Handling a Windfall Profit

by Moira Allen

Help! I've earned more money than I anticipated this year from freelance writing, and haven't paid any estimated taxes on this money. Is it too late to pay estimated taxes, and will I be penalized for not doing so? What can I do?

The writer of this letter might seem in an enviable position: Would that we all had such problems! The threat of tax penalties, however, is enough to alarm anyone.

Fortunately, this writer needn't become alarmed just yet. There is still time for her -- and you -- to make plans to reduce the tax liability of an unexpected "windfall" profit. The catch is that you need to start making those plans now, well before the end of the tax year.

Taxes and the Working Writer

Working writers (i.e., those who actively earn money from freelance activities) generally fall into one of three categories:

1. Writers for whom freelancing is a full-time profession and sole source of income
   
   
2. Writers who freelance part-time, but also hold a full- or part-time "day job"
   
   
3. Writers who freelance full- or part-time, but who also have a working spouse with a full-time "day job." (Writers in this category may also fall into Category 2.)

If you are in the first category, you may already be paying estimated taxes, and may therefore be familiar with the system. In addition, you have probably developed fairly accurate methods of "estimating" your future income, so that a sudden surge won't catch you completely by surprise.

If you fall into the second or third categories, however, you may have relied upon the tax deductions from your (or your spouse's) "regular" paycheck to cover your liability. So what happens when you unexpectedly receive more writing income than usual?

The immediate answer is "nothing." If you were not liable for additional taxes (over and above your payroll deduction) last year, you will not be liable for estimated taxes this year, even if you receive an unexpectedly large amount of income sometime during the year. However, if that sudden windfall increases your tax liability this year, you may be required to pay estimated taxes next year.

Fortunately, you can take steps to minimize your potential tax liability. If you already have a good idea of how much writing income you're likely to receive by the end of this year, this is a good time to start calculating exactly what your total liability will be, whether your payroll deductions will cover that liability, and whether you can find a way to reduce your tax debt.

Ladies and Gentlemen, Start Your Spreadsheets...

The process begins by looking at last year's tax return for answers to the following questions:

• Did you receive a refund? How much? Would that refund disappear if you'd received extra income, or been bumped into a higher tax bracket?
  
  
• What is your current tax bracket? What leeway do you have between your current bracket and the next highest bracket? (I.e., how much income can you earn before being "bumped up"?)

If you don't know your current tax bracket, you can find out by looking at last year's tax bulletin (the instruction book for Form 1040), or by visiting the IRS website at http://www.irs.ustreas.gov/index.html. (Search "forms and publications" for "tax tables".) Keep in mind that your bracket (percentage) is based on your total taxable income (including writing income), after you've taken all possible deductions (including writing expenses and itemized deductions). Note, also, that your payroll taxes may not reflect your actual tax bracket, as they do not account for either your extra income OR your various deductions. This extra income may often be taxed at a higher rate, if it bumps your total income above the "cut-off" point for the next highest tax bracket. For example, if you are "married filing jointly," and your total annual income is somewhere between $42,350 and $102,300, the first $42,350 is taxed at 15%, while anything above that is taxed at 28%. [Author's Note: This article was written in 1999; these are 1999 figures.] Thus, if your writing income has raised the total above the cut-off point, keep in mind that this income will be taxed at the higher rate, even when your wages may be taxed at the lower rate. (One goal, therefore, may be to reduce the contribution made by your writing income to a point that it no longer puts you in a higher tax bracket.)

Now, you'll want to calculate your tax liability for this year. The easiest way to do this is to create a simple spreadsheet based on last year's return. You can even start by inserting last year's numbers (to make sure all your calculations are correct); then replace them with this year's figures. Such a spreadsheet (based on an assumption of a couple "married filing jointly" with no children) might look something like this:

Even if you don't know this year's tax rates (the table above is based on calculations for 1998), you will still emerge with a good idea of whether you're likely to owe extra taxes. Note that your writing income also increases your self-employment tax. In this example, your tax liability would make it extremely likely that you would be required to pay estimated taxes next year.

To calculate your business profit and loss, you'll need another spreadsheet that reflects the income and expenses you're likely to claim on your Schedule C. "Guesstimate" your business expenses through the end of the year by dividing your current total by 9, then multiplying the resulting figure by 12. For example, if you've spent $500 on office supplies to date, your average monthly expense in this category is $55.55, which means that your annual expense will probably be around $833. [($500/9) x 12 = $833] Your business profit/loss spreadsheet might look like this:

Now that you have the basic details about your income and deductions, you can use these spreadsheets to evaluate various options that may reduce your tax liability.

Spending Money to Save Money

As a self-employed writer, you have several options for reducing the tax liability that might result from a sudden windfall profit. Most of these, ironically, involve spending money. The key is to spend it wisely, giving you an advantage now PLUS the advantage of avoiding estimated taxes next year. Here are some options to consider:

• Make sure you are taking every possible business deduction. If you qualify for the home office deduction, but have been nervous about taking it, take it now. (Remember that you can't use this deduction to create a loss, but you can use it to bring your profit to zero.)
  
  
• Increase your business expenses. Stock up on pencils and paper. Buy toner cartridges for your printer. Print new business cards. Subscribe to a professional journal.
  
  
• Buy equipment. If you've been yearning for a new computer or laptop, this may be the perfect way to spend your "windfall." New equipment does not have to be depreciated; within certain limits, it can be expensed directly from your income (i.e., deducted like any other business expense.) This requires some extra forms, but is well worth the hassle. Keep in mind, too, that you can use a credit card to buy this equipment at the very end of 1999, and pay off the cost next year.
  
  
• Increase your payroll withholding. Talk to your payroll department and find out whether you can increase the amount of taxes being withheld from your (or your spouse's) paycheck. Usually this is done by reducing the number of withholding allowances on your W-4. In some cases, you may also be able to specify a certain percentage to be withheld. While this reduces your take-home income, it can also preclude you from having to "save out" taxes for the quarterly estimated payments next year.
  
  
• Donate to charity. Charitable donations can be deducted from your income. Make sure your favorite cause is a legal tax deduction, and that you don't receive "goods or services" (e.g., "free gifts" such as PBS videos or t-shirts) in exchange for your donation.
  
  
• Postpone income. If you've already received a windfall and know that you have still more writing income coming before the end of the year, ask your publishers/editors to hold off payment until next year. Many publications will be happy to oblige. You'll only be taxed on the amounts you actually receive, not on amounts that are due but not yet paid. This will give you more time to balance your liability next year.
  
  
• Set up an IRA. It is now possible, in some cases, for a self-employed person to establish a tax-deferred IRA or 401K plan even if your spouse already has such a plan at work. Check with an accountant to find out whether you can shelter any of your writing income through an IRA, Roth IRA, or 401K.

Use the spreadsheets you've just developed to determine how each of these options (or a combination of options) would affect your "bottom line." For example, let's say that you decide to spend $5,000 on a new computer and peripherals (a nice printer, a scanner, a high-speed fax modem, etc.). Your business profit-and-loss spreadsheet now looks like this:

Now, plug these new figures into your master spreadsheet:

By purchasing that computer, you've just reduced your total "business profit" from $10,000 to $5,000. That, in turn:

• Reduces your self-employment tax from $1,530 to $765

• Reduces your total taxable income by $5,000

• Reduces your total tax liability from $2,084 to $31

• (Probably) guarantees that you will not be liable for estimated taxes next year

Chances are that with some careful planning, you can effectively reduce your tax burden before the end of the year, so that when April rolls around, you won't have to dread the IRS -- or the need to estimate taxes in 2000.

And now, the obvious disclaimer... First, I make no claims to the absolute accuracy of any of the preceding tax figures and percentages. Second, I am not an accountant. In fact, I wouldn't dream of doing my business taxes without an accountant, and I'd highly recommend that if you are earning money as a freelancer, you seek a qualified accountant who can make sure that you're doing everything possible to minimize your tax burden. Remember, the accountant's fee is also a deductible business expense!

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