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© Daniel Steven 2006
As a writer, you've chosen to be a creative person. Writing, however, is a business. Whether you're a freelancer with your first sale, or an experienced author with a multi-book contract, it is worth understanding basic income tax principles and rules. (Note: all of the IRS publications mentioned in this article are available online at www.irs.gov.)
Accounting Methods and Periods
Just as any other taxpayer, writers can choose to account for their income on either the accrual or cash method. The accrual method requires you to include all income you have the right to receive in the tax year, even if you didn't receive it until the next year, and likewise deduct expenses when they are incurred rather than when paid. Obviously, most writers will choose the cash method - reporting all income actually received and expenses actually paid in the tax year - it's much simpler and rarely causes any problems.
Types of Income
There are two types of taxable income: "ordinary" and "capital gains." Ordinary income is all income typically produced by your writing, while capital gains income is received from the sale of capital assets such as real estate, stocks, bonds, etc. The top tax rate for ordinary income is 35%, but capital gains tax is capped at only 15%. Some writers are under the impression that manuscripts and copyrights are capital assets, and therefore that royalties should be taxed at the capital gains rate. Not true. The tax law specifically excludes copyrights, artistic and literary material held by the taxpayer who created it from qualifying for capital gains treatment. Therefore, royalties from your publisher are considered "ordinary" income, as are grants, prizes, and award.
What's Your Form?
Most writers are sole proprietorships and must report their writing income, expenses, depreciation, and losses on Schedule C of Form 1040, "Net Profit from Business--Sole Proprietorship." (If your writing business is a single-member limited liability companies (LLC), it is what the IRS calls a "disregarded entity" and the same rule applies - use Schedule C.) Section B of Schedule C requires entry of a "business code": writers should use 711510, "independent artists, writers & performers." If your expenses are less than $2,500 and you claim no depreciation, you may use a simplified version of this form, called Schedule C-EZ. For further information, see IRS Publication 334, Tax Guide for Small Businesses, for Individuals Who Use Schedule C or C-EZ.
Assuming your Schedule C reports net income (rather than a loss), you'll also have to file Schedule SE - Self-Employment Tax. Self-employment tax is a social security and Medicare tax primarily for individuals who work for themselves. The self-employment tax of 15.3% is roughly equivalent to the social security and Medicare taxes withheld from the pay of most wage earners (adding together both employer's and employee's share). For social security tax, the maximum amount of 2006 wages subject to the tax has increased from $90,000 to $94,200 (and any wages earned by you in your "day job" and subject to FICA withholding also count against this limit). For Medicare tax, all covered 2006 wages are subject to the tax. Thankfully, you can deduct half of your SE tax in figuring your Annual Gross Income.
Writers can deduct from their gross writing revenue all their business expenses. To be deductible, a business expense must be "ordinary and necessary," but "necessary" does not mean "indispensable." Some common expenses that writers may deduct:
Note: For tax years beginning in 2006, the standard mileage rate for the operation of your car changes to 44.5 cents a mile for all business miles driven.
But You Can't Deduct For Non-Payment
Writers frequently sell stories and articles to publishers that go out of business or otherwise don't pay. There is a very common misconception that this is a "bad debt" for which the writer may take a deduction. Not so! In fact, according to the IRS in Publication 334, "Cash method taxpayers normally do not report income until they receive payment. Therefore, they cannot take a bad debt deduction for payments they have not received or cannot collect."
When can you take a bad debt deduction? If you are an accrual basis taxpayer (see above) and reported the income previously, you could take the deduction. Likewise, if you lend money for business or non-business purposes, and that debt is legally enforceable (you have a valid promissory note or other evidence of the loan), and the debt becomes worthless, it is deductible.
You can deduct ordinary and necessary expenses to entertain a client, customer, or employee if the expenses are directly related to your writing, with some exceptions. You cannot deduct the cost of your meal as an entertainment expense if you are claiming the meal as a travel expense; you cannot deduct expenses that are lavish or extravagant under the circumstances (not usually a problem for a writer); and you generally can deduct only 50% of your entertainment expenses. You must have records to prove the business purpose and the amount of each expense, the date and place of the entertainment, and the business relationship of the persons entertained. For further information on record keeping, refer to Publication 463, Travel, Entertainment, Gift and Car Expenses.
The Home Office
The IRS loves to audit home office expenses, but for writers who live and write at home, deducting home office expenses is permissible if you strictly follow IRS guidelines. Briefly, your use of the business part of your home must be exclusive and regular, AND the business part of your home must be one of the following: a) your principal place of business, or b) a place where you meet or deal with clients or customers in the normal course of your business, or c) a separate structure (not attached to your home). To qualify under the exclusive use test, you must use a specific area of your home only for your writing, although the area used for writing can be a room or other separately identifiable space. (The space does not need to be marked off by a permanent partition.) You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes. EXAMPLE: You use your den to write magazine articles and also watch television. The den is not used exclusively for business and you cannot claim a business deduction for its use.
The amount of the deduction is based on the ratio of business usage to non-business usage of your entire home or apartment. For example, if 15 percent of your home or apartment is exclusively used as an office, then 15 percent of all household expenses, including electricity, rent, heating, repairs, insurance, and tips to your mailman, are deductible. You cannot, however, deduct home office expenses in a year in which your expenses are greater than your writing income - in that case, you can carry the deductions forward and deduct them in a year you do earn money.
If property you acquire for business use is expected to last more than one year (a desk, bookcase, computer or printer, for example), you generally cannot deduct the entire cost as a business expense in the year you acquire it. Instead, you must spread the cost over more than one tax year and deduct part of it each year on Schedule C. This method of deducting the cost of business property is called depreciation. The method for depreciating most business and investment property placed in service after 1986 is quaintly called the Modified Accelerated Cost Recovery System (MACRS), which is explained in IRS Publication 946. Alternatively, you can choose to deduct the entire cost of certain depreciable property in the year you place the property in service. This deduction is known as the "section 179 deduction." For more information, see Publication 946. It explains what property qualifies for the deduction, what limits apply to the deduction, and when and how to "recapture" the deduction (pay back the taxes you saved if you sell or dispose of the asset before the end of the asset's depreciation period).
A Special Tax Rule for Writers
Book authors often face special problems regarding business expenses. You may work on a book - incurring large expenses - years before your receive a contract or any income from which the expenses can be deducted. Does this mean you lose these deductions in the current year? Nope -- not since 1988, when Congress exempted authors and artists from the Uniform Capitalization Rules (26 U.S. Code Section 263A(h)), requiring the matching of expenses with income. What that means is that an author does not have to "capitalize," or accumulate, his project costs to be deducted in a future year, when the income is received. Instead, you are allowed to deduct your project costs in the year they are incurred.
The Retirement Plan Bonus
Fund that IRA! Contributions may be made until the due date for filing your return, not including extensions - April 15, for most taxpayers. The amount you put into an IRA comes directly off your total income. Your IRA contribution limit for the year 2006 is $4,000, or $5,000 if you are at least age 50 by Dec 31, 2006. This limit applies regardless of the number of IRAs to which you contribute for the year. Therefore, if you contribute to a Roth and a Traditional IRA, or multiple Traditional and/or Roth IRAs, the $4,000/$5,000 can be allocated among these IRAs, provided the aggregate contribution does not exceed $4,000/$5,000.
Alternatively, writers, as any small business, can set up and maintain the following retirement plans:
If you are a sole proprietor, you can deduct contributions you make to such a plan for yourself on line 31 of Form 1040. For more information on retirement plans for small businesses, see IRS Publication 560.
Net Operating Loss and the Hobby Loss Rule
If your Schedule C shows a loss, generally this loss may be used to offset other income on your Form 1040, and if the loss is large enough to wipe out all other income, even be carried over to prior or subsequent tax years. The issue of "net operating loss," however, is complex; most likely you'll need an accountant to help you. For further information, see IRS Publication 536.
Unfortunately, the IRS has a rule that can prevent you from using your writing business losses to offset other income - the "hobby loss rule." If you have losses in more than two out of five years, and/or you can't satisfy the IRS that you have a genuine "profit motive" (there are nine factors, see the IRS regulations at 26 CFR 1.183-2, which can be found online at www.irs.gov), your friends at the IRS will say your writing is a "hobby," not a business. The significance? Hobby expenses may only be deducted to the extent of hobby income. This rule is particularly onerous for writers, who often spend years on research before producing a book, and it has been challenged in the courts. If you haven't been in business for five consecutive years, however, you can file a Form 5213, and postpone the IRS' determination until after five consecutive years have passed. Of course, if that determination goes against you, you could owe back taxes for all five years. Your best bet, therefore, is to try to show at least a tiny profit in three out of five years, even if it means not taking all the deductions to which you are entitled.