Starting a Freelance Business – How to Take Care of Legal, Tax and Contractual Paperwork

by Caron_Beesley, Community Moderator

• Created: July 18, 2012, 7:13 am

If you are new to freelancing or thinking of becoming a freelancer, you’ll no doubt have lots of questions, especially about the legal and regulatory paperwork you need to obtain and manage throughout the business year.

Freelancing, particularly if you are unincorporated, is one of the least paperwork-intensive forms of business ownership. Nevertheless, you are still a business and you need to be sure you have the right licenses or permits, make estimated tax payments on time, report your earnings each year, and deal with client paperwork such as contracts, non-disclosure agreements, and more.

To help you stay on top of your obligations, here’s a breakdown of key legal and regulatory processes, plus important “business-ready” documentation you’ll need when dealing with new clients.

Legal and Regulatory “Must-Dos”

Here’s what you’ll need to do to ensure you set up and manage your freelance business legally:

1. Get the Right Licenses and Permits – All businesses need some form of license or permit to operate in their state, county or city. In all likelihood, your freelance business is operated out of your home. So you may need a Home Occupancy Permit and a General Business License. You can get both from your local government website. Or simply use SBA’s “Permit Me” online tool for information about the licenses or permits you may need based on your zip code and business type. Be sure to obtain these before you start doing any business.

2. Register Your Business Name – If you want to name your business anything other than your given name, then you’ll need to register a “Doing Business As” name with your local government. This guide explains how. If you use your own name, skip this step.

3. Pay Estimated Taxes – This one often comes as a surprise to freelancers, who may be used to having their taxes withheld by an employer. As a freelancer, it’s your responsibility to pay Uncle Sam and your state revenue agency almost as soon as you earn income each quarter. If you expect to owe $1,000 or more when you file your annual return, then you must pay estimated taxes on income. For information on how to calculate and make your payments, read: How To Calculate and Make Estimated Tax Payments.

4. Complete a W-9 Form When You Get a New Client – When you ink an agreement or start work with a new client, it’s likely they will ask you to complete IRS Form W-9 (you may have to ask them for it). Filling out a W-9 is straightforward: provide your name and social security number, or “Doing Business As” name. The client holds this form and doesn’t send it to the IRS; it’s a formal certification by you that your tax ID (SSN) is correct. The form also asks if you are subject to backup withholding – most taxpayers are exempt.

5. Annual Tax Reporting: The 1099 Form – If you’ve earned more than $600 in a year from a client, they have to report these payments to the IRS through Form 1099-Misc. Your client will send you a copy by the end of January each year. Be sure it’s accurate – does the amount the client stated they paid you match your records? You don’t have to do anything with the form other than it in your records and use it as a reference when you report your annual income to the IRS.  Think of it as the freelancer’s equivalent of the W-2 form.

I’ve deliberately excluded incorporation as a “must-do” legal and regulatory step for freelancers. Incorporation isn’t a legal must-do. While it has its benefits, it can also have cost disadvantages. To help you decide if incorporation is right for you take a look at: Should You Incorporate Your Freelance or Consulting Business? SBA’s Incorporating your Business guide is also a useful reference.

Essential “Business-Ready” Documentation for Freelancers

Here’s a list of some of the day-to-day documentation and paperwork that you will likely need or encounter as a freelancer:

1. Cost Estimate and Proposal Documents – Give your business a professional touch by creating your own branded template for project quotes and proposals. You can pay a graphic designer to create many of your basic business documents and graphics, or use freely available templates in software such as Microsoft Word and Google Docs. Sites such as FreelanceSwitch also offer free templates and resources.

2. Contract Documents and NDAs – Most clients will have their own contracts in place for independent contractors or freelancers. Be sure to read through the terms with a fine tooth comb. Don’t be afraid to question anything that doesn’t make sense or is irrelevant. The Non-Disclosure Agreement or NDA is usually included and is pretty standard. It requires you to agree to the client’s legal rights for protecting company knowledge or information you may have access to during the course of business, as well as intellectual rights relating to the work you produce.

If your client doesn’t present you with a contract, you may wish to protect your own interests by producing your own. This blog offers tips: Setting Up a Client Contract.

3. Statement of Work – Even if you have a client contract in place, many clients will also ask for individual statements of work (SOW) for each project. It’s a good idea to volunteer one even if they don’t ask for it. A SOW is a project-specific agreement outlining the mutually agreed scope of work and the timeframe for its completion. It sets expectations, deliverables, and the price. It may also include information on resources needed for the project, including roles and responsibilities on both sides. The secret to a good SOW is to avoid being vague – if it’s too broad and non-specific, you may end up with a dispute.  Once the SOW is agreed and signed, you are ready to begin the project.

Special Tax Benefits for Armed Forces Personnel

Military personnel and their families face unique life challenges with their duties, expenses and transitions. The IRS wants active members of the U.S. Armed Forces to be aware of all the special tax benefits that are available to them.

Here are 10 of those special tax benefits:

1. Moving Expenses If you are a member of the Armed Forces on active duty and you move because of a permanent change of station, you may be able to deduct some of your unreimbursed moving expenses.

2. Combat Pay If you serve in a combat zone as an enlisted person or as a warrant officer for any part of a month, all your military pay received for military service during that month is not taxable. For officers, the monthly exclusion is capped at the highest enlisted pay, plus any hostile fire or imminent danger pay received. You can also elect to include your nontaxable combat pay in your "earned income" for purposes of claiming the Earned Income Tax Credit.

3. Extension of Deadlines The deadline for filing tax returns, paying taxes, filing claims for refund, and taking other actions with the IRS is automatically extended for qualifying members of the military.

4. Uniform Cost and Upkeep If military regulations prohibit you from wearing certain uniforms when off duty, you can deduct the cost and upkeep of those uniforms, but you must reduce your expenses by any allowance or reimbursement you receive.

5. Joint Returns Generally, joint income tax returns must be signed by both spouses. However, when one spouse is unavailable due to military duty, a power of attorney may be used to file a joint return.

6. Travel to Reserve Duty If you are a member of the US Armed Forces Reserves, you can deduct unreimbursed travel expenses for traveling more than 100 miles away from home to perform your reserve duties.

7. ROTC Students Subsistence allowances paid to ROTC students participating in advanced training are not taxable. However, active duty pay – such as pay received during summer advanced camp – is taxable.

8. Transitioning Back to Civilian Life You may be able to deduct some costs you incur while looking for a new job. Expenses may include travel, resume preparation fees, and outplacement agency fees. Moving expenses may be deductible if your move is closely related to the start of work at a new job location, and you meet certain tests.

9. Tax Help Most military installations offer free tax filing and preparation assistance during and/or after the tax filing season.
 
10. Tax Information IRS Publication 3, Armed Forces’ Tax Guide, is an excellent resource as it summarizes many important military-related tax topics. Publication 3 can be downloaded from IRS.gov or may be ordered by calling 1-800-TAX-FORM (800-829-3676).

Disposing of a Business - Allocating Sales Price

When the assets of a going concern are sold to a single buyer, the buyer and seller generally must allocate the purchase price among the tangible and intangible assets that are being sold. As the seller, you will want to allocate as much of the purchase price as possible to assets that yield capital gains, rather than ordinary income. The buyer's concern, on the other hand, will be to allocate as much of the purchase price as possible to assets that do not have to be fully capitalized and can be written off quickly.

These tensions are at play in all business asset sales, but they vary with changes in the parties' circumstances and in the tax laws. Since you plan to sell the assets of your business, we want to give you an overview of how the allocation process required by the Internal Revenue Code works.

The mandated method is called the "residual allocation method," which has a hierarchy of seven categories:

Class I assets: These are cash, and cash equivalents, such as demand bank accounts.

Class II assets: These are items such as certificates of deposit, government securities, and other readily marketable securities.

Class III assets: These are items such as accounts receivable, mortgages, and most debt instruments.

Class IV assets: Items such as stock in trade, inventory, and property held for sale to customers in the ordinary course of business.

Class V: These consist of all assets other than Class I, II, III, IV, VI, and VII).

Class VI: All Code Sec. 197 intangibles except goodwill and going concern value.

Class VII: Goodwill and going concern value.

Allocations are made first to the top category of assets, then to the second, and third. Whatever is left unallocated automatically is allocated to intangible assets in the nature of goodwill and going concern value.

Buyers and sellers will try to the extent possible to make allocations that serve their own tax interests. While no asset can receive an allocation greater than its fair market value, that value cannot always be determined with mathematical precision, so there often is some room to maneuver. The buyer and seller, however, both must use whatever allocation they finally agree to.

Until a couple of years ago, sellers wanted to allocate as much as possible to goodwill and going concern value, because it gave them capital gain. Buyers hated allocations to these assets, because they couldn't be written off. Now, however, they can be written off over 15 years.

Many other purchased intangible assets, such as covenants not to compete, that buyers used to write off over their terms, now can't be written off over less than 15 years. So buyers may want to enter into consulting agreements to shift some allocation away from the covenant not to compete and to get more immediate tax benefit from their expenditures. Although covenants not to compete and consulting fees both are taxable as ordinary income, sellers have to remember that consulting agreements generally will require them to perform services, while covenants not to compete do not.

We hope this overview of the allocation requirements is helpful to you in your negotiations. If you need additional advice on this complex subject, please call for an appointment.

 
Reproduced with permission from CCH’s Client Letter, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.

Disposing of a Business - Some Tax Considerations

Since you are considering disposing of your business, we thought you might want to know about the tax effects of some of the many ways that your deal could be structured.

If you are looking for an all-cash deal, and are willing to trade an immediate tax bill to avoid future uncertainties, your biggest problem may be finding a buyer with the cash you want. To help things along, you might have to consider an installment sale where you sell business property in such a way that you would receive at least one payment after the tax year of the sale.

Installment sales of personal or real property by "nonaccrual method nondealers" (translation: by most business taxpayers) are reported under the installment method unless a taxpayer elects out. The installment method permits the reporting of gain from qualified installment sales as payments are received rather than in the year of sale. You might consider "electing out" when you anticipate higher overall income in future years, or have other losses in a current year that may offset full recognition in the year of sale. Even when an installment sale may spread out gain for tax purposes, however, a seller should be careful to get enough up-front cash to take care of "recapture taxes" that may be due in the year of sale no matter how little cash you receive from the buyer that year.

If you sell the assets of your business, you and the buyer will have to come to terms on how the total purchase price is to be allocated among them. Since your interests will not necessarily coincide, it's important for you to understand what the tax effects of these allocations will be. The tax laws spell out how these allocations should be made, but there usually is room for some planning and maneuvering here.

If you are interested in disposing of your business with as little immediate tax liability as possible, some creative alternatives may be open to you. You might want to merge your business with another, or enter into one of a variety of tax-free reorganizations. Each of these requires strict adherence to many technical rules, so you will need professional help at each step of the way to ensure that you achieve the desired tax result. You might only want to dispose of part of your business, or split it up among current owners, in which case you may be able to accomplish a spin off, split off, or split up on a tax-free basis.

If you have a successful business, but are having trouble finding a buyer, you may want to consider setting up an employee stock ownership plan and selling your company's stock to the plan. This can be done on a leveraged basis and results in no current tax to you if you reinvest the proceeds in other securities. It gives you the opportunity to diversify your company stock holding without any tax cost until you sell the replacement securities.

As you can see, there are many options to consider and many pitfalls to avoid when planning to sell your business. Please call us if you would like to discuss your plans and goals in more detail.

 
Reproduced with permission from CCH’s Client Letter, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.

Planning 2012: Rental Real Estate Activity Compliance

Rental real estate offers tremendous tax advantages and opportunity for tax planning. Taxpayers, such as you, can depreciate property far exceeding your actual investment, deduct interest on borrowed capital, exchange rather than sell properties to defer tax on gains, use installment sales to defer tax on sales, and profit from preferential rates on long-term capital gains. Most importantly, you can generate “positive cash flow,” or monthly income, with depreciation deductions that effectively turn the actual income into tax losses.

However, deductions are not unlimited. For example, real estate income and loss is generally considered passive income and loss for tax purposes. Taxpayers generally cannot use passive activity losses (PALs) to offset ordinary income from employment, self-employment, interest and dividends, or pensions and annuities. The rental real estate loss allowance and real estate professional status are two important exceptions to this rule. In addition, the tax consequences of renting out a vacation home depend upon the amount of time the home is rented and the amount of time you use the home for personal purposes.

As one exception to the PAL rules, taxpayers with adjusted gross incomes of $150,000 or less can claim a rental real estate loss allowance of up to $25,000 for property they actively manage. Active management does not require regular, continuous, or substantial involvement. However, it does require that the taxpayer own at least 10% of the property. Also, to qualify for the exception, married taxpayers must file jointly.

The second exception allows real estate professionals not to treat their rental activity as a passive activity. Therefore, their losses are not limited to passive income. This exception requires material participation by the taxpayer which is demonstrated by meeting one of seven tests. These tests are complex and include the number of hours of participation and the facts and circumstances of the participation in the activity.

Vacation homes are taxed under one of three sets of rules depending on how long the homeowner rents the property. If you rent your vacation home for fewer than 15 days during the year, no rental income is includible in gross income. If you rent the property for 15 or more days during the tax year and it is used by you for the greater of (a) more than 14 days or (b) more than 10% of the number of days during the year for which the home is rented, the rental deductions are limited. Under this limitation, the amount of the rental activity deductions may not exceed the amount by which the gross income derived from such activity exceeds the deductions otherwise allowable for the property, such as interest and taxes.

If you have any questions as to how the rental real estate rules apply to your particular situation, please do not hesitate to call for an appointment. We can assist you in taking advantage of the available tax benefits and develop an overall tax plan.

Reproduced with permission from CCH’s Client Letter, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.