Being a freelancer gives you lots of freedom.
Freedom to choose when you work.
Freedom to choose who you work with.
Freedom to choose how much you charge.
Freedom to choose where you work.
This last choice is the one that many people find very attractive in freelancing.
It’s also something that can cause lots of confusion when it comes time to file your income taxes.
My buddy Shane, who runs Beating Broke (go check it out), recently brought this topic to my attention.
He made an inquiry about what his sister-in-law’s tax responsibility is as a self-employed individual getting paid for jobs done on location outside of her state of residence.
It got me thinking, and I realized that it’s an issue that many freelancers may already, or will one day face in their own businesses.
Faulty tax assumptions
The first thing that you should know is a clarification regarding location and income.
A lot of people think that a tax liability is created based upon where the client is located.
I can understand that point considering that’s how sales tax is calculated–based on where you, the purchaser of goods reside.
However, that application is only good on that one specific type of tax.
Income tax liability only concerns where the income was earned, that is where you were doing the actual work that the client is paying you for.
The example I always use to help people understand this is the case of the multi-state company paying its employees:
Say you work for a large corporation based in New York City, and it has offices in every other major city in the United States.
When it pays its employees, this company doesn’t treat everyone as working in NYC, instead it withholds taxes from their pay and reports the income for only the city/state where each person actually performs their duties.
This is how you should look at reporting income received when you cross state lines.
It is also the basis for everything that will follow…you only need to be concerned with where you are when you earn the income, not where you are based, or where the client is located.
Freelancer tax confusion
As an employee, you always had that taken care of for you…the company you worked for would handle all of that work in issuing your W-2.
As a freelancer, you work for yourself which means that you don’t get to enjoy that simplicity.
You don’t have someone else keeping tracking of where you do your work, and how much you earn in each location…unless you have a knowledgeable and qualified professional you outsource accounting duties to.
And because of this, you have even more work to do when it comes to bookkeeping (which I always say you really shouldn’t be doing on your own anyway).
If you travel to different locations to speak or work with a client on-site, you have another set of data you need to keep track of.
Not only do you have to keep your records straight for yourself regarding who you did work for, how much you invoiced clients and who has paid (or hasn’t), but now you need to start tracking where these jobs occurred for tax reporting purposes.
Don’t feel bad, though, you’re certainly not alone in this dilemma.
Pro athletes face the same situation–having to report income earned in the cities/states where they “work” throughout the year.
Just be happy you don’t have to deal with the Jock-Tax on top of what you already have to deal with the way they do 🙂
Location independence and taxes
As if just being a freelance who may earn income in different states wasn’t causing you enough tax headaches, it gets even worse if you move around frequently.
Having the freedom to earn a living from anywhere (and sometimes everywhere) in the world comes with even more accounting and tax stress.
Not only do you have track everything that was mentioned above, you also have to keep track of how much time you spent in a particular state.
Because every U.S. citizen needs to declare a domicile, you can’t just be a nomad and travel all over the place earning money to avoid paying taxes.
That causes problems if you happen to be on an extended travel schedule–the way my friend JD Roth is spending a year in a RV traveling across the US & Canada– or if you like to be mobile and move every few months and still earning money along the way.
You need to have a “home state” where you claim residence and figure out when and where you are required to file a State Income Tax Return from your money-making activities along the way.
And the states don’t make it very easy for you as each one sets its own rules for when a tax return is required:
- Some states will make you file a return just for spending one day working there.
- There are states that have a range of 10-60 days before you are required to file a tax return there.
- Some states base the filing requirement for tax-purposes on calendar day while others use working days as the guide.
There’s no uniform way to account for your tax liabilities in this type of situation, so being diligent with your record-keeping is mandatory.
One good thing is that you can research each state you plan on making money in and use it to your advantage by planning appropriately.
A word on reimbursements
This section is an excellent illustration of why it’s best to have an accountant handling your books as many people will read this and be completely lost!
There are many instances where you will be reimbursed by your clients for travel, accommodations and/or meals.
You’re going to want to account for these in a way that doesn’t materially alter what your true financials look like.
The reason for this is both transparency and consistency:
- Transparency–You want to be able to see and compare your “real” income, that is, your income from doing a job not from travel reimbursements or incidental reimbursements, which aren’t truly income.
- Consistency–You may not have as many travel jobs, or may not have to spend as much time on the road year-to-year, so by having your true income classified separately you can see the real income trends.
By lumping these reimbursed expenses into your income when you record the payment, you are artificially inflating the real numbers which can be misleading.
Instead, if you are going to lay out the money and get reimbursed as part of your invoice, I’d suggest charging the expenses to the proper travel categories, and then when recording your receipt, allocate the appropriate amounts back to those expense accounts (thereby creating a wash) with the true amount of income being classified as income.
Or, you can leave all of the expenses on your books just as they are when you record the payments for the travel arrangements. What you would do then is to record the reimbursements as “Travel Reimbursements” as an “Other Income” category. That way it get reported outside of your operating income and keeps everything in line.
(Possible) good news about state taxes
There is a bright side to all of this if you happen to itemize on your Federal Income Tax Return…
State income taxes are deductible!
That means you actually get a little benefit on your 1040 from having to pay taxes to the various states you pay taxes to.
Additionally, some states even have credits for paying taxes in other states, so you don’t get double-taxed in those situations.
Finally, there are nine states that do not tax earned income: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
As long as you only work in those states and have no other kind of income sourced in them you don’t have to worry about filing a State Income Tax Return.
Creating an action plan
So how do you ensure that you are accounting for your potential state tax liabilities and staying in compliance with all state tax laws?
Proper planning, that’s how!
Aside from having an accountant (which is always the best option in my biased opinion), there are a few things you can do to make your life easier:
- Adjust your accounting system to track where income is earned.
- Familiarize yourself with the non-resident tax requirements for each state you are scheduled to work.
- Research the possible reciprocity allowances between states you plan on working in.
- Keep detailed records in case you need to call in a professional so they can see exactly what is going on.
- Never assume anything when it comes to accounting for taxes.
- Have someone you can trust to turn to in case you get in over your head!
If you have an idea of what you will be required to report, you will also have an idea of what you will need to hold back to pay those state taxes when the time comes.
After all, what’s worse than getting hit with a tax bill when you file your returns?
Even though you don’t live in a particular state, you may indeed be required to file a state tax return in most states any time you earn money while working within their borders.
While there are a high number of people who fail to properly account for and report non-resident taxes to the states they end up working in, that doesn’t mean it’s okay.
It’s much better to spend some time doing your due diligence or paying someone to watch your back then it is to have to face the ugly consequences of failure-to-file and failure-to-pay penalties plus the interest owed on back taxes.