When you do your taxes, you need to know how much you earned and how much you spent on your freelance business. Here’s how to do it and how not to do it.
“I wait until my 1099’s come in, and I do my taxes.” Using this method is a common one and potentially dangerous to you. First, you’re reliant on the person who hired you to put in the correct income. Often the number on the 1099 is incorrect. If you haven’t kept track of what you’ve made, you have no way to know. Second, you’re assuming that you will receive a 1099 for every dollar you earn. Unfortunately, 1099’s often are not filed on time and sometimes don’t get to people because they get sent to old addresses. The result is a letter from the IRS a year or two down the line saying that you owe money because you didn’t include this or that income source. Not only will you owe the money plus interest and penalties but if you live in a state with income taxes, the state will also have to be paid.
Relying on your memory, another common method, also can lead to discrepancies which can backfire on you. If you overstate your income, you’ve paid too much in tax. If you understate your income, the IRS could send you a notice mentioned in the paragraph above asking for additional taxes plus penalties and interest.
Some people rely on bank deposits. If you deposit all your income into one account, this method would then at least include all your income. It could, and often does, lead to errors.
You could have also deposited gifts into this account and relying on this method would lead to overstating your income if you didn’t know from whom each deposit came. Same is true for refunds. Additionally, you wouldn’t be able to see if the amount on the 1099’s actually matches what came in.
The first proactive method is a written list of who paid you what, when and how much. This method requires you to add up the numbers by hand and is subject to error. You can compare the totals to what your bank deposits. You can also see all the income for a particular client and compare that to the 1099’s. This method however is the most laborious and does not have a backup.
If you’re going to rely on lists, Excel (or Google Docs) is something to be used. If you say you don’t know how to use a spreadsheet, please don’t reject this method out of hand. Learning how to add on spreadsheets is really much of what you need to know. I show clients how to add in less than two minutes. The advantage of using Excel (or Google Docs): you can total your entries very easily. Over the course of the year, you can see how much you’ve earned quickly. Of course there are errors but those are entry errors. You can save your work and access it whenever you want.
I personally prefer using a software bookkeeping system. I’m most familiar with QuickBooks.
Please note: Quicken is not a business bookkeeping system. It’s for personal finance and does not have the robustness that QuickBooks has for business purposes.
Why should you go to the trouble to use a program like QuickBooks for income: in addition to the advantages listed for using a spreadsheet, you can write checks out of QuickBooks, you can access your credit card information, and you can write your invoices on it. You have a way to track your income over the past years to see how it compares to previous years and to seasonal time periods to see patterns in your income that can be very useful to you in your financial planning. You can also plan vacations knowing that certain time periods are generally less busy than those that aren’t.
The reality of QuickBooks (and other software packages) is that you probably need some help learning it. I’ve found that many people who are not familiar with bookkeeping often try to do it themselves and get frustrated in the process. I personally learned to use it through a tutorial but I’ve been doing taxes for years and am very familiar with the concepts behind the software. What I usually tell people is to hire a bookkeeper to teach them how to use it. Perhaps they want to keep having the bookkeeper do the books. If not, they can have the bookkeeper come back after a month to check on what was entered and then at the end of the year to correct what was done and bring it up to readiness to be shown to a tax preparer.
Now what about expenses?
If you don’t have a method other than estimates to record your expenses, you are bound to be off on what you spent. The IRS normally wouldn’t accept this method. If you record your expenses be it by hand, by spreadsheet, or QuickBooks, you will come much closer to the mark both in terms of accuracy and in terms of satisfying the IRS requirements for recordkeeping.
Many people think that their credit card summaries suffice. The categories don’t necessarily match those on the tax returns. When credit cards have personal expenses on them, you can’t tell what’s personal and what’s for business. These summaries can be better than nothing but they’re not usually sufficient. For one thing, they don’t include cash expenses or any made by check.
Just as with income, the expenses recorded by hand is the least preferred proactive method. Why? Typically, the number is written down but there rarely is a complete record of the date paid, the type of expense, the vendor, the purpose, method used to pay, and the amount.
A spreadsheet like Excel can have more details depending on what you enter.
You can enter the expense type across the top of the page and put in the date, name of vendor, method and amount. This can get cumbersome. Many people leave out the name of the vendor and method. Without the vendor, you can’t see what the entries are for and thus it’s easier to make a mistake in where you put the expense and you lose some of the advantage of knowing what each expense was spent on. Without the method of payment, you can’t quickly access the original payment or verify the amount spent.
QuickBooks (or a comparable bookkeeping software) allows you to pay your bills directly out of the bookkeeping system. You can download what you’ve paid on credit cards into your expense categories. You get a complete list of expenses, to whom the expenses were paid, method used dates, and amounts.
Seeing what you spend in an organized way gives you the ability to see patterns in how you spend. You can compare previous years for different categories. You can see what you might need to spend at the end of the year. You can see when you paid certain items in years past so that you can plan for what needs to be paid in the coming months.
You can see if you haven’t paid something even though you think that you have. You can also see when you’ve paid something twice. It does happen. When it does happen, call the vendor and ask for a refund. Do not be surprised when the vendor says, “Oh, we were going to send you a refund.”
Best of all, using a bookkeeping system makes preparing for taxes easier to prepare for doing your taxes.
Self-employed people do not need to have accounts that are balanced. Corporations, partnerships, and multi-member llcs must. Single member llc’s should if they intend to become multi-member at any point. Bookkeeping software like QuickBooks provides this. Quicken does not.
What is important about tracking income and expenses is that you actually do it. Relying on other people to track your income is not reliable. Neither is not having a system to track your expenses.
Please note: this article is about tracking income and expenses. For information about the papers you need to have to back up this income and these expenses, please see “What Papers do I Need To Do My Freelance Taxes?”