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Worried About the Impact of Inflation on Your Freelance Business? Here’s What You Need to Know to Avoid Higher Tax Bills

With all of the news coverage about inflation, it is hard not to think about where the economy is going and, for those of us who are self-employed, the perceived risks and threats may be amplified. Is this anxiety justified? Read on so you can judge for yourself and take the appropriate action to reduce your tax obligations as much as possible.

First, consider the facts about inflation: Inflation is a loss of purchasing power over time. It’s not your imagination: right now a dollar will not go as today, as it may have previously. If you have noticed your expenses rising due to increased prices, you may already be keenly aware of the effect of inflation. Inflation artificially increases amounts received as wages, self-employment income, interest, dividends, and retirement plan distributions. These artificial increases are not real increases in income, as they do not represent increase in value, per se, but they are subject to income tax as though they were real increases in income.  The IRS inflation adjustments are helpful, but not a cure, because they do not exclude inflation from taxation.

What is the IRS doing about inflation and its impact on taxes? As inflation rises, the Internal Revenue Service (IRS) has boosted federal income tax brackets for 2022, standard deductions and 401(k) contribution limits, and has taken some additional actions. However, the question remains, is this enough to combat the impact of inflation on your self-employment wages and taxes?

As a freelancer, it is essential to make a real assessment of how inflation has and will impact your business.  Doing so will make it easier to understand the inflation impacts on your business and the trickle-down effect to your personal financial situation.

In general, as costs increase it is common for to see increases in the price products and services.  Consumers are not always willing to pay increased prices with very little differentiation in offerings, since they are often highly conditioned by costs. If you are a freelancer whose pricing strategy is cost-driven you likely have much less flexibility to increase your prices, making it more difficult to hedge against inflation.  For this reason it is essential to find a way to make changes that allow you to raise prices in exchange for delivering more perceived value in your product and or service offerings.

Failing to analyze your profitability and understand your margins may mean your profitability is less than the rate of inflation which can severely impact the success of your freelance business.

In addition, it is critical for freelancers to consider how inflation will impact your income taxes.  Many freelancers consider profitability to be the sum of income less expenses, however, we cannot forget about taxes, which directly affect the real profitability of your business.

Consider how rising prices and tax obligations will impact your freelance business: Let’s look at an example to help illustrate the effect of inflation on taxes.  If you are in the 15 percent tax bracket of a $10,000 a year income, this means the IRS collects $1,500 per year in taxes from you.  Assume that you received a cost of living/inflation increase to $15,000 a year in income the IRS collects $2,250 per year in taxes.  This example only considers federal income taxes and not Social Security and Medicare taxes for the self-employed.  Freelancers must consider the additional 15.3 percent in self-employment taxes when analyzing the actual cost of profitability of your business.

As a refresher, self-employment taxes are comprised of Social Security taxes, 12.4 percent, and Medicare taxes, 2.9 percent.  If you are an employee, your employer is on the hook to pay 50 percent of the Social Security and Medicare taxes, however, as a freelancer you pay 100 percent of the 15.3 percent “self-employment” taxes.  As a freelancer, you can deduct the “employer-equivalent” portion of the self-employment tax in figuring adjusted gross income, however, this deduction only affects your income tax.  It does not affect either your net self-employment earnings or your self-employment taxes and leaves you with less disposable income.

Since as a freelancer you are taxed on your net self-employment income, even if you are lucky enough to have your earnings keep pace with inflation, it is likely you will be in the situation of paying additional federal, state, and local taxes on the increased nominal income.

As we have discussed here, the increase in inflation is likely to decrease your disposable income.  Especially since freelancers have the additional burden of “funding” the “employer” side of Social Security and Medicare taxes, with no allowable deduction in net self-employment income.  The solution may not be as straightforward as you might hope.  For example, raising one’s prices with no perceived increase in value will not combat inflation or add to your bottom line.  Instead, you may want to consider looking for financial products that help protect against inflation and mitigate its impact on your self-employment income.

Common anti-inflation assets include gold, commodities, and various real estate investments gold may also serve as an "alternative currency," particularly in countries where the native currency is losing value. Consulting with a tax and financial professional is advised prior to making any investments in these areas.

Inflation is happening, how should freelance business owners respond? According to the Bureau of Labor Statistics, the Consumer Price Index for all Urban Consumers increased 1 percent in May 2022 on a seasonally adjusted basis after rising 0.3 percent in April 2022.  Over the last 12 months, all items index increased 8.6 percent before seasonal adjustments.  This is the largest 12-month increase since the period ending December 1981.

No matter how well your freelance business was doing prior to inflation taking on a more aggressive force in the economic markets, it’s clear that for you as a freelance business owner, it’s key to be educated about your tax, income, and expenses, so you can take action and keep delivering high-value services to the clients who align with your pricing structure. This will crate a business model that can absorb some of your added costs. Once you have these client relationships in place you can then consult with a tax professional to ensure you are doing everything you can to succeed despite the independent forces of inflation on your freelance business.

Jonathan Medows, CPA

Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York PostBusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.

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