From our ongoing discussion of How to Do Your Taxes as a Freelance Filmmaker:
As prepared as you may feel and as confident as you may be, there’s always the chance of misunderstanding some part of the tax code and applying it incorrectly.
So today we’ll cover five specific pitfalls that are easy to fall into if you don’t know about them.
1. Not Paying Estimated Taxes
As we talked about in the first part of this series, the government expects you to pay taxes over the year as you generate income. These are called estimate taxes. Here’s what the IRS says:
Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards. You also may have to pay estimated tax if the amount of income tax being withheld from your salary, pension, or other income is not enough. Estimated tax is used to pay both income tax and self-employment tax, as well as other taxes and amounts reported on your tax return.
One of the most common pitfalls (and one I’m guilty of) is not paying these estimated taxes. What happens if you don’t? You’ll owe the IRS an underpayment penalty in addition to the taxes — basically, they penalize you for not giving them enough of your money fast enough (seems fair, right?). That penalty is usually between 6% – 8% of what you owe — not an insignificant amount.
To avoid this underpayment penalty, and to stay within the good graces of the IRS, you’re expected to pay estimated taxes on your income on the following dates:
- April 15th - for income generated between January 1st and March 31st
- June 15th - for income generated between April 1st and May 31st
- September 15th - for income generated between June 1st and August 31st
- January 15th of the next year - for income generated between Sept. 1st and Dec 31st.
OK so now you’re going to file four times a year for estimated taxes, but with freelancing already a rocky road full of unpredictable income, how do you know what your estimated taxes should be?
Well, the IRS will not charge you a penalty if you pay the lesser of either:
- 90% of your total tax due for the current year
- 100% of the tax you paid in the previous year
That means as long as you pay as much as you paid last year in taxes you will not be subject to the penalty (in most cases). You will also not be subject to the penalty if what you end up owing at the end of the year is less than $1,000.
Sounds complicated, doesn’t it?
Well, the penalty part is, I’ll admit. But paying estimated taxes in quarterly intervals is fairly straightforward. The IRS also makes it easy to do online.
More Useful Information on Estimated Taxes:
- Paying Estimated Taxes – NOLO, Law for All
- Estimated Taxes – IRS.gov
- Estimated Taxes: Common Questions
2. Incorrectly Applying Home Office Deductions
Ah, the elusive “home office” deduction. What is it, you ask?
If you have a qualifying home office, according to the IRS, you can deduct several items which would contribute significantly to your taxes going down. Deductions relating to a home office can include:
- Rent (the amount in proportion to the size of the office)
- Utilities (again, in proportion)
- All equipment used in the office including computers and furniture
Sounds too good to be true, right? Well, it often is. Most people have what they think is a home office, but actually isn’t. According to the IRS:
There are two basic requirements for your home to qualify as a deduction:
1. Regular and Exclusive Use. You must regularly use part of your home exclusively for conducting business. For example, if you use an extra bedroom to run your online business, you can take a home office deduction for the extra bedroom.
2. Principal Place of Your Business. You must show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction.
The key phrase in this quote is “exclusively for conducting business.” That means your computer on your desk isn’t a home office. Just because you may use it for business purposes does not qualify it as a home office. Further, a home office cannot be in the same room that your bed is — which makes sense because an office isn’t really an office if you’re sleeping there.
Another key qualification in a home office is that everything in it must be used exclusively for business if you’re going to deduct it. So you can’t walk your laptop from your bedroom into your home office and then deduct it 100% as a business expense — the laptop must be exclusively for business use.
Some of the advice I found in doing research is to buy a cheap laptop for the home office, use it occasionally for business, and then use your other computers as you see fit for business. (Please note I haven’t done this myself and I cannot guarantee it is a sound plan of action.)
Further, even if you do qualify for a home office, you have to be careful how you take the deductions — they have to be proportional to the square footage of your house. So let’s say you live in an apartment with 1000 sq. ft. of space and your home office occupies a room that’s 100 sq. ft. of space. That means you can only deduct 10% of the costs of living for the office — 10% of your rent, 10% of your utilities, 10% of whatever you pay for the whole apartment.
But that proportionality only applies to deductions which also benefit your entire house. So furniture that exists solely in the home office for business use? That’s 100% deductible.
Finally, home office deductions are often targets for audits. I’ve read some reports claiming this is an old wives tale, but it makes sense to me. The home office deduction is easy to misinterpret and exploit, so I am sure the IRS keeps a watchful eye on them.
But as long as you use them correctly, it is an effective way to cut down on your owed tax — just be careful you aren’t claiming a “home office” as a Home Office.
More Useful Info on Home Office Deductions:
- Home Office Deduction – IRS.gov
- Secrets of Claiming a Home Office Deduction – Forbes.com
- The Home Office Tax Deduction – NOLO
3. Thinking Tax Deductions Are the Same as Tax Credits
Often people will use the terms tax deduction and tax credit to mean the same thing. This is a mistake. And using them incorrectly only helps push the misunderstanding about them further along.
(You may have also heard the phrase write-off used. That’s sort of a catch-all term for either a credit or deduction — further complicating things.)
To clarify, let’s turn to someone with experience doling out financial advice, Kim Kiplinger:
A tax credit lowers your tax bill dollar for dollar. A deduction shaves money off your taxable income, so the value depends on your tax bracket. If you’re in the 25% bracket, a $1,000 deduction lowers your tax bill by $250. But a $1,000 credit lowers the bill by the full $1,000, no matter in which bracket you are.
So, using the example above, to receive the same amount of money as a $1,000 tax credit you would have to make a $4,000 deduction (assuming you stay within the 25% bracket).
This is valuable so you can temper expectations for what deductions will give you. Buying a $3,000 computer for your production will not equal a $3,000 return on your taxes. Instead, it will give you a percentage of $3,000 depending on your tax bracket. That may be anywhere from $400 – $1000.
Knowing the difference between a deduction and credit is also useful if you are faced with an either/or situation. Some deductions may also qualify as credits, but you can’t have your cake and eat it too — you have to choose either to deduct the expense or cash it in for the credit. It may be tempting to take the credit. Or, if you’re none the wiser, you may think a deduction is the same.
But in some cases, the credits have limits, which will still allow you to deduct. Or, you may qualify for both and find the credit is the more lucrative choice.
Confused yet? That’s because it’s so circumstantial.
You’ll find most choices are clear-cut and easy to make. Plus, when all is said and done, both deductions and credit give you money back. You can’t go wrong utilizing either effectively.
More Useful Info on Credits vs. Deductions:
- Tax Credit vs. Deduction – Kim Kiplinger
- What’s the Difference Between Tax Deductions and Tax Credits?
- Understanding Tax Credits vs. Tax Deductions
4. Not Realizing Some Deductions Depreciate Value
The juiciest deductions are usually high dollar equipment like computers, cameras, and toolkits. But the IRS considers these assets that hold their value for longer than a year and, thus, have to be depreciated over several years. That means, although you dropped $5,000 on a camera this year, your deduction will be spread out over several years.
How many years? That depends on the type of non-real estate asset you are deducting. For example, computers and computer software depreciates over five years while office furniture depreciates over seven years.
Regardless of the depreciation lifetime, there are two methods that you can use to calculate what you’ll be deducting each year:
- Straight Line Depreciation
- Accelerated Depreciation
(Because I’m not well-versed in financial regressions and whatnot, I would butcher describing the differences between the two, so I suggest you visit here to read more.)
But if you’re not really liking the idea of spreading out your deduction, you can use Section 179 to claim the entire deduction this year. There are some limits to Section 179, but unless you’re running a massive operation, you’re not going to run into most of them (like you can’t claim more than $500,000 in one year).
There are, however, two Section 179 limits that are prudent for filmmakers to learn:
- You can’t deduct more than you earn in a single year
- Property used for rentals is typically not eligible for Section 179 deductions.
It’s up to you whether you want to depreciate your assets over a few years or claim them all at once. It’s just a matter of preference — would you rather have a continual deduction or all at once?
Either way, it’s good to know that depreciation is the default computing method for the IRS and most tax services. If you want to take advantage of Section 179, you have to be proactive about it.
More Useful Info About Deductions and Depreciation:
5. Not Understanding How Tax Brackets Work
When I first started learning about taxes as a young man working at a local deli, tax brackets seemed straightforward — you make X amount of money, you get charged X amount of tax. That’s the way everyone always makes it seem: parents, politicians, teachers, and peers.
But that’s an over-simplification of what actually happens when your money gets put through the government’s coffers. Tax brackets work more like a gradual slope than they do a set of stairs.
To illustrate, let’s do a little thought experiment. Before we start, here’s what the tax brackets for 2012 look like (for the purposes of this section, I am going to use these figures):
|Tax Bracket||Married Filing Jointly||Single|
|10% Bracket||$0 – $17,400||$0 – $8,700|
|15% Bracket||$17,401 – $70,700||$8,701 – $35,350|
|25% Bracket||$70,701 – $142,700||$35,351 – $85,650|
|28% Bracket||$142,701 – $217,450||$85,651 – $178,650|
|33% Bracket||$217,451 – $388,350||$178,651 – $388,350|
|35% Bracket||Over $388,350||Over $388,350|
Now let’s say you’re single and your taxable income (what’s left after deductions and all that) is going to be somewhere around $35,000. That puts you very close to two of the IRS’ tax brackets: the 15% and the 25% brackets. In one scenario, you end up making $35,000 and pay 15% ($5,250). In another universe, you make $35,400 and get taxed 25% ($8,850).
Whoa! That’s a big difference — about $3,600 to be exact. And all because you made an extra $400? That doesn’t seem fair.
It isn’t. And that’s not how tax brackets work for that very reason. It would be absurd for somebody making only slightly more money to pay significantly more in taxes.
The real way tax brackets work is by taxing your income only as it enters those brackets. So, the first $8,700 you make is taxed at 10%. Any money you make between $8,700 and $35,350 is taxed at 15%. If you cross into the next bracket, you’re only taxed for money you earn within that bracket.
So if we do our thought experiment again, you find a taxable income of $35,000 ends up with taxes of $4,815 (about 13.7%) and a taxable income of $35,400 ends up with taxes of $4,869 (about 13.75%). Now it seems fair, doesn’t it?
Don’t feel stupid if you never understood the tax brackets properly until now — it wasn’t something that came easy to me. But once you learn it, it changes your perspective on the entire tax process. Now you won’t fight tooth and nail to get your deductions to bring your income to a certain level because it all scales appropriately. You may also feel more relaxed about how much you think you’ll end up owing at the end of the year.
More Useful Info About Tax Brackets:
Next Up in This Series: Deductions
Much like working on a film set, I find that preparation and knowledge is what gives me confidence to do my taxes without anxiety. If you know where the potential pitfalls are, you’ll be able to jump over them and avoid getting stuck, losing money, or audited.
Now it’s time to move onto deductions: 50 of them to be specific. That’s right. In the next post there’ll be a list of 50 deductions you should be taking advantage of as a freelance filmmaker, so make sure you come back to check that out!
What are some pitfalls you’ve found while doing taxes? Where have you gone wrong? What would you change if you could start over again? Share in the comments, please!