How To Calculate Taxable Income: Guide For Freelancers & Agencies

“How much money do I owe the IRS?” Every April, freelancers and small agency owners have to ask themselves that question. And sometimes, the answer can be surprising because taxable income can be pretty tricky to calculate.

But you can’t simply avoid it! Knowing how to handle your taxes is one of the single largest things you can do to keep your business profitable.

Handling your taxes comes down to two basic tasks:

  1. Getting accurate papers submitted on-time.
  2. Keeping your tax burden as low as possible.

I’ll talk about both of these things in the post below, but first – just two quick notes before we begin.

First, I’m assuming that you are running a freelance or small agency operation in the US. So I’m assuming you’re a sole proprietor or single-member LLC. The rules are different for partnerships, multi-member LLCs, C corporations, and other types of businesses. And, of course, if you’re not in the US, you do have to follow the rules of our IRS!

Second, I’m not an accountant. I’m a business owner who wants to have informed conversations with accountants, and who wants you to be able to do the same! This guide is not a replacement for a tax professional. Rather, it’s meant to help you with your general financial literacy.

Caveats aside, I’m going to give you a brief overview of how you can calculate your taxable income in nine steps.

1. Familiarize yourself with the 1040 and Schedule C forms.

If you’re in the US and you are a freelancer or agency owner, there is a good chance that you’re either operating as a sole proprietor or single-member LLC. If that’s the case, there are two tax forms that you really need to understand.

  • Form 1040 for filing your annual income tax return.
  • Schedule C for reporting income or loss from a business you operated.

You’re probably familiar with at least Form 1040. Most citizens and permanent residents in the US have to fill out a 1040. Waiters and bankers, executives and janitors – like it or not, this form is the great equalizer!

Then there’s the Schedule C. It’s a supplement to the 1040. For each business you earn or lose income on in a given tax year, you file a Schedule C. That’s where you report earnings and expenses associated with each business you operate.

It’s helpful to review each section of these forms – even if you don’t have to file anytime soon – because they guide how you report earnings and expenses. Familiarizing yourself with these forms helps make sure you don’t miss important deductions or make errors in reporting. And that saves you money!

IRS Form 1040
All hail the mighty Form 1040, taker of revenues!

2. Create an accurate income statement.

You can’t calculate your taxable income unless you know how much money you’ve made and how much money you’ve spent. That means you need to have a way to track all your business revenues and expenses, as well as a way to generate accurate income statements (also known as P&L’s).

The best way to keep track of small business finances is to pick accounting software you like and use it consistently. You could use QuickBooks, FreshBooks, Xero, or something else entirely. The software itself doesn’t matter nearly as much as your consistent effort to use it correctly.

Specifically, you will need to keep track of all your invoices and sales receipts so you can track all your revenue. You will also want to keep your receipts or bank records for expenses as well. Then you can follow this guide to turn this raw information into an income statement.

3. Categorize your expenses and figure out what’s deductible.

A well-made income statement will help you understand how much money you’ve made and how much you’ve spent. That is tremendously valuable information when it comes to tax time, but it’s not enough to calculate taxable income on its own, even if your business is your sole source of income.

Expense tracking is really important here because not every expense can be deducted from your taxable income. Your expenses will need to be categorized into different types, some of which are tax-deductible and some of which are not.

This is a complex topic, so you can read a more in-depth guide here. Suffice it to say that most of your business operating expenses, such as office expenses, supplies, utilities, and advertising, will be tax-deductible. However, there are some special rules around other more nebulous expenses like meals and entertainment.

Another thing you will want to watch out for – some expenses are tax-deductible on your personal 1040 and not your business Schedule C. You may pay for your own retirement or healthcare out of the business bank account, but that probably won’t go on your Schedule C. Rather, there is a good chance that will wind up on your 1040 instead.

4. Add other sources of income.

Even if your business is your primary source of income, you need to consider other sources of income as well. On your taxes, you must include any personal earnings outside of your LLC, such as wages from another job or freelance work.

Additionally, if you have investment income, including dividends or interest, you need to factor that in as well. That AirBNB you’re renting counts. Any alimony or child support you receive counts. Prizes, awards, jury duty pay, gambling winnings, and so on – those all count too.

Basically, if it puts money in your bank account, the IRS wants to know about it. 

Gambling earnings are taxable
So I’m better at finance than Photoshop, I guess.

5. Apply other deductions and credits as applicable.

Most people want their taxable income to be as low as possible, and certainly much lower than their gross income or net income. This can be done by taking out deductions and applying tax credits.

First, look into the self-employment tax deduction. That will allow you to deduct half of yourself-employment tax from your net income. You might also be able to apply small business tax credits like the energy efficiency credit or small employer health insurance premium credit.

Money you put into a retirement account such as a SEP IRA or solo 401(k), up to a point, is also tax-deductible on your 1040.

At this point, I recommend you definitely find an accountant who can help you with the latest and greatest information. One of the key value-adds of tax accounts is that they can help you find and confidently apply every deduction that fits your situation. That way, you don’t have to ask yourself questions like “can I really take that home office deduction?”

6. Calculate your adjusted gross income.

To find your adjusted gross income (AGI), begin by adding up all sources of income. Then, subtract allowable adjustments like self-employment tax, student loan interest, and contributions to retirement accounts.

Your AGI is not your taxable income, just to be clear. What it is, though, is a key figure in the tax calculation process, as it determines the baseline for calculating your tax liabilities and eligibility for additional deductions and credits.

When the standard deduction is, well, deducted, AGI is what it is deducted from. This is also a figure that other financial institutions like banks and credit card companies tend to notice as well.

7. Subtract exemptions and standard or itemized deductions.

At the time of writing, personal exemptions are no longer available (for tax years 2018-2025). This may or may not continue to be the case in the future – this will come down to what the next batch congressional leaders decide to do with the Tax Cut and Jobs Act.

Since personal exemptions are out of the question, you have one choice to make here: take the standard deduction or start itemizing deductions.

The standard deduction is based on your filing status and age. For filing status, your options are single, married filing separately, married filing jointly & surviving spouses, and head of household. Here is a list of current standard deductions according to Forbes.

If you choose to itemize, you would add up deductions like mortgage interest, state and local taxes, and charitable contributions. Itemizing gets complicated quickly, so here is a guide on Investopedia to help you with that.

For the purposes of this guide, all you need to know is that if your itemized deductions will tally up to be more than your standard deduction, you should itemize. Otherwise, the standard deduction is the better deal.

8. Calculate your taxable income.

To determine your taxable income, subtract your chosen deductions (either standard or itemized) from your AGI. The result is the amount of your income that will be subject to federal income taxes.

Easy, right? 😉

It may be a pain, but if you understand where this figure – taxable income – comes from, you can optimize your business and personal finances to have the lowest possible taxable income. Translation: you pay less in taxes!

9. Pay up (annually and quarterly)!

Of course, the whole point of calculating your taxable income is to calculate your tax liability. You do this using the appropriate IRS forms and schedules, which – if you’re the intended audience for this article – would be your Form 1040 and Schedule C.

Depending on how you handled your finances in the preceding tax year, you might owe some taxes. Or perhaps you’ll wind up lucky and get a refund from the IRS instead!

Either way, if your business is a big part of your income, you should consider making quarterly estimated tax payments. If you’ve gone from working a day job to working for yourself, this can be a bit of a culture shock. It’s easy to forget that employers actually take a chunk out of your paycheck, withhold it, and turn it over to the IRS on your behalf. That way, you don’t have to file quarterly.

But if you are the employer, you have to do this yourself. Otherwise, you might get hit with penalties for underpaying taxes throughout the year.

Quarterly filing is done with Form 1040-ES via EFTPS. Quarterly filing deadlines are usually April 15, June 15, September 15, and January 15. Note that those are not all three months apart – that’s an easy thing to forget!

Remember: filing quarterly doesn’t mean you pay more taxes. It only means you estimate your taxes in advance so you don’t get hit with it all at the same time in April.

Final Thoughts

Taxes can be hard and scary to deal with if you’re a freelancer or running a small business. But it’s a fundamental part of running a successful business and you need to know how to handle them well.

This guide breaks down how taxable income is calculated. Breaking down how taxable income is calculated is a huge part of tax compliance. But it can also help you by making it easier to keep accurate records and lower your tax burden.

Even if it’s not riveting reading, you owe it to yourself to check out those tax forms. Knowledge is power, and in this case, it’s money too.

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