For a self-employed person or small business owner, cash is king. Because most freelancers rely on monthly revenue to cover their expenses, they must have good cash flow in order to pay their bills, market their services and take on new work. New York CPA Jonathan Medows, of CPAForFreelancers, answers some of the typical questions he gets from freelancers.
Q: How should someone who is considering going freelance prepare financially?
Jonathan Medows: I always advise my clients to get a line of credit from their bank before they start freelancing as a career. Apply for that credit line while you still have a paycheck as an employee, because knowing you have a steady source of income makes the bank more likely to approve your loan application. Once you quit your job and start as a freelancer, in the first year you may go from having a large salary as an employee to taking only $10,000 or $20,000 as a startup salary. This steep income drop makes you less attractive as a loan prospect for a bank’s loan officer.
Another thing that sometimes happens is that your credit score drops when you start a business because you may incur a lot of credit card debt. That’s why I say secure a home equity line of credit or another kind of credit line beforehand. Many lenders are coming under pressure to lend to small businesses now and there are some very attractive rates available.
Q: What about alternative forms of financing for freelancers and other startups?
A: We are seeing options like “factoring” grow in the service industry. Factors, who originally started out in the apparel industry, will lend to you based upon the creditworthiness of the people who owe you money. They collect your invoices, take out their fee and give you the rest of what’s owed you.
So, for instance, say you have $80,000 in accounts receivable. They pay you a portion of that money up front, they collect on your invoices, take their cut and give you the remainder of the money. It’s an expensive way to borrow, but it can be effective for people who have strong vendors.
Another thing to think about is credit cards. Again, they’re expensive and you have to be sure that you don’t destroy your credit rating by overusing them, but they can be a funding source for startup freelancers.
Q: It’s very important for freelancers to stay on top of their collections. What do you recommend?
A: Establish credit terms and try to get as much money up front as you can. If your clients are not paying, call them and try to work with them. Be flexible and sometimes if you give a little bit, you’ll get a long-time paying customer who gives you lots of referrals. But if you’re dealing with someone who just won’t pay, you have to get aggressive with litigation. Freelancers can’t let people rip them off. If they get away with not paying you, they’ll do it to other people.
Use some prevention by knowing who you’re dealing with before you take on a freelance project. Do a credit check up front. In my experience, the people who walk in my office dressed very nicely and act cavalierly about money are the ones I typically have problems with.
Q: How do freelancers juggle cash flow with periodic expenses like quarterly tax payments?
A: If you don’t closely manage your cash flow, it may be a constant stretch to make your quarterly payments. And if you have a terrific revenue year, but you haven’t put aside sufficient cash to cover your taxes, you may be in for major tax liability come April 15, when you may not have sufficient cash on hand to pay it. If that happens, you can request an automatic six-month extension, so you can pay all or part of what you owe on Oct. 15, incurring only a small additional fee.
For these reasons, I advise clients to set money aside for tax payments in a separate savings account. I recommend saving 35 percent of your profits and then you’ll have no problem covering your taxes. And if it’s in a separate account, you won’t be tempted to use that money for something else. That may sound like a lot, but it’s because when you were an employee, your employer paid part of your tax obligation and the money was likely taken out before you got your paycheck, so it’s likely that you didn’t notice it.
Q: What tax deductions and expenses should freelancers claim?
A: A home office is only deductible if it is used regularly and exclusively for work, according to the IRS. In my experience, almost all freelancers qualify for a home-office deduction. Keep track of your business expenses and if you’re not sure whether you can claim them, start a list labeled, “Ask My Accountant.” What’s important is not to wait until tax time to ask questions.
Q: Many freelancers buy private health insurance policies. Are these tax-deductible?
A: Health insurance costs may reduce your self-employment or income taxes if your freelance business turns a profit. Subject to certain caveats, you may be able to deduct your health insurance premium as an “above-the-line” tax deduction on your Form 1040. If you have a loss, you can itemize the premiums on Schedule A of your personal tax return.
Q: Who should freelancers work with on their tax and financial issues?
A: Work with a licensed CPA who is very familiar with self-employment and small business issues. If you’re working with a bookkeeper or an unlicensed tax preparer, chances are they won’t be able to explain these complicated issues very well. Someone who is licensed has passed state exams and has a certain level of professional experience.
And of course, once you’ve hired a professional, take their advice. They can’t help you if you won’t listen to them and respect their expertise.