You’ve earned some of your income as an employee that has gotten reported on a W-2. Taxes have been taken out. The rest of your income is from doing freelance work that has been reported (and sometimes it hasn’t been) on 1099’s. No taxes have been paid on this money. How should you proceed?
The W-2 wages get reported as wages on the front of the 1040. The money you earned directly whether or not a 1099 was issued to you is reported as gross receipts on a Schedule C which is the form for sole-proprietors and freelancers. Please note that in your business the word “freelancer” may be used to mean temporary employees; you will be paid as a salaried employee even though you are not on a full time contract or getting benefits. For tax purposes, you are not a freelancer.
Social security taxes (FICA and Medicare) are handled differently for W-2 work than for self-employment work which is what you do as a freelancer. If you are on a W-2, half of your Social Security taxes were withheld from your pay and your employer paid the other half. If you are self-employed, you pay both sides of your self-employment taxes on Form SE; you will get a deduction for half of these taxes on the front of the 1040.
Business expenses for wage or W-2 work previously were handled differently than they are for freelance or self-employment work. W-2 expenses were put on Form 2106 which was for Business Expenses. Up to and including 2017, they were subject to a 2% floor on the Schedule A. This meant that before you even thought about taking business expenses, you were only able to take the amount over 2% of your adjusted gross income. Other expenses on a Schedule A are state and local taxes, contributions, and mortgage interest and real estate taxes. For 2017, you had to have had more than $6,300 of these expenses if you were single or $12,600 if married filing jointly to make it worthwhile to file Schedule A and not just take the standard deduction.
As of the 2018 tax year, business expenses for wage or W-2 workers are no longer deductible.
Business expenses for you as a freelancer get deducted directly from your income on your Schedule C. In other words, if you make $15,000 and have $5,000 of expenses, your taxable freelance income is $10,000.
How do you divide expenses between your W-2 income and your freelance income? Business expenses are supposed to be for specific business purposes. Thus you should know what an expense was for. If you had to travel to Seattle for a freelance job, then those expenses should be handled on your Schedule C. If the job was for a W-2, then the expenses are no longer deductible.
Too often, people try to put all their expenses on their Schedule C because they no longer can itemize these expenses on a Schedule A Doing this is not acceptable and may well be disallowed at an audit.
Most expenses should be traceable to a particular job. If you take someone out who has already given you a freelance contract and you are discussing further work, clearly this expense goes on a Schedule C.
There are some expenses, however, that you have that cannot be specifically allocated to a Schedule C or to a W-2 job. Say you work at different W-2 and freelance assignments in the same field, all on short term contracts. Leaving aside the requirements for employees to have to have a cell phone and the question of what percentage of the cell is deductible as business rather than personal use, how would you allocate the portion of your cell phone you should take for business purposes? The IRS believes that you should allocate according to your income. That means if you make $30,000 on your W-2 and $20,000 on your Schedule C and if you have $1000 in deductible business phone expenses, $600 or 3/5 can no longer be deducted and $400 or 2/5 should go on your Schedule C.
Remember I said that this allocation is only for something you can’t directly trace. If you had to get a SIM card for a tour you did in Europe playing drums for a group on tour and for which you got paid as a freelancer, that expense can be directly attributed to your 1099 work and put on your Schedule C.
Remember that because as mentioned, as of the tax year 2018, any expenses allocated to your W-2 income are no longer deductible, does not mean that you can just include these expenses as part of your freelance or Schedule C expenses. You cannot deduct these W-2 expenses at all.
As to allocation method, some people will say that they should be able to allocate by a different method. The IRS also says that other reasonable methods can be used but you would have to back up these methods with proof. Say you believed that 50% of your time was spent on your freelance business, I would suspect that you would have to produce actual records of time spent if you couldn’t directly trace the expenses. Most people don’t actually have such proofs. Thus proving another method might turn out to be difficult.
On the specific subject of taking home office expenses, be careful because home office rules can trip you up if you try to allocate them . Besides that home office expenses are no longer allowed for W-2 work, any home office be it for W-2 or 1099 work has to be exclusive. That means no other work can be done in the same space than for the purpose you deduct it for. That means you cannot have the same office if you used it both for your W-2 work and for your 1099 work. Thus because your equipment is in your home office, you also cannot use the same computer for both. You cannot use the same physical space. It doesn’t matter if you say you work for the W-2 job at one time or for freelance at another. I understand that you might find this puzzling. However, please understand these are the rules. If you are audited, the agent may visit you to take a look at your home office. If you have a multiple use for the home office (which could also mean that it’s used for personal purposes, that it’s shared by your partner or children, or that you’re using it for your W-2 work when you’ve deducted it for your Schedule C income), the deduction could well be disallowed.