Becoming a Freelance Developer and Taxes

It’s been a while since my last reader question post.  That was the one where I confusingly announced on a Tuesday that I’d be doing reader question Mondays.  Well, today I start a new streak of doing reader question posts on Mondays.  My apologies for dropping the ball on that, but I took on a full time consulting gig for a few weeks while also running my content business evenings and weekends.  It was a busy run.

Anyway, let’s get down to business.  Both in the Developer Hegemony Facebook group and through other media, people have asked about some nuts and bolts freelancer/entrepreneur type things.  And, after recent videos about creating an EIN and filing for an LLC, the pace of those questions has increased.  So, apologies to those who come to this blog looking for rants about the perils of global state or unit testing.  Today, we talk taxes.

If I’m thinking of going off on my own, how do taxes work?

Nobody has asked me the question in these exact words.  Rather, this is a composite of what various people have asked.  So, without further ado, let’s dive right into the least interesting subject on the planet.  I’ll do what I can to make it fun.

Obligatory Disclaimers

Mercifully, I am neither a lawyer nor an accountant.  Nothing against either profession, per se — they’re just not for me.  I mention that here so that you understand the context of this advice.

I am going to describe what I have, myself, done, along with my understanding of how it works and various other options that I might have.  I’m pretty confident that I have a relatively complete understanding for a layman in those fields.  But there may be finer points that you’d need an accountant or lawyer to illuminate.

In the context of the software world, think of me as a the equivalent of a guy with 3 years of .NET experience teaching newbies.  I’ll get enough right to help them a lot, but I might not nail some of the more arcane language points or sophisticated design strategies.  Caveat emptor.

Non-US readers, this is also entirely US-centric.  I hope some of it helps, though.  I’ve had people from other countries tell me in the past that some of my videos/posts along these lines are helpful.

Taxes in the Wage Labor World

For the sake of easy math, let’s say that you take a job for $120,000 per year.  Let’s also say that the employer pays you monthly, at a nice, round $10,000 per month.  That should make it easy to figure out how much you’ll pay in taxes, right?

Wrong!  There’s no figure round enough to make it easy to figure that out in the US.  You go to a calculator like this, expecting to type in $10,000 per month and seeing that you owe something like $2,200 per month in taxes.  Instead, it wants to know whether you’re single, how many “dependents” you have, and something about “exemptions.”  And that’s a simple one.  Some probably ask you about your mortgage, whether you live in a flood plain, and how many blind uncles named Dwayne you put in rest homes last year.

It’s Really Hard to Calculate Your Taxes

That’s because the US tax code is really, really complicated.  The US government likes to engage in incentive games that some call “social engineering” to encourage certain behaviors.  So, if you buy a power efficient dishwasher or have a couple of kids, they’ll ask you for less in taxes.  That sure makes income tax time a lot of fun, but it also has the effect of making it really, really hard for you and your employer to know, in advance, how much tax you pay.

Adding to this complexity is the concept of tax brackets.  You don’t just pay 20% of your income or something.  Instead, it works conceptually like this.  You pay 10% on the first $10,000 you earn, 15% on the next $30,000, etc.  The actual brackets actually vary every year.

The upshot is that when you go to work for your employer, some magic you’re not really aware of happens.  The IRS wants to withhold its cut from each of your paychecks, and your employer wants to know how much they should withhold.  So they get together to try to figure out how much to withhold, but they can’t because the tax code is so amazingly complicated that nobody, including the IRS, truly understands it.  Instead, they punt, and ask you to fill out something called a W4 that will make a heuristic approximation to determine the withholding.

But that’s just a best guess shared between you, the employer, and the IRS.  Next year, at income tax time, you’ll take a better guess when you submit your tax return.  The IRS will probably take your word for it.  Or, they’ll audit you, taking a third, even better guess.

The Withholding on Your Paycheck and Your Employer’s Part

I realize I’m a lot of words in, but, for once, that’s not my verbosity.  It just takes 800 words to explain even the most basic facets of the tax code.  You fill out this W4 to the best of your ability, and it results in a guess as to your tax burden.  I punched in some hypothetical numbers for clarity’s sake and got the tax burden single person in Illinois with a monthly gross comp of $10,000.  Each paycheck has the following

• $1,972.48 in federal income taxes.
• $368.20 in Illinois state taxes.
• $620.00 in social security tax.
• $145.00 in medicare tax.
• $765.00 in FICA.
• You pay a total of $3,105.68 and take home a total of $6,894.32 (unless you contribute to pre-tax concerns like a 401K or a HSA, then you take home less, but forget about that for our purposes here.)

If you look at your paycheck stubs, you’ll actually see all of this information broken out.  What we think of as “tax” is actually a bunch of different taxes.  Now, with all of those taxes, you probably think “that’s got to be it, right?”

Nope.  It turns out your employer also quietly pays taxes for the privilege of employing you.  These are collectively known as payroll taxes.  I won’t go into more detail than needed, but these generally consist of unemployment insurance as well as additional medical and social security tax.  So as massive as your tax burden seems, it’s actually higher.

Take This Job and Shove It — I’m Hanging Out My Shingle!

Alright, so that’s the wage world from which you come.  I’ve given you a very detailed explanation of how things work in your world, rather than your prospective world.  But don’t worry — there’s a method to my madness.

But now, you execute a game plan to escape the wage world.  You line up clients, start marketing yourself, find a niche, and the moment arrives.  You hand in your two week notice and get started as a freelancer.

When you invoice your first client and receive your first payment, you’ll notice two interesting things.  First, they ask you for something called a W9.  This is just a record that they keep so they can show the IRS that you’re a vendor and not an employee.  (Otherwise, they’d come after your client for payroll taxes on what they pay you.)  Secondly, when you invoice them for $10,000, they send you… $10,000.

Woohoo!  Tax free money!

Your Default Tax Situation

Except, it’s not.  Oh, don’t worry, the IRS will get theirs, one way or another.  Here’s how taxes work in your new world.

By default, the IRS considers you a sole proprietor.  Basically, it just means that you’re both a human and a business.  It also means that you’re responsible for paying taxes, both as a human and a business.

As a sole proprietor, there’s no one to withhold taxes from your paycheck because there’s no paycheck.  So you might think that you just set aside about $3,100 of each $10,000 that comes in and give it to the state and the federal government at income tax time, right?  Well, that would make sense.  But the thing is, the IRS gets a little twitchy if you earn interest on your money instead of letting them earn interest on it (though they have no qualms about holding onto excess amounts of your money).

So you have to do something called estimated quarterly tax payments.  Basically, once per quarter, you send the IRS something like a third of what you’ve earned, and you also give the state government their cut.  Oh, and here’s a rookie mistake I made.  Don’t assume that when they say quarterly they mean quarterly.  Their “quarters” are 3, 2, 3, and 4 months long, respectively.

And Then, Freelance Taxes

Ah, but we’re not quite done.  I mentioned a moment ago that you’re a human and a business.  I also mentioned that the IRS is going to get all of its taxes from somewhere.  Well, remember that employer-side group of payroll taxes?  Someone’s going to pay that, and that someone is you.

You might think, “I’m not an employer, so I won’t need to pay that.”  But then you’d think wrong.  The IRS dreamed up something called self employment tax in order to get their cut.  True, you’re not an employer and you have no payroll.  Nice try, buddy.  They thought of that.

Ugh, Any Way Out?

There are a couple of corporate structures that you can have beyond a sole proprietorship (or a simple DBA).  You can form a limited liability corporation (LLC) or you can form a corporation.  Now, here’s where things get really stupid, as far as I’m concerned.  LLC versus corporation is a legal distinction, having to do with how your company forms and operates vis a vis state laws.

But there is also a similarly named, similarly constructed, but different, tax status.  Yeah, I’m confused just typing it.  Let me make an analogy.

C# and Java are programming languages, right?  Well, let’s say that I wrote a couple of text editors that became really popular, and I called them C# and Java.  And, to make matters stupider, I designed them such that C# the editor could only edit C# the language, but that Java the editor could work with Java or C# the languages.  Confused yet?  Of course you are.  Who wouldn’t be?  Anytime someone talked about using C#, you’d need to ask if they meant the editor or the language.  And, that’s if they knew to ask.  Most likely they’d just have slightly nonsensical arguments over which programming language had better menu fonts and plugins.

Well, that’s how the IRS chose its naming scheme for how it treats corporations.  So when you talk about forming an LLC or a corporation, a lawyer or accountant would ask if you’re talking about in a legal or in a tax context.

Why am I telling you all of this?  Well, it’s because of what I recommend that you do as a freelance software developer.

What I Did — The Most Favorable Tax Situation

If you want to follow my path (a good one, in my opinion, else I wouldn’t have chosen it), you should form a limited liability company (LLC).  That’s your legal entity.  Then, you should tell the IRS that you want it it to treat your LLC like a corporation (specifically, an S-Corporation).

This allows you legal simplicity.  Corporations have to do high-overhead stuff like have shareholders, issue common stock, etc.  LLCs on the other hand, can run much more simply.  This is especially true of the single member LLC, which is the ideal structure for a software freelancer.  (Among other things, incorporating lets you take significantly more tax deductions than an individual can, so you should incorporate.)

But it also lets you shield some of your income from self-employment tax.  Here’s how that works.

You can take money out of a business in two ways: salary and distributions.  Salary is what it sounds like.  Your LLC pays payroll taxes and you, as its employee, pay income taxes.  With distributions, you take money out the way you would if you owned anything that bore dividends, like a stock or a royalty generating enterprise.  Nobody pays payroll tax, and you just pay income tax on it.

By structuring your business as an LLC, you can pay yourself a “reasonable salary” and take the rest as distributions, saving you significant amounts on your taxes.  And you can still do this while operating simply from a legal perspective.

Work with Pros On This

I’ll conclude by saying that you don’t necessarily need to grok or even fully understand everything I’ve said here.  I wanted to be thorough and clear in order to give you the best possible chance of understanding.  But, I realize all of this is quite mind-numbing.

I’ve acquired this knowledge through years of running businesses, doing my own taxes, working with lawyers and accountants, and filing on my own.  And my knowledge is probably still imperfect.  But I actually do all of this stuff myself, by and large.

You absolutely do not need to do that.  Work with a lawyer and/or an accountant, particularly if you’re a new freelancer.  You have enough new things to tackle — outsource these to pros if you’re at all nervous.  My aim here was not to make you an expert, but to arm you with enough background and information that, when you go to a tax pro or a lawyer, you know exactly what to ask for and why.  It’ll make the process a lot smoother if you at least know where the mile markers are.

Fire Away with More Questions!

If you have a question, please feel free to ask:

And, by the way…

If you like the wisdom here, such as it is, you can get a whole lot of that more in my recently released book, Developer Hegemony.  If you want a sample of that, you can sign up to download some chapters below.

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