190 FS Accounting and Taxes with Trevor McKendrick
02:42 - Trevor McKendrick Introduction
03:41 - Why do we have to care about taxes and accounting?
04:48 - Quarterly Estimated Tax Payments
07:05 - Deductions
08:48 - Forms
10:55 - Recordkeeping
12:45 - Freelancer Income vs Salaried Income
17:19 - Auditing
25:27 - Doubling Your Income and Taxes
29:27 - Deductions (Cont’d)
- Home Office Deduction
31:14 - Avoiding Self-Employment Tax with an S-Corp
33:16 - Categorizing Expenses
35:17 - Costly Mistakes
39:27 - Product Revenue
41:32 - Finding a Good AccountantPicks
AppSumo (Trevor)nathanbarry.com (Trevor)Accounting For Entrepreneurs and Freelancers Course (Trevor)Pu Erh Tuo Cha Tea Cakes w/Rose (Philip)Safari Books Online (Reuven)
Transcript
[This episode is sponsored by Hired.com. Hired.com is offering a new freelancing and contracting offering. They have multiple companies that will provide you with contract opportunities. They cover all the tracking, reporting and billing for you, they handle all the collections and prefund your paycheck, they offer legal and accounting and tax support, and they’ll give you a $2,000 when you’ve been on a contract for 90 days. But with this link, they’ll double it to $4,000 instead. Go sign up at Hired.com/freelancersshow.]**[If you're someone who runs your own service-based business, then spending less time on pesky admin tasks means having more time to focus on your clients’ work which is why you need to give FreshBooks a try. FreshBooks is the invoicing solution that makes it incredibly simple to create and send invoices, track your time and manage your expenses. It allows you to quickly see and track the status of your invoice expenses and projects, and allows you to keep track of your expense sheets in FreshBooks. For your free 30-day trial, go to Freshbooks.com/freelancers and enter the Freelancers’ Show in the ‘How did you hear about us’ section when signing up.]**[This episode is sponsored by Nird.us. Do you wish that somebody else would handle all of those operation details when it comes to hosting your client’s web applications? Nird.us is a Ruby on Rails managed hosting designed to make your life easy. They migrate everything for you, and new sign ups referrals come with a $100 discount or referral fee. To sign up, go to freelancersshow.com/nird, and enter ‘freelancer’ into the contact form for a discount.]**[This week’s episode of the Freelancers’ Show is brought to you by Earth Class Mail. Earth Class Mail moves your snail mail into the cloud giving you instant access 24/7 and integrates with the tools and services you use everyday. It’s crazy that we’ve moved everything we do for the business over to the digital world but still need to pick up, sort and manage physical mail. With earth class mail, you can get all your mails scanned and accessible online 24/7. You can search your mail, send invoices over to your accounting software, sync important documents into cloud storage, deposits checks and really just make running your business a whole lot easier. You also get real professional address to share publicly with customers, business partners and investors, and you’ll never need to worry about someone showing up at your door if you run your business from home. Visit freelancersshow.com/mail and you’ll get your first month of service free when you sign up.] **REUVEN: Hi everyone and welcome to episode 190 of The Freelancers’ Show. On this week’s panel we have Philip Morgan. PHILIP: Hey, hey. REUVEN: And we have a special guest this week. Our guest is Trevor McKendrick. Welcome Trevor. TREVOR: Hello. Thank you for having me. REUVEN: So Trevor, tell us all a little bit about yourself. TREVOR: Yeah. So –. REUVEN: I’m sorry. Did I say I was Reuven Lerner? I don’t know. I always forget to say my name when I’m hosting. Anyway, Trevor, go ahead. Tell us about yourself. TREVOR: Sure thing. My name is Trevor McKendrick. My background: I went to school to be an accountant. I have a Master’s and a Bachelor’s degree in Accounting. I was an auditor for a firm called KPMG, which is one of the "Big 4"; it's like the Google or Facebook of accounting firms, just not nearly as sexy. And I worked as an auditor for a couple of years, and then quit all that and started making my own iOS apps for the iPhone and the iPad, started a company doing that in 2012, grew that to over a million users, and sold that to a public company in California last September. And now I’m creating a course for freelancers, like yourselves and your audience, on how to do their taxes and their accounting. So that’s me. REUVEN: Ok. So the first of many naive questions is why do we have to know about taxes and accounting? Can’t we just hire an accountant to take care of it for us? TREVOR: Yeah. That is a really good [chuckles] – yeah, that’s a really good common question. And the reason is because by the time you hire your accountant, you're talking to your accountant, most of the things that you need to do, the time for that has already passed. Especially if you're just talking to your accountant for the first time; in that case, it’s February, March, April of the – after the tax year, and then you can’t do anything at that point. And not only that, but there's – if you don’t have a – say you're hiring a CPA to do your taxes, be it a bookkeeper, well then you have to know yourself how to classify transactions, because different transactions can be deducted in different ways, and things like that. So once you get bigger, if you say you have a couple of employees, or you have a successful product, and you have a bookkeeper, a CPA, an outsourced accounting function, then it’s more of a solved problem. But when it’s just freelancing and it’s just yourself, or maybe you're with a partner, it makes sense to know some of this stuff yourself. PHILIP: Trevor, in your experience, what are some of the more common misunderstandings that freelancers have regarding taxes? TREVOR: Oh, that’s a big bucket. The most common thing that has a lot of confusion around, and frankly, it’s the easiest one to solve and just figure out about, is – has to do with quarterly estimated tax payments. [Inaudible] you guys; I actually don’t know your background. I’m assuming you guys are freelancers or something along those lines? PHILIP: Yeah. I’m a solo self-employed person. I occasionally bring on subcontractors from time to time [crosstalk]. But yeah, I fit that freelancer profile in a lot of ways. TREVOR: Yeah. And so – I’m sure you’re at least somewhat familiar with quarterly estimated payments. But when people are first getting into this, or you got a couple of years in, they – there's a lot of confusion on “how much do I have to pay, and what – is it me paying or is it my business paying, and do I have to file quarterly or file annually” and – there's all these confusion. And the rule is basically, whether we know or whether the person knows it or not, we’re all in a quarterly pay-as-you-go tax system. It’s just normally our employers are taking care of that for us. They do the withholdings and they forward it to the government for us. So when you're self-employed, you're going to have to do that. Everyone has to do that. And so the rule to, just real quickly, to figure out how much you have to pay so that you don’t get penalized is take whatever you made last year as reported on your 1040 – and I have in my website how to find all these numbers – divide it by 4, and that’s your quarterly tax payment. The one exception is if you make more than $150,000, then you divide it by 4 and you multiply it by 1.1, and that’s your quarterly tax payment. And that’s just really a simple thing that [inaudible] I’m getting to the weeds here early on, but that’s a really simple thing to figure out that a lot of people seem to be confused about. REUVEN: We should probably stress, although it maybe goes without saying – I live in Israel, and I know we have many listeners from abroad, we’re talking here about US taxes, right? TREVOR: Absolutely. Yeah, yeah. It’s [chuckles] – I didn’t realize your audience was – I guess that makes sense more international. But yeah, taxes are complicated enough in one country, so yeah, we’ll have to stick to the US here. PHILIP: What other misunderstandings do you run into out there? TREVOR: I see misunderstandings about what to be afraid of. So people might be afraid to take all the deductions that they're entitled to, or they might be really afraid of an audit, when in reality budgeting for the IRS, you're in the US, has declined over the last couple of years; so not as many audits are being conducted these years right now. There's confusion – a common one is mis-class filing employees and independent contractors and things like that. It’s just there's a number of things that any freelancer getting into whatever business that they are, they should just be aware. It can save you a lot of stress and it can save you real money too, especially when it comes to deductions. Deductions save you both on your self-employment taxes and your income tax. So if you're afraid to take a deduction because you're – you think you might get audited or that the IRS might be upset, that’s a really – it’s a poor business decision to make, especially if it’s justified when you can back it up. You should be taking all those that you can. REUVEN: At the same time, though, you seem to be saying – I guess what you're saying that if a client pays me, say $5,000, then it would be really really foolish for me to go and spend that $5,000. I should be taking some of that and putting it aside because within the next 3 months, I will need to package some of that up and hand it to the IRS as part of my quarterly tax return or payment. TREVOR: Yeah, of course. Absolutely. You're answering the question yourself there. Anyone who gets a cheque, any cheque, from a client as an independent contractor when there's no taxes at all being withheld, you need to absolutely put some of that aside, not only for end of the year taxes, but for your quarterly tax payment as well. REUVEN: Well, does that happen? I know in Israel, for instance, every time I work with a client, I have to give them a special government form that says “you don’t need to withhold taxes because I pay my taxes”, and it’s something that I get from the government every 6 months or so, or a year or so, and my accountant gives it to me and it’s like – basically says they don’t have to, but otherwise, they would. Are there cases in the US when your clients would withhold taxes for you? TREVOR: Not that I’m aware of, no. There might be – I think I've heard of that when you're dealing with – if I’m in the US and I’m dealing with a foreign contractor, then there's specific rules for that. But if you're dealing with a contractor here in the US, generally that is – not generally – 90% of the time, that’s not the case. You just pay them, and then at the end of the year, [inaudible] take a step back – when you hire someone, when you pay them as a contractor, they should need to provide you – it’s called a W9, and a W9 is just a form that the IRS provides that lets them give you the information like [inaudible] or their social security number that at the end of the year will [inaudible] you issue them a 1099. And the 1099 goes to the IRS and it goes to them, and that’s what's the IRS know that “hey, this contractor received some income”, and so if – we need to be aware that they should be reporting this income on their own income tax statement at the end of the year. PHILIP: Trevor, what do you see freelancers who are successful at minimizing their tax burden do that others don’t? [Crosstalk] Is there some kind of insider knowledge? Is there a secret trick we should know about? What do you see them doing? TREVOR: That’s a really good question, and it’s not a secret. It’s not the super fancy trick; it’s just boring. And what it is it’s just having really good books, being really diligent with your record keeping. And so what does that mean? That means whether it’s you, you're doing it yourself or hiring a bookkeeper for 20 bucks an hour, but at the end of every month, giving your bank statement and your credit card statements and creating an income statement; classifying all of your expenses by category, classifying all of your income, and then of course, keeping the receipts to go along with those expenses in case they're – in the case of an audit. But that way, when you do it every month instead of scrambling at the end of the year, you're more likely to make sure that you have all of your expenses in one place. What also happens sometimes with some freelancers I've seen is something will come up; for whatever reason, they have to pay an expense from their personal account. They don’t have their business credit card with them or whatever the case is. And if you're not diligent with your record keeping, you'll forget about that expense. And even though you paid for it personally, it’s still deductible at the end of the year. And so the number one secret or number one way to make sure that you maximize on your deductions and have a really solid return is just by having really good records. PHILIP: Interesting. So those could be paper-ized soon, but a lot of that’s going to be online, right? Is there anything that I need to know about recordkeeping that’s not obvious? TREVOR: No, so – no, not at all. You can do it however you want. I would be surprised, frankly, if most of your records were paper. What I do personally is the only pay I have are my receipt, and I take a picture of those and upload them and store them on my computer or to the cloud, and then I throw away the receipts. That’s the only paper that I have. The best system is the one that you actually use, and so whatever it is that works for you, whether if it’s accounting software if you have more complicated books; if you only have a couple of transactions a month, you can do it in Excel. Whatever it is that works for you is, I think, the best way to do it. In your experience, what are some of the problems that you yourself or have seen other freelancers run into; maybe something that you wish you had known beforehand or things that you [inaudible] along the way? PHILIP: One of the things that surprised me when I was starting out was that you can be really unsuccessful as a freelancer and still owe taxes. I don’t know, that was almost a cognitive distortion about like I just thought if you were barely scraping by, you didn’t really pay taxes. Bur that’s not true, especially if [inaudible] business for yourself. It was really interesting wake up for me. TREVOR: When you say – you don’t think you – specific numbers, but when you say barely scraping by or not super successful, are we – what level of income are we talking about? Is this – were your expenses particularly high or this is the only thing you were doing, or – I guess, give a little more color on that. PHILIP: Yeah. In 2008, I along with other people got laid off, and I went into freelancing thinking “oh man, this is going to be easy. I get to be the boss. I don’t – I’m not going to make any mistakes like my previous boss did” or whatever; that was my attitude. And wow, did I make a lot of mistakes. A lot of them were around managing cash and marketing myself improperly, and some of them were around this idea that I was like “well, I am making probably” – like my first year of freelancing, I don’t have the number in front of you, but I guess I made up most like half of what I made as a full time employee; maybe a third, even. It was terrible. And so, it was – in my mind, I was like “wow, I’m just above the poverty level here”. In reality, I was well above the poverty level, but still it felt – I think that’s where the cognitive mismatch came in. I felt like I was scraping by, but by IRS standards, I was making some money. And so taxes were owed. So it just took me a while to realize that I needed to be making tax payments. I make them every month. I make estimated tax payments monthly because – even quarterly is just too long of a horizon to manage that cash easily. TREVOR: Sure. And that’s an interesting point that you bring up about comparing your freelancer income to a salary income because they're really apples to oranges for a couple of different reasons. One, freelancer income, you're going to have deductions and expenses that net against it. So your actual income as reported to the – or I should say your actual income reported to the IRS is going to be lower than your freelancer income because you're going to have some expenses. But at the same time, whatever income you have left over are going to have more taxes taken out of it because you're paying both sides to the self-employment tax. And I know there's a lot of people talk about self-employment tax and it’s 15%, “why is it so high”, but really it’s, as an employee, you're paying – it’s around 7 ½ percent payroll tax, and your employer pays the other 7 ½ percent. But when you're self-employed, you pay both of those. And so comparing freelancer income to a salary income isn't always a great comparison because more taxes are generally going to be taken out of a freelancer income when it’s reported to the IRS. PHILIP: That was a huge realization that took about, I can say, about 3 years for me to come to terms with, is it – my only point of reference prior to that was working for the man, and so when I entered the world of freelancing, the whole idea of how you look at revenue and understand what's enough and all that just took a while to figure for me. It was really interesting. TREVOR: Absolutely. One of the benefits, though, of being – and I want to ask about this of being a freelancer and being a contractor is that all of a sudden, you are exposed to, in a good way, exposed to business deductions for things that as a salaried employee, you were not able to take, whether that’s a home office or your cellphone or your computer gear or all the software that you buy, all these different things that are required to do your job. How have you been in making sure that you get those deductions over the years, or have you been more aggressive, or have you gone with the advice of an accountant or just figured out in your own? How have you gone about figuring that out? PHILIP: Well, that’s an awesome question. If you're trying to take a while, and I think again, getting back to that beginner’s mentality, at least for me, the whole idea of the IRS was kind of terrifying to me. The fact that they could insist on an audit of your tax filings or whatever, that was kind of a, in my mind, this monster that you wanted to avoid at all cost. TREVOR: Sure. PHILIP: Nowadays, I don’t see that as a horrible thing because I assume as that happened, you could get the option of just refilling your taxes for that year. That would be an interesting thing for you to clarify if you feel like it. But your question was about level of aggressiveness, and I would say I’m on the higher end of the aggressiveness scale now when it comes to working at things as a potential expense for my business or not. So I’m pretty hip to that, or least aggressive about it. But it took a while to get there. And part of it was just because of this idea that your life would be over if the IRS decided to audit you. TREVOR: Yeah. I’m an accountant and I still feel a little bit of that because it is – it’s like very abstract – I don’t know – Big Brother or something, kind of all-powerful force in the background. You read about the IRS as more access, more powers that almost any other agency of the government. And it’s true. If you owe the tax, they're going to get it from you one way or another. That’s just going to happen. But in the flipside, audits don’t happen I don’t think as often as people think. Roughly, right now, I've got 1% of returns get audited every year, and that’s weighted more towards the higher end of income. And that’s just a practical reason, is that the IRS, they have limited resources, and so they're going to go after returns where there are most likely to get the biggest bank for their buck. PHILIP: I would venture to guess most people actually do not personally know someone who’s been audited by the IRS. And so any –. REUVEN: I’m sure I do. I know I've heard stories of people I know that I couldn’t name – not that I’d do on the podcast, but [inaudible] – but I do remember hearing stories here and there. And they seem pretty horrible, and they're mostly horrible in the sense of suddenly you have to get all these paperwork together that you no longer knew or cared about. And so [inaudible] every – so again, I know it’s a different system, but here in Israel, you have to keep all of your paperwork for 7 years so that the – if the government decides to audit you. And so every year, when I go and sign off on my taxes and so forth with my accountant, either then or about a month or so later, he says “ok, time to pick up your paperwork” and I've this ridiculous number of binders full of paper from the last 7 years so that if and when they come and audit me, I can say “look, I have my paperwork in order”. And of course, what would really happen is they would talk to my accountant because I would have no idea what to tell them, but at least having it is better than not having it. TREVOR: Yeah. And that goes back to being really diligent in your record keeping, because for me, fortunately, all my stuff is electronic. So if I ever got – I’ll keep my stuff for 7, 10, 20 years, but it’s just more zeroes and ones in my hard drive, so it’s no big deal. But what's more important, at least, I think for me and a lot of people is having good records to rely on because after 2 or 3 years when the IRS comes to audit you, and you look back and overturn “oh my gosh. And I've gone through this” where it’s just “I don’t remember doing any of this. Where in my brain is this memory stored because it is not here”. But the thing is it’s funny that you mentioned about everyone – or not many people know someone who’s been audited, well, when we think of audit, like a capital A, audit, we think of the IRS plying their people outdoor or home or offices, sitting with us and interviewing us, and maybe one of the agents got a gun or something crazy. And that’s the extreme movie version of audit. And yes, those do happen. But a much more common form of – at least in the US there's a different types audits. And there's 3 – well, there's 4, but there's 3 one that people should really know about. And one – we’ll start off with the really serious one, and let’s call it field audit, and that’s what I’m describing as where they come after your home or office, they sit down, they want to see your whole return, they want to see all the documentation, and it’s a really aggressive thing, and it’s as scary as it seems, but it is very rare and it’s mostly for cases where they're either making a lot of money or there's some really fishy stuff going on. And then the second level is when you have an office audit where they ask you or command or – I guess it’s in the government; they tell you to do it, but you go and you go to the local IRS office to meet with them. And they want to see a couple of – I want to say documentation for a couple of deductions or transactions. They might want to see the whole return, but it’s more like they just want to see a specific part, and they want to see the documentation, you go to them. And then there's the highest level or the lightest level of audit, which is – we just call it a correspondence audit, and that’s literally just a letter in the mail from the IRS. And that same “hey, we think you owe this much more. Either pay it or prove that you don’t”, or instead of demanding payments, sometimes it’ll be “can you send us in this documentation”. And so that counts as an audit, and I bet you more people have gotten one of those letters from the IRS than most people realize, but at the same time [inaudible] exactly talk about with people, a, and b, you don’t really – this don’t really feel like an – you don’t consider it an audit. But it happens to people, and again, this all falls under the 1% [inaudible] that I was mentioning earlier. But that kind of stuff happens and there's no reason to freak out. If you're doing your taxes correctly and you have the documentation, you're going to be fine. PHILIP: Yeah. I've had the privilege of dealing with the IRS quite a bit because of how much of a dummy I was when I started working for myself. So I've done thing – I've filed the often compromised for back taxes, but I've been further inside the bowels of the IRS than I suspect a lot of people have. And after all that experience, I feel like we – to me, I would personify the IRS as a polite older gentleman who’s extremely fastidious and does everything at about the slowest possible speed you can imagine, like walking with a cane. Their customer service reps are better trained and more polite than most I've ever dealt with. Apple’s the only company where I've had a better customer service experience over the phone. And they just –after all that experience, I don’t feel like they're out to get me. I feel like they're out to make sure they don’t lose their job by accidentally granting somebody an exception they're not entitled to under their very complex rules about things. So it’s actually – I have a much positive feelings about IRS than I do about – I don’t know – Dell computer – [crosstalk] – Comcast; there you go, yeah. I’d rank the IRS way above Comcast in terms of customer satisfaction. REUVEN: Yeah. I had to deal with them years ago. It’s probably a good 6, 7 years ago already. And I was dealing with an American client and I had to call the IRS because I still have to file American taxes even though – because I’m a citizen, but I live abroad. And I was really surprised by how easy and decent they were to deal with, and they said “oh, you need these documents?” I think they had – what is it that you get that’s like contractor – I think it was a W9, you said – they had them all on file, and they could just email them to me. And I was really quite impressed. TREVOR: Yeah. I think it goes to – it speaks to the point of they're not interested in hurting you; they're more interested in getting to the truth so that they can save their jobs. The entire accounting profession and legal profession in most big companies and organizations operate under a CUIA philosophy. I expect most of the IRS to be the same way. PHILIP: Trevor, I've got a question on a slightly different note. What if someone becomes dramatically more successful in the course of a year? So they're a freelancer or – [inaudible] you may have some experience with this in selling a company, but same thing could apply to a freelancer. You're chugging along, things are flat, and they figure some things out, and all of a sudden their income doubles or something like that. What kind of problem should – not problem – what things should they be on the alert for with regard to their taxes now that they have this new more prosperous revenue situation? REUVEN: Let me jump in for a second and say this just happened to me this week [chuckles]. PHILIP: Congratulations. [Crosstalk] REUVEN: Right. So basically, in last year, I told the training company through which I was working that I will stop working with them and I was going to go back to doing training directly with companies, and I’m very happy to say that the companies decided to move to dealing with me directly, and my income, more or less, doubled overnight because instead of this training company taking a cut, I was now getting all the money, which was great, except that my estimates – and again, it works a little different in Israel, but my estimates were based on what I've been making until October or say November. And so my accountant called me 2 days ago or 3 days ago, and said “I don’t know. What happened to your – our estimates for your annual income were just completely off. You owe a lot of taxes for 2015 now”. And so we’re doing an initial payment, we’re doing some installments, but this can definitely happen, and as you said, it’s a good problem to have. So I’m curious to hear how many have actually prepared for this as opposed to getting a surprise call? TREVOR: Yeah. I don’t how it works in Israel, obviously, but in the US, literally, there's two things to do. One is [inaudible] about quarterly estimate tax payments. So if in your quarterly estimates, if you pay 100% of the tax that you pay in the prior tax year – so let’s say 2014 you pay – let’s just say you paid $20,000 in taxes. In 2015 you have an amazing year. You sell your company for a hundred million dollars, and you have no idea what to do with your taxes, whatever, whatever. If you pay in quarterly payments in 2015 the same $20,000 that you did in 2014, you won’t get penalized and won’t have to be any interest on late payments; that is the rule of the IRS, so that’s one. Number two is, and this is an easy fix because you have the money, but number two is just don’t spend all your money. You made a bunch of extra money, set some of it aside for the tax bill at the end of the year. So I can tell you my case; I sold my company – it was just me and a bunch of contractors – I sold my company for half a million dollars last year, and on the high side, I estimated my taxes are going to be 100K for that. So I have 100K just sitting aside in a bank account that is ready for the tax man when I file in a month or two. Is it going to end up being that much? I don’t think so, especially if you take away the quarterly payments that I made for last year, but just set aside – it’s ready for the tax man and we just have to file and then I send them the payments. And as long as you do those two things, you're going to be fine. That’s what I would recommend here in the US. PHILIP: This gets a little, I suppose, political, but I love how my wife refers to the IRS as our business partner. They're not really – to me, it helps if you think of it that way because in some way, that money is creating an environment where it’s somewhat friendly to business here in the US, especially relative to places in Europe and so forth. So that’s how I like to think about that. It helps me mentally part with that money aside from being legally required to. TREVOR: Helps you part with it in the sense that – [crosstalk]. PHILIP: Oh my god! [Inaudible] to my business partner. They earned that money [chuckles] TREVOR: That’s a – that’s a very – yeah, European take on paying taxes. PHILIP: So how aggressive can you be with these deductions? TREVOR: Oh, there's whole books written on the topic. I think the best way to maximize your deductions in a legal way is to – I know I keep preaching the same song here, but it’s to have good records and have your expenses classified correctly. Because if you have your books in order, and you all of your expenses classified whether it’s office supplies or marketing or your utilities from where you work whether it’s home or an office, and travel, and all these different things. If those are all classified correctly, then you don’t have to know all of the rules, you don’t have to know how all the deductions work, then you can actually go to an accountant like you should at the end of the year and say “here's all of my actual expenses”, and you can ask them “which – taking some of these, what would the – let’s be more aggressive or less aggressive or what are the rules for these different expenses”, because some expenses are deductible and some aren’t, and there's all these nitpicky rules that, as a freelancer, you don’t want to have to learn or know about; you just want to go to an accountant and have them help you out. And so, again, it comes back to just having – keeping track of your income and your expenses and then doing really good books. I will say one thing that people sometimes overlook is the home office deduction where if you work out of home, the IRS lets you deduct either some of the utilities and rent or mortgage interest in your home, or there's a formula that calculate the square footage of your office. It’s an easy one to do. It’s also you're more – slightly more prone to be audited [inaudible] deduction, but it’s one of those things that it’s easy to do, it’s right, it’s legal that you can easily figure out, and it puts a little bit of extra money into your pocket. PHILIP: Yeah. I've heard that that’s like a sort of an indicator that you're more likely to get an audit. Are there other things that are –? TREVOR: Yes, there are, actually. Another more common one is if you – and we’re really going to get into the weeds, but if the entity that you – if your business entity is an S-Corporation, raising freelancer set up S-Corporations is to save on self-employment tax. So the way it works is that say your company and profit makes $200,000 in a year, normally you would have to pay self-employment tax on the whole 200K if you were just giving yourself a distribution. But if you instead set up an S-Corp and pay yourself a “reasonable salary” whether that’s 50K or 100K or whatever it is – let’s say it’s 75K, then you only pay self-employment tax on 75K and you take a distribution on the reaming 125K. And that 125K is not subject to self-employment tax. I know this is a lot of numbers and boring stuff to listen to in a podcast; I apologize, but to answer your question, because this is such an easy and fairly common way of avoiding self-employment tax, and it’s correct to do, but sometimes people will be too aggressive and they will pay themselves – instead of saying salary at 75K or whatever is actually reasonable, they’ll pay themselves 10K or 20K or 5K. And the IRS, especially in the last couple of years, has really started to nail down on those and to go after people that aren’t paying the proper amount of self-employment tax because they're not paying themselves high enough of the salary. [Crosstalk] Have you heard of that before or is that totally new to you or somewhere in between? REUVEN: I've heard of something similar. My wife and I own our company, and I have an employee also, but basically, my accountant has made it clear that we can’t just arbitrarily raise my salary and my – we can’t arbitrarily raise my wife’s salary so that the taxes are split up. You said [inaudible] you have to be realistic because the tax authorities will notice what people are supposed to be paid and how much you're actually paying them and you have to be reasonable about it. TREVOR: Yup. PHILIP: Yeah. I've heard the same sort of thing here in the US. Back to the categorization of expenses, how granular should you be? Let’s go do an example. Let’s say that someone buys a computer and a little stereo system for their office, and some furniture, and they paint the office as well; are all those office expenses or should they be categorized separately? TREVOR: Yeah. That’s a tricky question. I don’t know if I have a great answer for this on how to figure this out on your own. I think the best strategy if you're really bootstrapping it and want to do your books by yourself, and maybe you have an Excel spreadsheet or whatever, you're keeping track of things, is make it as – and you don’t want to make it too granular or – too granular is just a list of transactions; it’s not useful. And then too narrow, of course, is not useful than you might be breaking some deductions with the IRS. And so I would do your best – use common sense. If you're buying a chair for your office, that’s going to be office expense or furniture expense. If you're traveling on business, that’s travel, but it could be claimed hotels and travel and meals and all that. And really, unfortunately, I think the best answer to this is if you're not hiring a bookkeeper, at least talking to a bookkeeper the first couple of months when you go through your transactions – and bookkeepers are relatively inexpensive especially compared to CPAs. I would almost recommend you getting a bookkeeper just always in general to do your books, but if you're really trying to don’t want to pay the extra 20 or 30, 40 bucks a month, just do it yourself. I would try and do it yourself, tag the things that you're not sure about, call up a bookkeeper and say “hey, can I talk to you for an hour? How would you do this?” and then you can learn that way going along. Because this is – it is hard. It is hard to get this 100% perfectly right if you're not an accountant, if you don’t know how the IRS looks at different categories and things like that. So I would say, first to tackle is common sense, and then talk to a bookkeeper on the [inaudible] if you don’t want to hire someone. PHILIP: Cool. Here's another annoying question [chuckles]. What are the mistakes that are most costly when it comes to taxes in general? I imagine this may overlap with some of what we've already talked about, but are there other big landmines people should watch out for? TREVOR: Most costly – I’m just trying to think here. The worst thing you can do is not report income and then be audited and then have to pay interest and penalties on missed income. I’m trying to think most costly; this is specific to developers and it’s kind of niche-y, but one thing I've heard of is, and as a iOS person myself, I've seen this happen where – and [inaudible] actually just developers, but when you get paid – when you charge someone through PayPal or Stripe or you saw an app in the Apple’s Appstore or Google Playstore or you use Square, there's this new form that started a couple of years ago called a 1099-K that the merchant has to provide to the business owner. And what's tricky about this 1099-K is that it reports on the gross. So for in the example of – if you use – you guys [inaudible] Stripe? PHILIP: Yup. TREVOR: Ok, so if you use Stripe to – say you have an e-commerce store and you Stripe, so Stripe is going to take out their cuts and they're going to report the gross. Same with Apple; Apple – say you sell an app for $10, Apple keeps $3 and they give you $7, but they're going to report the gross of $10 to the IRS. But as the recipients of the cash, me personally and most of the developers I know, we don’t even think about the extra $3. We don’t think about the Stripe fee. It doesn’t even enter our mind. We don’t even include it in revenue, on our income statements. But because of this 1099-K, that’s incorrect. You have to report the gross and then show the expenses as the Stripe fee or the Apple fee or whatever it is. And that’s the same amount of tax, but you have to show those fees. And to answer your question, the reason this can be costly is because you’re – in the case of Apple and Google, if you don’t report the gross as income, then you were underreporting your income by 30%, and then the IRS freaks out – yeah, and it’s not something like that’s going to be difficult for them to find out. They are literally – the IRS gets the 1099-K; it says the number, they [inaudible] in the computer, they compare it to your number, it’s up by 30%, and they come talking to you. So it’s not a difficult thing for them to figure out. So that’s a specific thing that can be really costly. And to be honest, I've talked to people [inaudible] this problem and they freak out; they go talk to an accountant, the accountant sends a nicely formatted well-worded letter to the IRS explaining what happened, and I hear the people – they get [inaudible] – and again, don’t be so afraid of the IRS. If what you actually – if what happened to you was a real expense and you just didn’t report the expense along with the income, then you're probably going to be ok. But it’s just something to be aware of that you just can avoid upfront. PHILIP: Interesting. REUVEN: I actually had to deal with – I've had to deal with the exactly that [inaudible] my ebooks. I sold them through Gumroad [inaudible]. And [crosstalk] – and so I have to report not the amount that they – actually, I’m trying to remember. I actually am trying to remember that now. No, I was thinking actually of when I get bank transfers from companies abroad, I have to report how much they paid, not how much I received. I should probably check on Gumroad. Aha. [Crosstalk] The IRS doesn’t lift [inaudible] [laughter]. PHILIP: That’s going to be a giant pain. I was aware of that fundamental problem, and a large part of my services revenue gets handled by either Stripe or PayPal. I have not cashed a paper cheque in a long time [chuckles]. It becomes troublesome because a lot of the reports that you're getting from – I use SendOwl rather than Gumroad, but it’s the same idea. And so you get reports that show you both the net and the gross, and it just becomes something you have to think about every time you deal with those numbers. But I think that brings up an interesting question of is there something fundamentally different about product revenue? I know a lot of freelancers just are dreaming about bringing in some stream of revenue that doesn’t depend on their time, and does that change anything fundamentally when you start getting product revenue in terms of your tax situation? TREVOR: I don’t think so; not fundamentally. It’s a – providing services, you're probably going to be getting a bunch of 1099s that if you're selling products, you don’t have to worry about. But as far as dealing with reporting income or reporting on expenses, no, there aren’t going to be any significant differences there, at least off the top of my head. Same with most businesses, income is income, and your expenses are your expenses. It’s generally – especially in this freelancer selling services, selling products areas is going to be pretty similar. PHILIP: That’s good to know. TREVOR: Yeah. And going back to the Gumroad and the 1099-K issue, it’s been alarming because it is this new form, and a lot of times you're not sure if the provider has the wrong number or if you just didn’t know what the right number is, and it can be a little scary at first. And I encountered this last year, but when ended up happening is we initially – we filed one return, and then after the fact, Apple sent me this 1099-K and so I had filed a return that underreported my income by 30%. And so my accountant, apparently, he – thankfully, he had a lot of clients in a similar situation with this one. He was like “oh, no big deal. I’ll just re-file”, and he bumped up the revenue, he bumps up the deduction by the same amount, [inaudible] stayed the same, which was making sure that you include it in the return. So at first, I was terrified and scared that we’d file my return incorrectly, and to my accountant it was no big deal, and he took care of it in a day. I think a) speaks to – again, don’t be afraid of the IRS if you're doing things correctly, and b) make sure you have a good accountant that you like and you can trust. Speaking of which, how did you guys find your accountants? What was – I hear most people go through a couple of accountants until they find someone that they like. I don’t know if that was something that you guys went through, but how did that process work? PHILIP: I just want to briefly say it’s good to hear that a former CPA is also sometimes terrified of the IRS [laughter] [inaudible]. TREVOR: Yeah. I think it help [inaudible] good when you're doing your taxes. [Chuckles] REUVEN: Philip, you go first. How did you find your accountant? PHILIP: I don’t have an accountant. REUVEN: Oh boy, that was easy [chuckles]. [Crosstalk] TREVOR: There you go; impressive. You should be doing this podcast, not me, man. You got all [inaudible] yourself. PHILIP: I think if people followed my advice, they would also be in a lot of trouble sometimes [laughter], I mean on taxes. REUVEN: My situation is a little complicated. I’m a US citizen so I have to pay US taxes. And before I moved to Israel in 95, I knew I was going to set up as a consultant, and I found out that even if you're living abroad, you have to pay US taxes. That’s not only true for taxes, but it’s true for self-employment tax if you are self-employed. And so the number one thing that I was told was don’t register, and you have to register in Israel as self-employed. Rather, form a company and be an employee of that company, and then you don’t have to pay yourself employment tax. But in order to do that, you have to get an accountant and you have to go through all sorts of [inaudible]. So when I first moved to Israel, someone suggested “hey, why don’t you talk to – someone he know – he’s an accountant”. And I was with him for a few years until I got married and moved to a different city. And he was really nice. But now, I see he really made some bad decisions for me. And my current accountant, he has a medium-size office, he has probably 15, 20 people working for him. And so I've – my bookkeeper who’s not just working for me, working for a bunch of other people, but she knows me and my business really well, and I basically dump her a lot of paperwork every month. And the accountant himself is with a high level staff for when I have questions. Now, is he really doing a great job? It’s hard for me to know, but they seem to be on top of things, and when someone said to me “oh my god, you're paying so much for your accountant”, and I looked around, I could not find anyone who is cheaper who would also offer me the same level of service. So I feel in many ways that finding an accountant is – I am in the same position now as many of my clients are. They don’t know how to evaluate, at least if I'm doing software work, if I’m doing good job or not. So I get good vibes, he seems responsive, he has good people on his staff who would do – who haven’t messed up too much so far; yeah, I’ll keep going with him, sure. TREVOR: Yeah. I feel like 70% of what you're paying in an accountant is peace of mind, is “do I feel – are they actually taking care of any” – I was going to say the exact same thing that I feel – trying to evaluate a developer when you know nothing about code is impossible. How do you know how good they are? And it’s the same when you're talking to an accountant and you don’t know anything about accounting. Yeah. It can be hard to find a good accountant. What I found in the US, at least to be a pretty good way of evaluating people is – ideally, your accountant has either clients in the same industry as you, so this is an area that they're doing with frequently, and so one of the ways that you can really evaluate whether it’s true or not is by asking them questions that are very specific to your business and kind of getting into the weeds, and seeing – really just testing their knowledge. Because obviously, you know your business better than anybody, and an accountant who has multiple clients in the same field as you, in the same industry, should also be fairly knowledgeable. And if they're not, if they're having [inaudible], if they're speaking too broadly, then they might not be a great fit for you. So that’s one thing that I recommend when people are looking for accountants. REUVEN: I’ll say about it also of Philip [inaudible], during the 4 years we lived in Chicago when I was doing my PhD course work, I said “oh no, I have to worry about US taxes. I know. I’m above average smart guy. I’ll go buy TurboTax, and I’ll just do my taxes that way”. Oh my god. It was hell on earth [chuckles]. And I’m sure I did everything wrong. And the – basically, I’m in awe that you do this yourself. I did it myself when I was 19 and my total savings was like $200 and I had no real income. But as a real person to do my taxes, that was one of the hugest mistakes I made as far as I’m concerned when I was living in the US. TREVOR: Yeah. Software is really – this is speaking for me. I use TurboTax for a number of years, too. And it’s really good until you start getting into like idiosyncratic – living in Israel as a US citizen, yeah, I would not – definitely not use TurboTax for that. PHILIP: I should say I have a very simple tax situation. I don’t have a depreciating assets and stuff like that. TREVOR: Exactly. And so yeah, the more straightforward the tax situation, the more sense a software solution can make. Reuven, would you – what – I don’t know how familiar you are – obviously, you're a US citizen, but I’d be encouraged to hear about the tax and the business acumen of the two countries. How do they compare? How does it compare working in the US versus working in Israel being self-employed and dealing with the two different regulatory environments? REUVEN: The first accountant I mentioned when I first moved to Israel asked me [inaudible] “ever run a business before?” and I said no, and he said “good, you'll think the way we do it in Israel is normal” [chuckles]. And it’s true. It is a totally different system. First of all, basically, if you receive any income, by Israeli law – and I’m sure there's some threshold, so [inaudible] don’t do this, but you have to register as self-employed with the government, which basically means you are a business. I forget exactly what the term is in the US, but you're a business and you then have to report to the government your income. And if it’s above a certain level, then you have to take that, which is like sales tax in many ways. So it’s more or less illegal to accept any money from anyone, even if it’s like you just want to help someone out; it then becomes this whole affair where someone needs to fill out the tax forms, and it’s a pain. But if you got a business like I do, not just self-employed, then I set up a company and I have to report to three different tax authorities every month or every other month, depending on the size of the company; one is Income Tax, one is VAT – again, it’s the sales tax type of thing – and the third is National Insurance, which is like Social Security. But once you get it set up, it’s really very smooth. The calculations – everything is computerized now. So when my accountant called me 2 or 3 days ago and said “listen, you need to make this tax payment”, I said “oh, well I guess I can do the bank transfer”. He said “no no no, we are hooked up – we, your accountant, are hooked up through the tax authority and to your bank account, and we can just do that and it will be done within the day”. So everything is finally automated, highly computerized. I actually have no idea how easy or hard it is to deal with the government offices unlike what we’re talking about the IRS before because I don’t deal with them directly. My accountant does all that, but the bonus there is they deal with them all the times so they know the people and they're familiar with them. TREVOR: Absolutely. That’s absolutely true. REUVEN: And basically, if you – yeah, yeah. Where things start to get complicated, or it gets more complicated, is if you work in more than one place; the other thing is Israelis never file tax returns. And it’s not because everyone a [inaudible] law, it’s because the only people who have to file tax returns each year are business owners and the wealthy. So your average Israeli never files anything at all. TREVOR: Even thinks about it. REUVEN: Right. It’s all taken out of source. TREVOR: Interesting. [Crosstalk] TREVOR: Go ahead. REUVEN: If you're working in more than one place then, then you have to file a form to the governments saying “I work in more than one place, so you should take out less in the second because it’s the higher bracket”. [Inaudible] TREVOR: Yup, yup. It’s interesting because – I don’t know if you guys have heard about Estonia’s e-residency in the way they do taxes, but basically, every citizen of Estonia is given an ID, and basically, every transaction that that person experiences, whether they're in their business or personal or whatever, it all – it’s all tracked by the government. So doing their taxes at the end of the year is literally like clicking through 3 different buns and they're done with their taxes. To which to me in the US sounds like amazing, but then you have, in the US at least, you have these – and I -guess we’re going – I’m going off topic here, but people that are privacy-prone, I guess, and so the idea of all these information being tracked by the government outrage them and frustrates them and –. I can see both sides, but it does seem like just a dream world where filing the taxes in the US is just such a nightmare. I have an old accounting professor [inaudible] stubborn, do their own tax and it takes him a day, and he [inaudible] a PhD in tax or whatever; but this is crazy. This doesn’t make any sense. So yeah, it’s – one of the – I love the US, and there's lots of great things about the US, but our taxes I don’t think is one of our strengths unfortunately. REUVEN: In terms of privacy ID – basically, if I go to a government office, I show my ID card. As opposed to in the US, I remember when I had to get a driver’s license there, you carry basically a suitcase full of documentation so that the combination of them is your ID as opposed to – because no one wants to have an ID. So, anyway. I’m sure if Chuck were only here [inaudible] about how good that is, but ha ha [inaudible]. [Chuckles] TREVOR: He lives in [inaudible] Utah, is that right? REUVEN: Somewhere around there, I think, yeah. TREVOR: Yeah. I lived – I went to school 10 minutes away from where he lives, so I can almost – I could be his side of [inaudible]. REUVEN: Any other questions or comments, things people should know, or maybe – you know what, Trevor, maybe are there any resources people can and should look at when they're running their own business, like good books or websites? And if I’m stealing you’re your picks, then I’m sorry. TREVOR: Oh yeah. I was actually just going to go over my picks. Can I just do that? Is that ok? REUVEN: Sure. Philip, do you have any more questions for Trevor? [Crosstalk] TREVOR: [Inaudible] I realized the picks are definitely at the end. I apologize. REUVEN: Oh yeah. Otherwise, the podcast authorities give us trouble. [Laughter] PHILIP: They audit this podcast [chuckles]. I rest my case and I’m done with this cross-examination, and we can move on to picks. TREVOR: Great. So yeah. So I have just three picks. One is a company called appsumo.com. They sell discounted digital products to entrepreneurs and freelancers; all sorts of different things. They're run by a guy named Noah Kagan who’s an early Facebook play. So you can go to appsumo.com. Another pick is nathanbarry.com. He sells a lot of different things. His most recent company is called the ConvertKit and they do really great simplified automated email marketing. I don’t know if you guys have heard of him. His company has shot through the roof in the last year. It’s a pretty remarkable story. I use his stuff or I use ConvertKit for my email marketing. It’s like Infusionsoft, but about a hundred times easier to use. And then, if you don’t mind, I’ll pitch my last thing. If you go to my website, trevormckendrick.com, I’m creating a course specifically for developers for them to learn about taxes and accounting so that they don’t get stuck with a huge tax bill. So you can go just check that out. I also talk about, specifically for developers, how I made my apps, how I sold them, how I signed license and deals with the content owners of these big publishers and a bunch of different things that people seem to like over the years. So those are my three picks. REUVEN: Excellent. Philip. PHILIP: Ok. Coffee drinkers who want a coffee experience in – from the world of tea leaves, this is for you [chuckles]. I like Pu-erh teas. They're sort of a fermented tea leaf. And particularly, I like the cheap low-end non-fancy Pu-erh teas which – it’s kind of gross; I think they're – if you imagine a bunch of tea leaves and making a compost pile with them, and then letting them sit there for a while, and then package them up and selling them to people like me, that’s kind of what Pu-erh tea is like. But it’s got this rich smoky taste, and the fancier it is, the less I like it because the – it’s kind of lighter and more delicate tasting. I like, if I’m going to have some tea, I like it to kind of remind me of coffee. And I’m going to put this link in the show notes. It’s a link to something by LuxTea. It’s this little cakes – that’s the other thing about Pu-erh tea is it gets pressed into these cakes. Some of them are quite big and it break off a little bit and make your tea with that. These are individually wrapped. They are artificially aged, meaning they're aged with heat rather than just putting them in a big compost pile. And they are awesome. So that’s my pick for this week. Check the link in the show notes if that sounds appealing at all to you, because when you brew these things, they come out super black like coffee. REUVEN: Ooh. Sounds [inaudible]. I’m a tea drinker, so that sounds attractive. PHILIP: Nice. REUVEN: So for my pick – my pick is a Safari Books Online. And I only recently decided to give it a shot, and the reason is that many, many years ago when I started my column for Linux Journal, I have a friend who was doing a magazine column, and he told me that one of the great perks about running a magazine column is you don’t actually have to buy books. You can contact publishers, and assuming it’s actually in the field that you're writing about, you could say “look, I write this magazine column. I’m always interested in finding new books to recommend to my readers and review”, and assuming you actually do review them and assuming you actually do mention them, then they're happy to keep sending you books. Over the last years, publishers have gotten, shall we say, stingy and stingier with doing that, and so whereas my bookshelves are full of slightly greying and [inaudible] dingy books, they don’t have as many new ones. So I've actually started to buy more and more books, especially ebooks. And I finally realized now, people keep talking about Safari. I heard about it when it launched all so many years ago; I should give it a shot. And I am really impressed. Maybe I've only been using it for 2 weeks now, and I will find all sorts of holes in it, but they have an incredible library of stuff. It’s not just O’Reilly; it’s really a very large wide variety of publishers. Even the facing is pretty good. For those of you who are not familiar with it, it’s basically like a Netflix for technical books. So you pay a monthly fee, or an annual fee which gives you a discount, and then you have access to just a huge, huge, huge library of books that you can read on your browser or on a mobile app. And again, I've been researching stuff for courses that I've been teaching, and I feel kind of foolish for having bought a bunch of books over the last month because I could’ve just done them through Safari. So it’s definitely worth a look if you enjoy reading and [inaudible] lots of technical stuff. And I guess that brings this episode to a close. Trevor, thank you so much for joining us and giving us lots of insights into why the IRS is not scary [chuckles] and other things we could do to take care of our businesses. And thanks again, and we will see you all next week.[Hosting and bandwidth is provided by the Blue Box Group. Check them out at BlueBox.net.]**[Bandwidth for this segment is provided by CacheFly, the world’s fastest CDN. Deliver your content fast with CacheFly. 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