Un-Complicating the Tax Nightmare for the Independent Contractor

This morning, as I wrote out my checks to the government to cover my estimated taxes for the second quarter, I sighed with exasperation. 

Every time I write those checks, I get sad. It's difficult to hand over such a big chunk of money every couple of months when you are working so hard to earn it. It's different than having it just come out of your checks without ever seeing it; When you pay taxes by writing out a personal check, you really feel the impact on your total income. 

However, as we all know, taxes are a necessary evil, and as a solopreneur or independent contractor, they're a BIG part of figuring out the finances of your business. Sigh. 

Given this fact, I have an amazing guest post for you today! Paul Fendler, a self-employed CPA for over 30 years (and blogger over at Cape Cod Coaching), has put together a list of 5 simple tactics that will make dealing with income taxes easier and more efficient for all of us solopreneurs. Hooray! I'll take all the help I can get. 

So, if you, like me, are already feeling the tax crunch this year, read on for some GREAT tips from Paul...

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Un-Complicating the Tax Nightmare for the Independent Contractor

Taxes…ugh!

When you do business as an independent contractor, nothing can evoke more dread than dealing with income taxes. Rightly so.

When you are independent, it’s all on you.  You do not have an employer withholding taxes from each of your regularly scheduled paychecks and sending these taxes to the government(s) for you.

You have to deal with it. 

When the end of the year arrives, you do not receive a W-2 form, like an employee does, that tells you exactly how much income to put on your tax return. You determine how much income gets taxed.  You have to compute how much revenue you had, how many expenses you incurred and what is the resulting profit from your independent activities.

Easier said than done.

With every dollar in profit you earn, you are accumulating a tax debt along with a reporting responsibility. 

Not only do you have to pay the actual taxes due, you are expected to essentially “tell the story” of how you earned this money. It’s not enough to report the total amount of business expenses you incurred.  You need to itemize what these expenses are by grouping them into categories.

The responsibility for taxes hangs over your head like a black cloud.

If you are like most people, income taxes are probably not your thing.  Doing what you do is your thing.

I feel for you. I’ve probably done close 1,000 tax returns that involve reporting the activity of an independent contractor. I know how stressful it can be and I know how it can essentially take you out of your “flow.”

It’s one thing to deal with income taxes when you are an accountant.  It’s quite another to deal with it when you are a singer, a real estate agent, a massage therapist or something really cool…like a yoga teacher.

When it comes to income taxes, there are rules upon rules upon rules. You could hire ten different tax preparers and get ten different answers as to how much tax you owe.  It’s not because they don’t know what they are doing.  It’s simply due to the enormous complexity of tax guidelines and that their interpretation of the rules is slightly different than another’s.

It’s no wonder you find the tax return process tedious and stressful. Everything you read about taxes just adds to the confusion.  Deduct this. Don’t deduct that. Watch out for this. Beware that. Don’t miss out on these great tax-saving techniques. This is a red flag. This is trouble. Warning, warning…Blah, blah, blah.

It’s too confusing for a normal person.  An uncluttered, simplified approach is needed.

Here are 5 simple tactics that will make dealing with income taxes easier and more efficient:

1.   Don’t Do Things For Tax Reasons

Here’s something you can implement immediately.  That is-- don’t make tax implications the primary reason for making any business decision. This includes choices involving buying, selling, renting, leasing, borrowing and generally operating as an independent contractor.

Operate as if you knew nothing about taxes. Make decisions about how to spend your money based primarily on what makes sense, regardless of any tax implications.

Want to know whether or not to buy a new computer? Ask yourself what makes the most sense given your current needs, cash flow and sense of what is on the horizon. The fact that it may or may not be a deductible on your tax return should provide very little support for the decision. It should stand on its own.  Once it stands on its own, you can address the tax impact and it can reinforce your decision, or not. Either way, it’s a minor consideration.

It may seem obvious to some of you…but just to be clear…if you spend $1,000 on an item that is tax deductible against your independent contractor income, it does not save you $1,000 in taxes. You do not get all the money back from the government.  It will save you a percentage of this amount. That percentage depends on several factors.  It may save you $150.  It may save you $350.  But it’s a portion of the $1,000 you spent.

It is important to understand that even if something is tax deductible, you are still spending money.

As an independent contractor, when making decisions, tax implications are of low priority. If one day you find yourself wrestling with the decision to lease or buy a car, don’t let taxes make things even more complicated.  Just ask yourself what is the better deal.

2.  Don’t Try to Know the Tax Rules

This guideline is much like the first in that it suggests you NOT do something.  In this case…don’t try to know all the tax rules.  There’s too much to know.

Leave the details to your accountant/tax preparer. Unless you are particularly gifted at reading tax rules and filling out forms, preparing your own tax return is going to be a very poor use of your resources.  Be prepared to get some professional help. Then let them worry about the rules.

That’s not to say you put your head in the sand and avoid learning anything about taxes.  But, in my experience, problems are often created by the client who tries to know too much.  They do their best.  But the knowledge base required is too vast. Sometimes a little knowledge can be a dangerous thing when it comes to taxes.

I’ve seen many people who pride themselves on their awareness of taxes make too many assumptions and, as a result, make unnecessary mistakes by either missing out on potential deductions or assuming that they will receive tax benefits that do not materialize.

In other words, don’t clutter your mind with a lot of information that may actually be misinformation.

3.  Get a Feel For How It All Ends Up

Instead of learning the details of taxes, just try to get a feel for where it all it ends up.  In other words, look at the tax return. Specifically, look at the tax schedule where the details of your independent contract work is reported.  It’s called a schedule C.  It goes with federal form 1040.  Don’t be afraid of it. Just look at it.

If you hired a tax preparer for previous years’ tax returns where you were an independent contractor, look at how your schedule C was completed.

If you know what is reported on a tax return, it will help you set up your recordkeeping system.  No matter what method you settle on for keeping your business records, it will help you to know, in general, what information your recordkeeping system needs to produce.

The idea is not to look at schedule C and be able to complete it. It’s just to understand that expenses need to be reported according to type.  There’s a separate line for rent, advertising, office expenses etc..  Just know that you, or someone helping you, need to be able to easily extract this information from your records.

Get an awareness for what the tax return requires. Leave it at that.

4.  Keep the Big Picture in Mind

Income taxes are about money. It helps to remember that.  Even if your return is riddled with errors, the government is generally satisfied as long as you end up paying the right amount.  You don’t get any extra points for exactness or precision.  The bottom line is what matters.

Speaking of money, you need to save some for taxes.  How much? Well, you need help in figuring that out because there are many factors that go into it and it would take quite a while to explain it all. But to give you a general idea, you need to set aside AT LEAST 25-30% of your net income (revenue less expenses).

Since taxes are about the end result, it makes no sense to get overly nitpicky. In other words, you don’t want to spend hours and hours hunting, gathering, tallying if these efforts are going to reduce your taxes $50 (exaggerating for effect).  But don’t forgo a deduction. Take reasonable shortcuts. Use estimates if practical. A good tax preparer should be able to guide you.

Even though it’s about getting the right answer, you want to present things in a reasonable way because you don’t want to attract attention from the government. It’s not that you can’t survive an audit.  It’s mainly due to the fact that any sort of inquiry by the IRS or state costs you time and money. Sometimes it’s a lot of time and money. It’s a headache you can do without.

Consequently, you want your return to make sense. You want expenses to be in proportion to revenue and you want your total revenue to equal or exceed the total of the 1099’s you received.

In summary, focus on getting the right result and presenting things in a way that makes sense.

5.  Have a Recordkeeping System

In order to avoid a lot of pain come tax time, you need an effective recordkeeping system. It needs to be simple and workable.  It needs to be a system that you can actually do.

When the end of the year arrives, it should be no big deal to pull together the necessary information.  There should be no suffering.  If there is, you need to tweak your system.

There are a lot of ways to accomplish this but whatever method you choose, it needs to fit you.  For example, if you have no facility for computers, you do not want to buy Quickbooks and try to keep your books yourself.

A lot of problems start when people open their mail…or don’t open their mail. Get your mail sorted.  Apply some discipline. File your bank statements in one place. File your credit card statements in one place. Put your unpaid bills in their own folder. Once a bill is paid, file it by vendor in alphabetical order. Keep good files.  You’ll see that simply putting everything in its place will make a world of difference.

Don’t file things by month. You don’t file monthly tax returns.

A good business recordkeeping system funnels the business activity through very specific channels; a checking account devoted to your business, a specific credit card, a separate envelope for out-of-pocket expenses etc.. You want your activity contained…not spread out over multiple bank accounts, credit cards and shoe boxes of receipts that may or may not be duplicated by cancelled checks or credit card charges. 

Try to make it so that you, or a helper, can easily figure out what you spent on what.  Don’t worry too much about what’s deductible and what isn’t.  Instead, assume everything is deductible and let your tax advisor help you rule things out bit by bit.

There’s a lot to good recordkeeping but it all begins with the fundamentals. Try to do first things first.  Don’t do things unless you understand why you are doing them. Get organized before you computerize.  Keep it as simple as possible.

So there you go. A few pointers to help you get you headed in the right direction.  There’s no reason to be intimidated by the whole tax process.

I sincerely hope this helps.  If you have any questions or there is anything in particular that causes you pain when it comes to taxes, please comment below and I’ll respond.

Whatever you do…don’t let taxes…and all that goes with them…grind you down. 

Be strong.

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Thank you so much for sharing your wisdom, Paul! This is *very* helpful and reminds me that I need to get myself a bit more organized...

Fellow yoga teachers + solopreneurs of all kinds--I urge you to heed Paul's advice and get yo-self sorted out BEFORE next April. Now is as good a time as any to start!