Did you just open a business, start freelancing or receive a “1099 Form” for the first time? Congratulations on joining the ranks of the self-employed. You have earned the privilege of paying estimated taxes directly to the IRS, and perhaps your state as well.  The skinny:

When you are an employee you have taxes withheld from your paycheck.  Not   just income taxes but social security and Medicare, commonly referred to as “payroll taxes”.  5.65%** of your gross wages is withheld from your paycheck; unlike income taxes, this withholding is statutory, with a few exceptions, until your earnings reach a certain limit***.  You don’t see it. You also don’t see that the employer is required to “match” –pay 7.65%** and remit it to the federal government.

But guess what?  One of the delightful aspects of being self-employed is that you are your own boss, the employee and employer. The retirement system was created to cover everyone, and for 2012 you are required to pay 13.30%** of your net earnings directly to the IRS, plus your estimated income tax.

The IRS knows this can cause sticker shock and has established four target dates to pay your estimated taxes – April 15, June 15, September 15 and January 15 of the next year.  The idea is that you not be left with a huge tax bill on April 15 that you are unable to pay.  Especially given that April 15 is the first target date for the New Year’s estimated tax payments, it’s easy to fall behind and even harder to catch up.

How do you know how much to pay? At the very least, and known as the “safe harbor”, you will be expected to remit at least 100% *** of your prior year’s total tax or this year’s actual tax, whichever is lower, in those four installments.  You may still owe tax at the end of the day but you will not be penalized for underpayment.  Obviously you will not know until after December 31 what your earnings for this year will be.  So you need to project.

Let’s say Nancy’s new consulting business is on target to make $50,000, after expenses, for 2012. She is a single mom and owns a home.  Her federal income tax for the year, after all the credits and deductions, is projected to be about $2,600.  But her self-employment tax will exceed $6,000. Her total federal estimated tax bill for 2012 is therefore $8,600.  How much does she need to actually pay during the year?  Remember we said the “safe harbor” is the lower of the 2011 tax or the 2012 projected tax.  Let’s say 2011’s tax was $5,000, far less than her projected 2012 bill of $8,600.   Then her minimum payment per installment will be $1,250. But – and this is a “big but” – she may owe about $3,600 on April 15, 2013 AND her first payment for her 2013 taxes will be due then as well.

And this is all without accounting for state income taxes.  Again, you no longer have the benefit of salary withholding and will need to remit those as well.

You can see that staying on schedule with both your payments and projections is critical – both to avoid “underpayment penalties” and a double whammy of a tax bill.  Now I hope I have not scared you out of starting your exciting new venture.  Stay tuned for Part II when we discuss strategies to minimize your self-employment tax.

**        The statutory rate for combined social security and Medicare taxes is 7.65% for both employee and employer. Through February 29, 2012, a payroll tax cut of 2% is still in effect for the employee portion only, reducing it to 5.65% while the employer rate remains at 7.65%, for a total of 13.30% if you are self-employed. It is widely anticipated that the cut will be extended through the end of 2012 by the time March rolls around.

***      Medicare represents 1.45% of the payroll tax (double for self-employed), and earnings are subject to tax no matter how high they are.  Social Security tax thresholds are indexed for inflation; for 2012 wages or net self-employment earnings above $110,100 are not subject to the social security tax.

****    110% is the safe harbor if your adjusted gross income exceeds $150,000.

Have you just started a business and been wondering whether or not to incorporate?  Or freelancing for a while and wondering if now is the time to do it?

What are the pros, cons, choices? LLC, S Corp, L3C, R2D2 – my head, she is spinning.

The turning of the year is a good time to review your options.

Preliminaries

In most situations incorporating* is an option not a requirement.  You are a freelance architect, you are an architect with your wife, you are an architect with your wife and your mistress – you may incorporate but you do not have to.

When would you have to? You are going to be a publicly traded company, say on the New York Stock Exchange. (I have precious few of those.  Actually – none. )

(* technically LLC’s and partnerships do not incorporate per se; for instance an LLC “organizes”. For simplicity’s sake I am considering LLC’s and partnerships as “incorporated” for the purposes of this article.)

Liability Protection

One reason businesses incorporate is liability.  You’ve heard it; we are a “litigious society.  You are a sole proprietor if you run your own biz and are not  incorporated, or even if you are simply freelancing.  Because your business has no distinct legal identity,  your personal assets are fair game if the business is sued.  MartWall gets a judgment against JC Waters for improper installation of a sump pump and resultant flooding – MartWall can look to JC’s personal cash, investments, art collection to satisfy the judgment.

If JC instead was JC, Inc. then Mallwart could only look to his business assets.  He is “shielded” (nice armor JC).

Liability protection is nice – but do you need to?  If your assets consist of a rented apartment, your dog and some loose change, well, what do you have at risk? It also depends on the profession – if you are a one-woman show building small websites there’s less exposure then say, making kids’ toys.

Do not assume that simply adding “inc.” to your name gives you an invincible corporate shield.  If you are covered by your state under a “professional corporation” or “professional service corporation” statute then you will need malpractice or similar insurance to protect your personal assets from professional liability.  Each state deliniates professional corporations differently.  Lawyers, accountants and physicians are most commonly included in the category.  Rhode Island does not include social workers as a professional field for this purpose but some states do.

In any case, the corporate shield will still protect you for “slip and fall” type events. Planning on gross negligence, malfeasance or delinquent payment of payroll taxes? Sorry, no matter what your business structure you cannot count on protection.

Owner Compensation

Important!  If you are a corporation you will be paid a salary (hopefully!). Most LLC’s and partnerships are more like sole proprietors – the active and major owners receive a “draw” from the business (hopefully!) and not salary.  Often they need to pay estimated taxes since they do not have any salary withholding.

Some of you prefer a structured approach and appreciate knowing you have (at least some of) your taxes taken out through payroll.  Others are comfortable “paying as you go” and being responsible for estimated taxes.  What doesn’t work is not being accountable for your choice.  Choose a corporation, then don’t dodge salary by just taking money at will.  You’ll end up with a higher tax bill, and make your accountant cranky as well.  Choose an LLC and dodge the estimated taxes – recognize that you will be behind the eight ball next year and the penalties will accumulate.   By the time you pay your 2011 tax bill you’re halfway into 2012.  If you can never keep up then you may need to look at the viability of your business model , but I have had clients who had the money, they just did not get around to paying.

Both liability and compensation are complex subjects; I hope I have helped by telling you “the least you need to know.”

Next Up:  Tax Implications of Different Business Structures

NOTE: Every situation is different, and federal and state tax and business laws are subject to change.  This article is presented exclusively for informational purposes and is not intended to substitute for obtaining tax, financial or legal advice from an accountant, lawyer or other business professional.

Can You Share Control?

 501 (c) (3) organizations require a board of directors that oversees their operations.  You can handpick them in the beginning and be a member of that board.  But members and agendas change and you could find yourself disillusioned or eventually even fired.  Maintaining a board aligned with your vision and yet strong enough to be effective can be a tricky task.

 Do You Have a Business Model?

Yes – it is a great idea for helping others. But you are also planning to start a business.

Revenues can come from programs, donations, grants and even unrelated business ventures (subject to tax).  Going the grant route?  Do you know/can you employ someone who knows the grant-writing landscape? Government funds are shrinking and foundations are overwhelmed with applications.  There ARE opportunities AND it will  take time and resources to access them.

Is your business model an existing for-profit enterprise that you want to take the tax-exempt route? Be careful.  If you are already paying income taxes on a healthy business, the IRS will be skeptical that all of a sudden you have a charitable purpose.  Establishing a non-profit foundation funded by the for-profit may be a better alternative.

Can You Afford It? (Application)

 The IRS application fee ranges from $400 to $850, depending on the proposed scale of your organization.  You may need to engage an attorney or accountant to prepare the application, and that could easily be at least $1,000; it is not an automatic process and the IRS may well reply to your application with questions, which extends the process and your professional expenses.  Sadly I have seen clients plow halfway through the process and then delay or even abandon the process for lack of funds.

Can You Afford It? (Approval)

 Is this where you are expecting to earn your livelihood? It usually takes time to ramp up, so you may well need to exist off savings or other income for a while.  Even when times are good, you are entitled to a reasonable salary and not a direct share of any increased “profit”.  And your salary if you are in charge is public record, via Guidestar, which publishes the IRS Form 990.

Have You Explored Other Options?

You do not have to be tax-exempt to do good work.  And there are new hybrid models out there, like the L3C, which is a for-profit model that allows non-profit investment and a double bottom line.  (The L3C is effective in Rhode Island as of July 1, 2012).  Or you might wait to apply– incorporate as a non-profit in your state, but find an existing 501 (c) (3) to receive tax deductible donations on your behalf while you establish yourself. It may be a small price to pay a fiduciary while you find out if you really have a viable idea worth such a major investment of time and money.

If I have not scared you off yet – great! Stay tuned for Part II – the application, Form 1023.

Image Source: Anna Rosenfield; appears in Finance for Artists

I like to  think that Larson Gunness is to financial planning what I am to accounting: completely professional AND totally bucking the stereotypes.  Larson has worked for years in the investment field and is NOT your button downed guy pushing the latest stock or insurance product. To the contrary, he has authored the colorful, informative and unique as unique gets site — Finance for Artists.

The site reflects Larson’s love of writing and his passion for helping fellow artists. There is a non-technical glossary, (“accountant: a professional who keeps you out of debtor’s prison”.) and hilariously familiar case studies that teach you stuff: Here Art talks to his accountant:

“I don’t want to go to prison,” Art says again.  Only this time, he says it in a calm, even tone, firm with resolution….   “The next time I saw Katya, I asked her what I was supposed to do with that form and she said I should give it to my accountant when I do my taxes this year.  She said it’s kind of like the 1099s I always turn in (here, Art adds air quotes around ‘always turn in’).  I played it cool, like I knew what she was talking about.  …

 The whole conversation sent me into a sort of panic because I haven’t dealt with taxes, basically… ever… as far as I know…….

Who knows?  Prison might even improve my paintings.  Heck, might even make them more valuable.”

There are also simple worksheets that befit the founder of the speaking series “Peace Love and Financial Planning — For Creatives” (yes, I got the idea for the name of my site from him).

Larson works out of his house in Barrington Rhode Island where he strums his guitar and engages in other creative mischief.  He is an independent financial planner.

I’ll be telling you a bit more about some of these FAVS in the coming days; meanwhile if you let your mouse “hover” over a FAV you’ll get a thumbnail sketch of why it’s special to me.  Maybe even about my therapist? Maybe not?

Stay tuned.

Image Source: Richard Masoner

In preparing for my first sales tax webinar I happened on an outstanding website – The Sales Tax Guy.  The author incorporated some of my points in a recent post, and it was so well-written I asked and received permission to share it.  The article below is useful for anyone who sells things.

A Short Course in Sales and Use Taxes for Artists (Part 1) 

A reader (Richard Streitfeld at peaceloveandbusinessplanning.com) recently asked me about sales taxes related to art and artists and I referred him to an article I’d written a while back. We continued to exchange emails and he told me about the writing and training he’s done on this topic.  He inspired me to try my own spin on this. In weak moments I think of myself as an artist, so maybe an article for the right-brained folk might be interesting.

I’m going to be writing this article in multiple parts because this is going to take some time. And this should be useful not only for artists but for other entrepreneurs as well. Most of the issues an artist faces will be dealt with by other businesses as well. So this “course” will apply to pretty much everybody.

Some of you may have taken issue with something I said above. Yes, if you’re selling your art, you’re in business. And you should be collecting and paying sales and use taxes as the law requires, just like any business. I’ll make the assumption that you want to do that. Everyone should be paying their fair share, right?

I’m going to avoid some of the theory that I love to talk about it. I will also be omitting, skipping and simplifying to keep the right-brained among you interested. But please see the disclaimer.  Get a second opinion; don’t take my word for it. I’m just trying to give you an overview. I strongly urge that you sit down with an accountant and discuss the issues I’ve raised here. And if you don’t have one, you’re making a big mistake.

OK, let’s dive into it.

Things that you sell

I hate to break it to you, but to be very plain spoken, if you’re an artist and you’re in the business of selling your art, you sell stuff*. And sales of stuff are generally taxable. So if you sell a painting, you should be charging tax. And if you sell a photograph, you should be charging tax. If you sell crafts, you should be charging tax. If you’re a musician and you’re celling CD’s at the back of the room, you should be charging tax.  It doesn’t make much difference if you sell five pieces a year or 500 a year. If this is your work, then you should be charging tax.

If you sell something from a web site, like Etsy, eBay, or your own web page, you should be charging tax. However, there’s a big exception here. If you’re shipping to someone who’s not in your state, then you may not have to charge them tax. And the taxes that apply are based on the state you’re shipping to. If you’re not in that particular state, you probably don’t have to worry about charging taxes for that other state.

However, if you’ve visited clients (or prospective clients), done art shows, worked on an exhibit, have work on consignment at a gallery, or done any other kind of work or performance in that other state, or paid someone else to do so, then you may need to charge that state’s taxes. And yes, if you do that art show in another state, you should be collecting that state’s taxes on any sales you make both during and after the show.

Remember this also means that it’s taxable when you sell something to someone who is in the same state you are.

And just charging taxes isn’t enough. You have to send that money to the appropriate state. Which means you must register in that state and start filing sales and use tax returns. You don’t just write on a scrap of paper “here’s your taxes” and mail them a check.  You have to register and then fill out a very left-brained form.

And to make matters even worse, the rules are completely different in every state. So if you do an art show in one state, and then do some production artwork in another, it’s not going to be the same.

Are you sure you don’t need an accountant?

That’s enough for today. There’s lots more.

I’ll post a link to the next articles as they get posted.
*My definition of stuff, to make it really easy: A single piece of stuff is something you can hear, see or touch and that can be moved without damage. This isn’t complete but it’s about 90% of the way there.
The Sales Tax Guy
http://salestaxguy.blogspot.com

See the disclaimer – this is for education only.  Research these issues thoroughly before making decisions.  Remember: there are details that haven’t been discussed, and every state is different.  Here’s more information

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Don’t forget our upcoming seminars and webinars.
http://www.salestax-usetax.com/
Picture note: the image above is hosted on Flickr. If you’d like to see more, click on the photo.

Arts and Business Council Greater Boston

The date is December 13, 7 PM. For more details click here: And check out all of ABCGB’s great offerings, including upcoming webinars on The Visual Artists Rights Act (VARA) and on Trademark and Your Personal Brand. Click here for the full calendar.

Some of the topics addressed:

Tax deductions for artists; minimizing audit risk; incorporation options; record-keeping;

I love doing these; let me know if you want me to speak, in person or remotely, to a receptive audience you are familiar with. View the slideshow: