While freelancing holds many rewards, most independents don’t take advantage of how lucrative it can be. As a freelancer, I learned the hard way the three key misunderstandings that keep us from hanging on to more of our cash. This is how it happened:
Four days after getting a surprise $4300 tax bill, I found myself at a coffee shop sitting across from Patrick, a financial advisor and tax attorney. It was the spring of 2009, and I had been doing well as a web designer in Colorado for several years and was used to getting a nice refund. This year something had gone wrong.
“I’m not surprised your tax bill is this large, given that you just threw away your receipt.” He motioned toward my steaming latte.
“What do you mean?” I asked.
Patrick reached into his wallet and retrieved his own receipt. “Think of this as money,” he said. “And my guess, without even looking at your records, is that you’ve been throwing away a lot of it.” This piqued my interest and I leaned in. “After all, isn’t this a work meeting?” he asked. I had to agree that we were meeting about my work expenses, but how significant could one little $2 receipt be? In what seemed like a detour he asked, “Tell me about your last vacation?”
“This past fall I went to Hawaii over Labor Day with my girlfriend.” I filled him in on the fun, 12-day adventure and answered specifics about our trip.
“Did you even consider writing that off?” he asked. I must have stared blankly at him because he started to explain that most freelancers don’t know how easily they can turn a pleasure trip into one they can deduct for work.
“I bet you didn’t know that with some advanced planning you could deduct your airfare, hotel room, rental car, 50% of your restaurant meals, and even some of your entertainment, like golf.” I shook my head. “In every place, you might want to travel there are opportunities to promote and grow your business, so why not take advantage of them?”
“But what kind of a vacation would that have been if I was working all the time?” While his advice seemed financially interesting, I couldn’t imagine having spent those sun-drenched days inside slogging overwork, not to mention how mad my girlfriend would have been.
Patrick held up two fingers. “Two days. Maybe for an hour each day. From what you’ve told me about your itinerary, that’s how much you would’ve needed to work to write off most of your travel expenses.”
“How is that possible?” I asked. He must have been used to that question because he quickly started to explain that if 7 out of my 12 days were considered business days then the trip was largely deductible. He could tell from my expression that this number sounded less appealing than the two days he had just stated, but he continued. “What most people don’t know is those travel days can be considered business days, so they contribute to that total, as do weekends and holidays.
I must have looked confused because he clarified, “That equals seven business days: the Monday you travel, the Friday you work, the weekend and Labor Day, the Tuesday you work, and the Friday you travel.”
“You said I needed to work two days, even if it’s for an hour each day. What kind of work could I have done?” I was beginning to feel like he had just given me the key to some long lost treasure.
“Well, you’re a web designer. You could’ve arranged to meet with a prospect to discuss working together on Friday and on Tuesday you could’ve visited a successful web design agency to discuss referring business to each other. When you work on getting clients or learning new skills, your business benefits from it, and this is the basis to determine business days. ”
I was stunned! “Why isn’t everyone doing this?” I asked.
“A lot of freelancers are, in fact, taking full advantage of the tax code, but most others never bother to study it. I don’t blame them. It’s a huge, boring document, 10 times the size of the Bible! But if you want to win the game, it pays to know the rules.”
While Patrick let me digest what he had just told me, he reviewed the documents I brought and then looked up. “It seems like you’ve been overpaying your taxes by about $5,000 a year,” he said. “However, this is not free money. It will take a lot of diligence on your part if you want to put back in your pocket all you’ve been leaving on the table. None of this means anything if you don’t have a way to keep track of it all.” Though Patrick’s words seemed discouraging, I could tell by his demeanor he was about to give me some good news.
“Actually you’re making plenty of money. You just need to learn how to keep it.”
What I didn’t yet know was that I had been acting on some misconceptions that can derail the best efforts of many freelancers.
Three Myths That Keep Us from Saving Money
Five years after my conversation with Patrick, my business grew from a solo freelance web design shop to a 10-person, full-service digital marketing agency. One day, a successful entrepreneur told me he wanted to buy my business. At first, I told him I wasn’t interested in selling, but he made me an offer I couldn’t refuse and promised to keep all my staff, so I finally said “yes” and we got acquired in early 2015.
During the seven years, I had my agency, I traveled six months out of each year and visited over 75 countries. While owning the agency meant I was no longer a freelancer, my travels put me in constant contact with those who had been like me, independents living their passions. I skied in Aspen with Karla, a photographer from Brazil, rode camels in Morocco with Danielle, a writer from Australia, went scuba diving in Greece with Antoine, a management consultant from Angola, and rode motorcycles in Vietnam with a German software developer named Klaus.
In my travels, I met hundreds of freelancers who shared my dream: being our own bosses, making our own schedules and working from anywhere. We all enjoyed the freedom that freelancing had given us to live our lives as we wanted.
While all of these freelancers were good at pursuing their passions, I realized through our conversations that most had never been taught how to keep more of the money they made. Though they came from diverse backgrounds and had differing skills, it seemed that the reason these freelancers weren’t taking advantage of the available tax deductions boiled down to three powerful myths:
Myth #1: My Accountant Takes Care of My Taxes
One of the mistaken beliefs that freelancers have is that at tax time our accountants can claim all of our allowable deductions, no matter what we do during the year. The problem is that part of the job of an accountant is to minimize our chances of being audited and having to pay penalties for undocumented deductions.
This means that if freelancers don’t work diligently during the year (each week in fact!) to record all of our work-related expenses, an accountant can’t use those deductions. In effect, we have tied the hands of the very person we’re paying to act on our behalf!
Let’s use an example from the first section of this book. Ultimately I was not able to deduct the Hawaii trip that Patrick and I discussed because it had already happened. This means I had not done the necessary work, in advance, to solicit work opportunities, nor had I saved any of the receipts and needed documentation from the trip.
For an even more common example, you may wish for your accountant to claim your work-related meals. But if you merely hand over a receipt, with no details, he or she cannot guess who you met with and why. It would be irresponsible of your accountant to rely on this limited information.
So the bottom line is that even though we’re paying our tax accountants to take all of the possible deductions, we’re failing to do the work they need in order to take those deductions. In the race to finish our taxes we pass them the baton, but trip them up along the way!
Myth #2: I Can Only Save a Few Bucks a Year
Not all freelancers I met were unaware that they were squandering potential deductions. Some chose to ignore them! The most common reason I heard for this was that they didn’t think it was worth the effort. In other words, they thought the hassle of keeping track of their expenses wasn’t worth what they might save.
The truth is many had no idea how much money they were forgoing. Sandy Botkin, CPA, former IRS tax attorney, and senior tax law specialist, estimates that small business owners leave about $4,000-$10,000 on the table every year.
Even if you’re not currently making a lot of money, business losses can be used to offset other income, including that of your spouse, and can be carried forward for up to 20 years. So, if you find $4,000 in deductions but you only made $500, you have $3,500 in tax credit that you can use against your other income, your spouse’s income, or the future income of either one of you. If more freelancers knew how much money they were leaving behind, they might find a few minutes a week well worth the effort!
Myth #3: Taxes Are Done Once a Year
If you’re an employee, you fill out a form when you’re hired and by January 31st of each year you get a W-2 to give to your tax preparer. Easy! So it would make sense that many people feel that tax time only rolls around once a year. But what if you work for yourself?
There are actually two tax systems in the United States. When I tell freelancers this, they rush to say: “I know! One for the rich, and one for the rest of us.” However, that’s not the case. The two tax systems are the one for employees and the one for business owners.
As you saw in the first section, it turns out that the tax code for freelancers is quite appealing. In America, we promote entrepreneurship by allowing business owners to deduct meals, travel, car expenses, home offices, etc. However, getting all these tax deductions takes a little work. You can’t just write down “Trip to Hawaii – $4,000” and expect a deduction.
The IRS has very specific guidelines on how you need to document your business expenses. They need a certain level of detail (which I’ll cover in the next section) and they need to be recorded in a “timely manner” (weekly is ideal).
Accountants, tax preparers and bookkeepers tend to err on the side of caution and won’t claim deductions that can’t be proven because they can be on the hook for penalties. They don’t want to expose themselves or their clients to this risk.
Business owners need to capture receipts as quickly as possible so their accountants can file accurate and complete tax returns, and get as many deductions as possible.
Randy Johnston, CPA and one of the Top 100 Most Influential People in Accounting
The IRS tax code is a whopping 80,000 pages (10X the size of the Bible) and the IRS is not in the business of helping you lower your tax bill. It’s your job to learn the rules of the game and make sure your expenses are recorded in a timely manner.
Once I had debunked these three misconceptions, I began researching how to take full advantage of the deductions available to me as a freelancer. How was it possible to organize and maintain the right amount of documentation? The answer was a 15-minute weekly habit that would forever change how I managed my finances.