Extremely Important Tax Rules for Freelance Designers in the United States

Do you have to pay taxes on earnings you make online?

I’ll make this short and sweet: YES! If you live in the United States, you owe taxes on any money you make, whether it be online, offline, or in some alternate universe that the IRS has an ability to track (and they will be able to track it, I promise).

Contrary to what your best friend’s cousin’s sister-in-law’s friend Bob may have said, money made online isn’t different from money made anywhere else. In fact, the only difference between the money that you make online and the money you might make from a US business is that the online company (ie: Envato) won’t be sending you a 1099 at the end of the year – which means it’s your responsibility to record those earnings.The fact is that you are responsible (by law) to report and pay taxes on all income, regardless of its source.

A short preface: This article includes information that is specific to the United States of America’s tax laws only; if you live in another country or are not a US citizen, you’ll need to do your own research. Furthermore, I urge everyone (including US citizens) to speak with your own CPA regarding your specific tax situation; This article is only intended to lay out the generalities of this particular subject, and the advice given here may not be right for you. I am not a professional tax expert. However, to write this article, I did a LOT of research into tax rules. I also personally interviewed a handful of professional CPA’s (the folks in America responsible for actually navigating our tax law) just to be sure that I’m not blowing smoke. Like it or not, what follows are the facts regarding how the US government treats income made from online sources.

Rule Number 01: You Owe Taxes on Everything you Make.

In the US, you are required to pay taxes on any income that you receive, even if money is passed through Paypal accounts or is sent from a foreign entity. Let me be clear: As a United States citizen, you are responsible to document and pay taxes on quite literally any income that you make, ever.

It gets worse though: not only do you owe federal and maybe state taxes, you also owe Social Security & Medicare taxes! How much is that? Another 15.3 percent on top of whatever you already owe for the federal and state taxes. So, depending on how much you make in a given year, you likely owe somewhere between 40% and 50% of it back to the government! If that’s not that the financial equivalent to a punch in the stomach, I don’t know what is.

In my own case, I actually owe about 52% of my income back to Uncle Sam. Yikes! That means that out of the $200 that I was given to write this article, I get to keep just $96. That’s right – the IRS gets to keep $104 of my fee for writing an article that basically tells you to pay them. You’d think I’d get some sort of an IRS kickback… nope, but if they did offer me a kickback, you can be sure that they’d want to tax it.

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Rule Number 02: Don’t Think you Can Hide it; Don’t Even Try.

Some have alluded to the fact that money moved around online is somehow able to evade the reach of the IRS. This simply isn’t true, and acting as though your online accounts are magical tax shelters is one of the quickest ways to place yourself into the boiling cauldron that the government calls “tax evasion”. The IRS considers a failure to report income from these accounts a crime – punishable by fines, interest, and imprisonment.

Paypal hasn’t ever officially reported income to the IRS… until now: Starting in the year 2010, Paypal is required by the US government to report all earnings over $20,000 a year. That might seem like a lot of dough for some of you… I can already feel a few of you breathing a sigh of relief. Wait, wait, wait! $20,000 is just the start – in the future that number can almost be guaranteed to drop as low as $200. What’s more is that that number represents all money going in and out of your Paypal account, NOT your total income for the year.

There’s also no guarantee that if the IRS is auditing you, that Paypal or any other company won’t be subpoenaed for records from previous years, which very well may still bind them to turn over past records even if they don’t officially do this on a yearly basis. Rather than play dumb or hope for less income, your best bet is just to assume that your records are completely visible to the IRS. The IRS is not naive to your Paypal or any other account with your name attached to it.

curious

Rule Number 03: What the IRS Doesn’t Know Only Makes them Curious.

Now initially, the IRS will not necessarily know whether transactions made across Paypal are taxable because it can be used for so many things… but the IRS will still have full access to that information, which they can then investigate further if they think it is appropriate to do so. Chances are, the moment your name shows up on that list, the IRS will be undoubtedly more critical of your reported earnings in past years unless you’ve been diligently declaring your online earnings. The IRS can audit you for as far back as 7 years… that’s further back than a lot of us can even think.

It’s not just Paypal either. The IRS might be slow to hop on the online bandwagon, but once they smell blood in the water, you can be sure they’ll go into a frenzy. If I were a betting man, I’d say that most online transaction websites will be under intense scrutiny within the next few years (if they aren’t already).

Despite the temporal success of places like The Pirate Bay, these supposedly private sites just won’t be able to fight the IRS. If Swiss banks can’t fight them, what makes you think Payoneer or Google Checkout will? If the Pirate Bay were up against the IRS, that ship would have sank years ago – thank the pirate gods that the RIAA isn’t nearly as competent in their ruthlessness as our wonderful revenue service.

The notion that the IRS doesn’t know how to track online sources of income and therefore don’t care actually backfires in this case. Instead of shrugging and going on their merry way, the IRS is actually more likely to scrutinize anyone with a decent amount of income or expenditures online. Why? Because the IRS is inherently untrusting of citizens, and with every other guy on the street having his own personal brand of tax-evasion philosophy, you can imagine why.

This means that instead of being less-mindful of your online money management, you should actually be MORE mindful. Print receipts, invoices, payment stubs, etc. The IRS will very politely demand them if you are ever audited. If you can’t provide proof of what you actually earned/spent – the IRS will be kind enough to tell you what you earned using their own fuzzy logic, then hand you a bill for more than you probably make in a year.

Conclusion: Just Do It

Many people think that by just not doing the proper paperwork, you somehow fly under the radar of the IRS. Let me be clear about this: this strategy is only good until it fails (and let’s just be safe and assume that it will fail in the next 50-80 years of your life); and when it fails, it will blow your life into a massive pile of stink that most people wouldn’t touch with a 100 ft pole (even on the internet). Like my momma used to tell me: Evading taxes is real funny until someone gets stuck with a bill for $200,000 in back taxes + penalties and interest.

So What Can You Do?

To save yourself from fire, brimstone and tax debt, it’s not hard. Start with these steps:

1. Find a CPA that’s right for you. Your CPA can help you to maximize your deductions and keep as much of your hard-earned money in your pocket as possible. Check out this article on how to do this.

2. If you haven’t already, file your formal business declaration paperwork. Every state has different rules, so do the research (or better yet, let your CPA do it) and file the paperwork that’s right for you.

3. Get a bank account specifically for your business.

4. Begin documenting and saving all financial paperwork, from that receipt for ball-point pens to the Newegg.com invoice for your new liquid cooled computer, to the payment stub from Envato for your monthly earnings.

5. Report all of your earnings on your next tax filing. Yep, all of them. Then put the copy and all of your paperwork from step 4 for the year into a folder. Save it in a safe, dry place for at least 7 years.

6. Consider making quarterly tax estimate payments. Your CPA will tell you about these.

Finally, if you live in another country, seek out the professional advice of whoever it is in your area that is an expert on tax-law and filing taxes. While the specifics of your country’s tax laws might be different, there’s a good chance that your government still wants you to, at the very least, declare your income – my best guess is that they’ll want to tax it as well! Seek out a pro, get their advice; you’ll be better safe than sorry.

Don’t Shoot the Messenger!

me75

I’m an author at ThemeForest (check out my account here) and I’ve been freelancing for about 6 years now for various companies both inside and outside the US. I also live in California, which boasts some of the highest taxes of any state in America, so believe me, this article has been written with as much sincerity and honesty as you can imagine.


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Comments
  • Randy says:

    I have a buddy of mine who does some work online and he is a minor, meaning he doesn’t pay taxes in general, does that mean he has to pay or what?

  • Andre Chappelle says:

    Thanks for the tips. I’m switching from freelancing to robbing old ladys–why even consider earning an honest dollar anymore?

  • Andre Chappelle says:

    Thanks for the tips. I’m switching from freelancing to robbing old ladys–why even consider earning an honest dollar anymore?

  • Matt says:

    *Golf Claps*

    Off topic note, this reminds me of an instructor I had when I went to a technical school to fill in free-hours during high school. She was a “professional web designer” (in this case one who goes and gets a click-and-print program to do it for them).

    Anyways, she blatantly told us that by moving money into PayPal. Needless to say, she’s now in jail for tax evasion.

    The IRS is Magic! Don’t try them!

  • @Matt : That’s not off topic at all – I’ve actually never heard of anyone actually going to jail for tax evasion, but it’s definitely in all of the current literature and my CPA mentioned that it’s a very real threat for those who blatantly disregard tax laws… it’s a frightening reality that I wouldn’t wish upon anyone (hence the writing of the article) Thanks for sharing! :)

  • raptrex says:

    So if we are making money through themeforest, we have to pay taxes? Even if I make less than $100?

  • Someone mentioned in the forum a little bit ago that I should bring up that there ARE ways of reducing your taxable income… The two best ways are always going to be :

    1. IRA’s (savings accounts that you can’t touch until you are 59)
    2. Carefully documented business expenditures.

    While these are great ideas in many cases, you should still seek out professional advice.

    The simple fact is that when you work for a company in the US as an employee, they usually deduct taxes from your paycheck automatically – which is why lots of people get money back at tax-time.

    This couldn’t be further from the truth for freelancers who don’t pay a dime during the year though… when tax-time comes around, they usually owe quite a bit. This can be a shock to anyone working freelance if you’ve had a job that handled tax-payments for you with or without your knowledge.

    There are certainly ways to keep as much of that money in your pocket (I mentioned a few in the article – your CPA can give you professional advice though), but the reality for most freelancers this is still a harsh tax environment – I mentioned that I’m paying about 52% – I can get it down to the mid-forties if I’m lucky and spent a lot on business during the year, but it’s still a throat-clenching figure if you aren’t paying on a quarterly basis.

    Sigh – I know – the article ain’t no fun. My next article is going to be titled “Free Beer and Pink Ponies for Everyone!”.

  • Marcus says:

    Make sure you make quarterly tax payments or you will get slapped with a fine at the end. Just as an example – last year I made 68K – taxes – 21K – just a note I work in the finance industry and not in design. Yes you get slapped hard with the self employment tax – they tax 92.5% of your total income at the full FICA rate of 15% (there’s a decimal in that – I think 15.3). But you get to deduct that somehow from your total taxable income etc – a CPA would know more about that. I don’t want to tell you guys something and be completely off base.

    Brandon is right – get receipts for everything business related. If you are thinking holy crap I don’t save anything – if you ordered online just log into those respective accounts and boom – invoice city. Just note if you do itemized deductions you lose your std deduction so make sure it is higher.

    He is also doubly right – do not try to hide income. None of us are rich enough – yet ;-) – to get all the tax shelters.

    Anyways big props to Brandon for the article

  • shane says:

    I worry less about people getting busted for tax evasion than your new freelancer not realizing they are in a real business. The big thing to know is this. If you made more than $600 from a source, then you are legally required to report it. That means babysitting, designing or dog walking.

    I can’t tell you how many freelancer’s on our team have discreetly asked for extra hours or a supplemental project in early march due to the discovery that they are 10k shy of their tax bill.

    Great article B.

  • Daquan Wright says:

    I find it pathetic how the government is always dipping into people’s pockets, unfortunately no one thinks about whether the common man has enough to eat and pay his bills.

    I hope there is an age limit or something. Kids who get into freelance work aren’t the least bit interested in legal wires that adults have to frequently deal with.

  • Balron says:

    Omg, 52%? That’s crazy and sad.

    Anyway…well written article, good job ;)

  • Nice article which i’m sure will help out many US based authors.

    Unfortunately, only a very small minority of your rules/tips would apply to me here in Australia, but never the less, a great resource.

  • Josh says:

    I never cease to be amazed at the way the US government literally RAPES your wallet each and every day. Especially if you’re “self employed”.

    I attempted the whole “American Dream” BS a couple of years ago by running my own small business, and needless to say, I now owe Uncle Sam over $9,000 in back taxes.

    Luckily, my “CPA” was to blame in regards to filing my income improperly for the year. So rather than having to pay the ridiculous fees and penalties, I just have to pay the taxable balance. Whereas the CPA has to pay the fees and penalties.

    “Self Employment Tax” in the US is a ridiculous percentage of your income. So it would almost seem as though the government was trying to prevent anyone from doing it to begin with.

  • David says:

    You stated that Paypal starts reporting to IRS starting from 2010. It seems to be wrong, according to the official Paypal blog they say 2011. Here is the source:
    https://www.thepaypalblog.com/2008/08/proposed-irs-reporting-requirements-become-law/

  • @Daquan: I agree with you to some extent… I understand that governments require money to function and provide the basic services to citizens that they do – but when I hear about multi billion/trillion dollar wars being waged that I may not even agree with. This isn’t a political statement as much as it is one of general business concern though – if we could reduce taxes and increase jobs, I think we’d all be happier. If the gov. can’t run their own business efficiently, why should all other businesses be expected to underwrite them? If you ask me, this is the core of political interest – this is why big businesses usually have more at stake in the lobbying than independent citizens.

    That said, the law is the law is the law. Tax evasion is still a crime, whether or not you agree with it. Unlike speeding on the highway where if you get caught there’ll be a small fine and you’ll have a bad day – tax debt can be life-ruining. So, regardless of your political beliefs, you’re responsible for taxes. That’s what this article is about :) If you don’t like how the money is being spent (or how much of it they are taking), you have the freedom to A) get involved or B) move, which for most people in the US isn’t practical or desirable.

  • @Balron: Thanks! I know it’s not a fun article – but I hope that it’s useful for freelancers in this position.

    @Andrew Turner: We’ve opened this up to Australian authors (at least on the forum)… the first person to get in touch with Jeffrey and write the article has carte blanche to write the Australian version.

  • good stuff. play it safe!

  • Steve says:

    Move to Texas – keep more of what you make.

  • Cy says:

    This is a very timely article. The IRS is not a headache…it’s a MIGRAINE.

    Save all your receipts, record expenses, and keep tally of your income. Keep your records year after year. The IRS will come back to haunt you.

    Having said this… be aware of all that you can probably deduct as home business operators.

  • Scary stuff. I am in California as well.

  • ram says:

    Hey I am from India, any Indian or others here to explain the Freelancer tax rules in India?

  • Ce. says:

    This makes me want to quit and go get a job at McDonalds.

  • Bart says:

    I love how IRS-fearing you all are. And I won’t debate the fact that you should pay taxes on everything you make online. But speaking purely in practical terms, it is simply impossible for the IRS to check every single transaction on the internet. If you make a few hundred bucks by designing a website, please don’t rush to the IRS and immediately declare all your earnings. If this is your full time job and you have a legit business you should. If you made some money on the side, don’t be scared into handing it over. The IRS has more interesting guys to go after than you.

  • jlh says:

    I’ve been doing various bookeeping jobs since 1976, and this is good advice. At the point my husband & I were setting up our own business which we ran successfuly before returning to jobs that gave us w-2s and health insurance, I had a nice conversation with an IRS rep on their helpline.
    when I asked, how will I know what our taxable income is before the end of the year, he had a simple answer.
    “We get ours first”. treat every piece of income like you were writing a paycheck, deduct taxes then, and segregate for depositing. what is left is yours to pay business expenses first, then you have personal money.
    btw, when you work for an employer, for every 7.65 % you have withheld from your paycheck for FICA, that employer is also paying the exact same amount as tax. so “selfemployment tax” just means you have to pay your taxes as employee and employer.

  • Anthony says:

    Don’t you guys just love America and it’s taxes? I know I sure do. Whatever, I suppose it’s fair. How else would the country make money? Although, keeping records is a good way to stay organized… not just a way to make sure you pay your taxes. Great article, Brandon.

  • app103 says:

    So PayPal will be double reporting all funds flowing through them regardless of where it came from and where it went?

    I see that as a potential mess.

    Imagine if you will, Grandma that doesn’t earn a dime online, transferring $100 from her checking account to PayPal, then sending it to her grandson as a birthday gift. That’s $200 in transactions right there.

    Her grandson receives the $100 gift from grandma, through PayPal, and spends it online. That’s $200 in transactions.

    That single $100 transfer has now been reported to the IRS twice, as a total of $400, creating a $200 tax liability for both parties.

    Or this one…

    Someone transfers $100 from their checking account to PayPal, changes their mind and transfers it back to their checking account. That’s $200 in transactions with nothing earned and nothing spent.

    And these innocent people could be nailed for tax evasion for not paying taxes on these transactions? Something about that doesn’t seem right.

  • Hi everyone – first – thanks for all of the excellent comments and feedback. It’s really appreciated! This is a pretty serious issue for everyone, but its nice to see a healthy dialogue over the topic.

    Second – as Shane so aptly mentioned, the biggest problem that any freelancer can run into is not reporting/paying taxes at all because they don’t realize that their little side projects represent a full blown business in the eyes of the government. This is an especially dangerous pitfall for younger freelancers, just out of school or working while they are in school. This also represents people who are making money on sites like ThemeForest but don’t realize that it’s both trackable and taxable.

    Most established freelancers have already come to terms with the tax system … while it sucks, we just factor it into our cost of business in one way or another. To put it another way, the problem generally has already been “learned or burned” by 5+ year veterans; the real lesson is for the younger freelancers who are working just to make a buck and don’t recognize that the buck they just earned is actually just 50 cents.

    The good news is that you, me, or anyone else on this forum don’t actually need to have all the answers. An established CPA with experience dealing with contractors/freelancers in similar situations will help you enormously in your early years of business. Don’t stress about knowing all the in’s an out’s yourself – just get advice :)

  • @Bart: I’m a very “act practical” guy myself (ask my fiance’, it drives her nuts), but not when it comes to this kinda stuff. I totally hear you on the notion of what is “technically” true and what is “practically” true. Lots of things in life (ie: the speed limit on the freeway) are technically valid rules that the wide majority of people don’t follow in practical situations. I get it – most police officers get it, too; but I haven’t found a police officer in my life that will hesitate to give a speeding ticket simply because of the “but officer, everyone else was going fast too” argument. It’s their job to enforce the law to the letter, not interpret the validity of it based on the flow of traffic. Unfortunately, a short skirt or a crying passenger won’t persuade your average tax auditor.

    You’re probably right in a practical sense – if you report most of your earnings and pay taxes on a quarterly basis, you probably won’t get audited if you try to hide a few dollars here and there – There are indeed much “bigger fish to fry” for the IRS than to go after regular Joe Sm. Businessman unless he’s blatantly evading taxes. But when the stakes are so high as to ruin your life, why bother risking it if all it is is a few dollars? Put the taxes away AS YOU EARN them into a separate business savings account, then bonus yourself at the end of the year if you end up owing less than you anticipated.

    This is also besides the fact that the article attempts to bring up the point that the IRS is cracking down on online income sources… which if you’re making a significant income that’s channeled through a source like Paypal, that fact alone will immediately raise the curiosity of the revenue service in the years to come. I can’t say it’ll demand an investigation for certain (and I hope it won’t), but again, why risk it?

  • @Ce : I hear ya – a fulltime job that handles your tax allocations for you is truly appealing, and for a LOT of people, this is still the right thing to do. Show up, do your job, go home, live. It’s not a bad life at all and I did it for a while myself. Lots of people who want to get into their own business (and freelancing is a business) just don’t realize that it’s not good enough to 1) Be good at something and 2) Enjoy doing it. If you can’t actually learn to manage the business side and you can’t afford to hire someone to do it for you, then the business is likely doomed to failure. This is a harsh truth. That said, the business side of things (finances, taxes, rates, etc.etc.) are intimidating at first, but can be quite fun once you get your head around them – and the ultimate reward is that you work for yourself, which beats the pants out of any burger flippin’ job if you ask me. :)

  • rob says:

    Nice article, i have a question.

    i work for an US company, but i’m in another country.
    i get paid thru paypal, but my paypal account was open in the US.

    so because of that the company and me are thinking bout me getting an ITIN for them to discount me the taxes and declare them.

    will it work for them?
    if i get that, i won’t be able to get those taxes later, right?

    thanks for your help.

  • Kayla says:

    Great overview, this is my first year paying taxes on my own as a freelancer, so this was informative. I just can’t believe how high the tax rate is for a freelancer!

  • @Rob – this is really a question for your tax-guy/gal – I’m pretty sure you only pay taxes to your country of citizenship though – but please don’t quote me on that though, as I may be dead wrong. Just ask someone who get’s paid to know – most tax professionals will answer a question like this for free over the phone :)

    @Kayla – yep – it’s steep, but you can do a lot (especially as a first year business) to reduce your tax rate. Contact a CPA as soon as you can to make sure that you’re doing everything that you can do now to reduce your taxes come April. It’s really not as bad as it’ll seem – but it will give you a good hard look at how much you actually need to charge to keep your young business alive. Thanks for the comment!

  • We look forward to the day of earning $20,000 a year online! Right now all our money is made via checks (save for $32 * .5 from ThemeForest sales!)

  • Tax Man says:

    This is going to make me sound like a real jerk, however the tax advice you give here is some of the worst I’ve ever seen regarding freelance.

    People if you follow this you’ll either get audited or end up in the poor house. No you don’t need an accountant.

    Seriously save your receipts, realize as a freelancer you can nearly write off everything you do and own, if you used it in connection with your business. All your electronics, your transportation after certain miles, your food, everything.

    Use TurboTax it lets you check on and off deductions like these to see how they work.

    Freelance should allow you to pay some of the lowest taxes in the united states.

    Another thing you pay TAXES in the country you are working, and possibly the country you are a citizen off. Not the just the country you were born in!

    I know you heart is in the right place but people don’t walk away thinking taxes are cruel.

    Freelancers have the best tax breaks in the world, and not using them makes you a sucker and a poor business manager.

  • @Tax Man – You don’t sound like a jerk at all – in fact I welcome the criticism and a healthy argument :) I did a lot of research for this article, but by no means am I a tax expert – I simply did the legwork and presented the facts as I found them. This includes professional advice from several professional accountants with decades of experience on the subject…

    Sure you can do your best to handle taxes on your own, but this seems kinda silly if you ask me. I wouldn’t try to fix my own plumbing on my own, and the tax system is a lot more complex than the maze of pipes under my sink.

    Furthermore, this article isn’t about tax-breaks; in fact, it stops just short of that by making it one of the steps in the “what can you do” section – the idea of talking with a CPA is to figure out just how many tax breaks that you can get. In many cases, freelancers certainly DO have the best tax breaks in the system, but not being an expert on the matter, I can only reference that in passing. Take the advice or leave it, the article attempts to define what you owe “technically speaking”. What you do with the advice, and how you work to reduce your taxable income is totally up to you :)

    Anyways, thanks for the comment – you’re the first person to offer up real criticism and pushback and it’s a critical part of this kind of discussion.

    Cheers!

  • Alex says:

    Someone mentioned this already but it wasn’t answered. Do minors (lower than 18 years of age) have to pay taxes on PayPal/Theme Forest transactions?

  • @Alex – Yep – as I understand it, everyone pays taxes, regardless of age :)