Taxes and the Freelancer

Taxes: What the IRS Wants From Your Pocket

February 21, 2002
Speaker: Eric Fain
Organizer: Mary Heldman
Notes By Dawn Adams

As winter turns to spring and April 15 gets closer and closer, our thoughts begin turning with anticipation and dread to taxes. Eric Fain, attorney with the IRS, addressed the February forum in his private capacity to give an IRS perspective on tax issues affecting freelancers and people in the editing field.

"It's not like there are a lot of secrets," he said. "Everything that I know and use at the IRS that everyone else there uses is all public information, and you can get it on the Internet at the IRS Web site. The entire IRS manual is strictly electronic; over 90 percent is on the Internet. The only thing that is redacted is dollar levels; for example, if your bill is below a certain amount we're not going to bill you."

Dealing with Audits

According to Fain, the IRS recently changed the definition of "audit," because Congress did not think that the IRS was conducting enough audits to justify its budget. Now interactions with taxpayers that take place strictly on an electronic level (no IRS personnel involved in the initial contact) are classified as correspondence audits. The traditional definition of an audit (a desk audit) is when a person must justify and document every single line of his or her tax return. In a correspondence audit, for example, a letter goes out asking for proof on a line item of a tax return; the taxpayer then provides the necessary documentation or amends the return.

Since 1998 there is no such thing as a random audit, Fain said. For the 2001 tax year, the IRS will perform a desk audit on 50,000 returns—really only a few, considering.

When asked if having a paid preparer reduced the chances of being audited, Fain stated that that made no difference and was not part of the criteria at all. But, should you get called in for a desk audit, Fain advises that you not go. Send your CPA or your attorney instead, but be aware that these professionals may charge an additional fee for meeting with the feds. "Auditors don't like talking to taxpayers," Fain said. "They want to talk to someone who knows the lingo and the regulations."

Situations More Likely to Be Audited:

Schedule C—Freelancers should be aware that Schedule Cs are always more likely to be audited, according to Fain. Since the income and expenses on a Schedule C are broken out into categories, it is more likely that any anomalies will come to the attention of the IRS. Fain recommends that if you file a Schedule C, you should be aware of what belongs on the Schedule C and what doesn't.

Larger dollar amounts (not a problem for your typical editorial freelancer)—Even though the audit criteria don't include dollar amounts when kicking out returns to audit, the IRS concentrates on the return with the most reward, with 10 percent of $10,000 not being as desirable to spend resources on as 10 percent of $200,000.

Incorrect information—For example, be sure to double-check dependents' social security numbers. The IRS computers are hooked into the Social Security Administration so that SSNs can be easily verified. But if you put down the wrong number, the IRS will send a letter, stating that your dependents don't exist and amending your return to account for your increased liability. Also, if you file a 1040 form in a 1040A envelope, don't be surprised if you experience a delay since the +4 part of the ZIP routes the forms to the correct processing center.

Previous audits—If you've been audited before and owed money, the IRS is more inclined to look at your return.

Earned income credit—Earned income credit is always audited, according to Fain.

During peak tax season, the IRS hires code-and-edit people, normally at a low salary. These temps are paid a bonus based on productivity, so when your return arrives, it will normally get around 45 seconds of attention. If you file late, a full-time IRS employee may code and edit your return—and take a closer look. Once your return has been coded, someone else enters the information into the computer. If this person gets to a point where he or she can't input information needed into the IRS system, a letter will be generated.

You can, of course, always amend your return with the corrected information, but it's a complicated three-column form that most people have difficulty filling out correctly, Fain said, which will probably cost around $200 for a tax professional to complete.

E-filing is the most certain way to avoid getting audited, Fain says. If you file electronically, most of the software programs out there have checks and balances to make sure that you haven't left a critical piece of information out of your return, such as your SSN or your signature; also e-filing helps you to avoid math errors. Fain recommends that people using software to file their taxes have electronic or hard copies of appropriate forms and instructions available, so that if a questions arises about why the tax program is asking for particular data, they can use the forms and instructions find out. Ideally, you want the IRS to only look at your return one time, process it, and send it back. "If you file electronically and have direct deposit, you can theoretically get your refund in eight days," Fain said.

Although the IRS does have Web-based forms that you can fill out and then print copies of to mail in, the agency does not currently have its own e-filing software. You can use commercial packages such as Kiplinger's TaxCut and TurboTax to e-file, and your CPA can e-file on your behalf. And there is never a penalty for filing late if you're getting a refund.

That's how the government finances itself, by people having too much money withheld from their pay, Fain said. It's an interest-free loan. Your goal is to end the year at a break-even on your payroll deductions, or owing a little bit.

Working Around and with the IRS

If you need help on an IRS problem, you can always contact the Taxpayer Advocate Service. Information about this service is available on the IRS Web site. According to Fain, they will cut through the red tape for you—if you and your problem meet the criteria (listed online), they'll solve the problem, if it's solvable.

Again, Fain recommends the IRS Web site as the best single resource for tax information and general tax law. You can go to the "Help with tax law questions" page and submit your tax questions directly through the site. But if you do decide to call, you need to make sure that you are calling the right IRS department. The Tax Law people cannot access your account; they only give general advice on questions regarding tax laws, but they can help you phrase your question so that you can get to the answers you need from the IRS accounting staff. The accounting staff, on the other hand, generally are not equipped to answer complicated tax law questions.

"About three-quarters of the calls are correctly answered," Fain said. "Up to a point, people are taught when to transfer [to other IRS staff]. This time of year, the more complex questions [e.g., depreciation calculations, sale of business assets, capital gain and loss, etc.] are normally written up and passed on to be answered later. You need to phrase your questions correctly and clearly to get them answered."

And if you're calling about your account, you must have your tax return(s) in hand; otherwise you may not pass the disclosure test. Like many government and financial agencies, the IRS is concerned about preserving privacy.

Evaluating Your Business Options

Some freelancers are concerned about whether they would be considered employees in the eyes of the law, rather than contractors. According to Fain, there's not too much there to worry about as a legal matter, and for those who are interested, the IRS Web site has rules that help determine the difference between independents and employees. And if you have a combination of 1099s and W2s, it's not necessarily a red flag. Fain said there is a differential index that assigns values to certain discrepancies.

For those considering incorporating for tax reasons, Fain advises against it. "If you're thinking about becoming a corporation, you should not do it for tax reasons alone," he said. "It may end up costing you more."

Keeping Records

Keep your personal tax records (tax returns and supporting documentation) for at least three years and Schedule C records for six years, according to Fain. If you have any records pertaining to income or loss on property (land, stocks, etc.) that you still own, you should keep those records until you sell or otherwise dispose of those assets. Check the IRS Web site for the kind of records that you should keep.

For deducting business expenses, you need a record supporting those expenses. Fain recommends keeping a daily log of expenses. "If you have a log, whenever you spend money, make a note in the log and save the receipt," he said. "That documentation will normally be enough to justify the expense to an auditor. And if a credit card receipt shows a different payee name, be sure to match the receipt to your log."

Business Deductions:

Bridge tolls (and other receiptless and minor expenses)—If you can prove that you make the same trip regularly and have other evidence to support that you're crossing a bridge with a toll, then you're probably OK, according to Fain.

Mileage —If you keep good mileage records for the first quarter, that is probably enough data to support taking the same mileage expense for the other three quarters, if the first quarter can be considered typical. Mileage accounts for everything but tolls and parking, so if you want to deduct gas expenses instead, you cannot take mileage expense. Also, you cannot take commute miles as a deduction. If you are a contractor working onsite, you can't claim commute miles, Fain said. But if you have multiple clients that you work for, or if you have a business stop along the way on your commute, maybe you can deduct the miles. But it depends on facts and circumstances.

Home office—Taking the home office deduction requires extensive documentation, according to Fain. You've got to pass the exclusivity test, meaning that that area of your home (it does not have to be an entire room) is 100 percent devoted to your business. Fain recommends taking pictures of your work area to support your claims. And remember that capital expenses such as additions need to be depreciated.

Computers—A computer must be at least 50 percent business use if you want to expense it for your business. With at least 50 percent business use, you can take the entire business use portion of the expense the year of purchase rather than amortizing.

Cars—Business expense for cars has a limit of $3,000 in the year of purchase, and the car must be at least 50 percent business use. The remainder of the cost is depreciated over the life of the car, a time period determined by the IRS.

Advertising—Advertising costs are deductable.

Health insurance—If you are self-employed, you can deduct a percentage of health insurance if you pay out of your own pocket. You need to be careful with this if you're going back and forth between 1099 and W2 status.

Education—Educational expenses are deductable for courses that pertain to your business. For non-business-related education, look into Hope and Lifetime Learning Credits. Since 1998, these credits have been available for up to $1,000 (20 percent of course fees, maximum $5,000). The school must qualify for federal student loans, and the best part is that you can take this deduction even if you weren't able to attend the course. More deductions are on the way for education, as well. "Starting next year there will be an above-the-line deduction for educational expenses that will reduce adjusted gross income," Fain said.

"My advice is to keep records of everything and sort it out at the end of the year," Fain said. There are not hard and fast rules about many of these situations. A lot of questions are unanswerable because they depend on facts and circumstances. Your basic choice is to pay a lawyer to give you an answer or take your chances. You're probably OK if you're doing the best that you can.

Recommended Resources:

J. K. Lasser's Taxes Made Easy for Your Home-Based Business: The Ultimate Tax Handbook for Self-Employed Professional, Consultants, and Freelancers

The Ernst & Young Tax Guide 2002

Tax Savvy for Small Business: Year-Round Tax Strategies to Save You Money
(Nolo Press)



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