up with QuickBooks!”

Tamara: Yes. The other thing I would recommend is that if you’re starting out with just a bit of freelancing, QuickBooks Self-Employed will be enough; you won’t need anything more than that. But if you’re growing a business that you hope will someday be your main job, go ahead and start out with a software that reflects that. It won’t cost that much more.

The next recommendation I’d give is that even if you are acting as a sole proprietor, get a business checking account and credit card, and only use that for your business, rather than commingling your business and personal finances. That way, you won’t lose track of an expense, or have that issue where you see a line item and can’t remember if it was business or personal. It just makes it simpler for you to keep track of everything, simpler for the accountants and tax professionals you work with, plus it gives you fewer things to dig through when you’re categorizing expenses, either on a monthly basis or at the end of the year for tax time. If you have to go through that process with all your business and personal transactions, then it’s an awful experience. Plus, it’s easier to do at start-up rather than when your business is already growing and thriving.

Michelle: You’ve mentioned categorizing or tracking categories a couple of times now. How do people know what categories to use? Are categories pre-determined by the IRS?

Tamara: Yes, the categories are IRS-determined, for whatever company type or legal structure you have. When you’re thinking about expense categories, go to the tax returns form for your type of business. Look up a Schedule C if you’re a sole proprietor, 1065 for a partnership, or go to 1120 for a corporation, and see how they categorize things. The IRS will give you guidance on how to properly categorize everything for tax purposes, what types of items are typically included in each category. It’s cleaner if you start out with that knowledge, so do some research on the front end. That way, you don’t have to go back and clean up your data later. From there, you can also break out sub-categories that make sense for your particular business. For example, if you needed to specifically track pencils, add it as a sub-category for the IRS category of Office Supplies. That said, don’t give yourself too many sub-categories, or make new ones separate from the IRS categories, or else it will be much harder to put them in the IRS-friendly categories at tax time.

Michelle: Shifting gears slightly, I want to get back to this issue of quarterly tax payments. Is there a good resource for a ballpark percent to set aside for taxes?

Tamara: Not really. One of the reasons why I recommend starting with QuickBooks Self-Employed is because it does that calculation on a quarterly basis, and that gives you a good idea of what the calculation looks like in general for when you move past the self-employed stage and start operating as a separate business. For my clients, I tell them to set aside 25-30% of gross earnings. That’s on the high side, but I don’t like for people to get to the end of the year and owe something like $8000 and have it absolutely wreck them. It wrecks their business, it wrecks them personally. But at the end of the year, if you have saved $8000 and only owe $6000, then you’ve got $2000 already saved to put towards your business next year.

Michelle: Another question I’ve received is from people who aren’t sure itemizing deductions or tracking expenses is worth their time, or who are worried that it will open them up to a potential IRS audit. What can people do to prevent an audit? How long should they plan to keep their records?

Tamara: The IRS standard for recordkeeping is 3 years in most situations. But again, the reason that I’d recommend tracking everything in QuickBooks, is that it will let you attach receipts there in the software digitally. That way, if the IRS says you’re being audited, you can quickly pull all of the records in QuickBooks. It’s more rigorous than just keeping track yourself. I’m sure that if you only have a handful of expenses, keeping paper or a scanned copy would be just as good, but I like the attaching function because I don’t have to keep track of receipt files or look for them anywhere.

I will also say that the IRS audits aren’t as scary as they sound. Don’t be scared to start a business because you’re afraid the IRS will audit you or not accept your deductions. The IRS recognizes that most business owners are not tax professionals, and they make mistakes. The interest and penalties are usually small for an honest mistake, you just have to pay back whatever tax you owe. They won’t send you to jail for little things, or anything like that.

Michelle: Let’s say you’ve got someone on the cusp of becoming a freelancer. How much should you be making at your side hustle before you need to start thinking about these things?

Tamara: I’d say any more than a thousand dollars, because at that point the self-employment tax gets to a noticeable point, at tax time. Anything more than $1000, I’d start putting money aside for tax time. And then if you’re making any more than $5000, I’d go ahead and start setting up a method for you to track your expenses. Of course, if you’re pinching pennies, go ahead and keep track of every expense to maximize your deductions no matter your income level.

Michelle: What are the signs that you’re ready for a more complicated business structure than that even?

Tamara: Well, there are lots of factors to consider. The first one is business growth. If you want to grow, you’ll need to take on help, either an employee or partner who’s doing the same kind of work, so that you can increase your capacity. If you start taking on a contractor, it’s easy to be a sole proprietor but if you want an employee, consider filing as a C corporation or S corporation. If what you’re doing has the potential for you to have liability, or you get held responsible for your actions, you may want to consider an LLC.

From a tax perspective. C corps, S corps, and LLCs all have to file their own tax returns (1120, 1120-S, and 1065, respectively). The return for C corps involves a tax liability calculation, and tax is due based on your business’s fiscal year. The return for S corps and LLCs are informational in nature only, and tax is due on April 15 with your personal tax return.

Whether to be an LLC or S corp is a tax-based question that you would ask when your business starts to get larger: there are tax benefits to being an S corp, but it requires that you do business in certain ways, such as treating yourself as an employee and giving yourself a salary. Most small businesses don’t do it because they just don’t think it’s worth it. Becoming a C corp also has some tax considerations, but is also driven by legal considerations.

The setup for all these is really a lawyer question, not a tax question, though there are some good resources out there. Choosing the right structure can get complicated, since it depends highly on the nature of your business.

Michelle: This has been super helpful, but I think you’ve covered all my big questions at this point. Is there anything I missed, or do you have any other thoughts you’d like to add?

Tamara: Overall, I would just recommend getting an accounting system set up, even if it’s not super rigorous. Also, keeping track of everything on a regular basis will make your life a lot easier. One of the big hurdles, or big issues, is trying to catch up with everything at the end of the year. Set aside 1-2 hours per week to categorize and track expenses. Don’t wait to the end of the year, or it will feel overwhelming, and you’ll get to the point where you don’t care about losing money, you just never want to look at another receipt again. So instead, schedule your 1-2 hours per week, and then do an extra reconciliation with the software at the end of the each month.

This is going to do a lot for your business. Not only will it make it easier at tax time, but will also give you a good idea of what your profit and loss is throughout the year at any given time. If you aren’t keeping track of that, you won’t know how well your business is doing until the end of the year when you sort through all your expenses. So really, tracking isn’t just beneficial for tax purposes, but it will allow you to keep a pulse on your business as well.

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