“If you need to borrow money, the IRS is not the place to do it."
-Martin Whitaker
photo by Tax Credits
My good friend Martin Whitaker is both a CPA (certified public accountant) and an excellent drummer. In addition to managing his own playing career, a portion of his accounting clients are fellow musicians. In Part 1 of this interview we discuss how to start your tax return, what changes when you become a self-employed musician, how to estimate your future tax liabilities, and good record keeping. Stay tuned for more upcoming interview segments.
Martin Whitaker Interview
BD: Martin, what are the legal and practical limitations for the advice you are about to give?
MW: Everything we’re going to discuss is intended to be used for general information purposes and should not be relied upon as advice in preparing a tax return. All tax returns are unique by nature, but the things we’re going to discuss are general in nature. They may give you some guidance in terms of what kind of informative questions you might want to ask your tax preparer or give you a general idea of things you might want to consider if you’re preparing your own return. Of course, I always recommend the use of a competent, professional tax preparer whenever possible.
BD: So how does a musician begin to file his or her taxes? Where do you start?
MW: I think the best place to start is just to understand that musicians typically tend to earn income in several different ways. They’re not like the guy that works down at the factory who receives a W-2 from his employer reflecting the only income that he earned the entire year. Musicians tend to have a variety of jobs. In some of those jobs, you’ll be considered an employee. In others, you’ll be considered self-employed. If you are considered to be an employee, you’ll receive a W-2 at the end of the year and the company that you’re working for will withhold income taxes, Social Security taxes, and Medicare taxes from your check. The other way that musicians tend to earn money is through what is called self-employment, which is typically money from gigs, teaching private lessons, or any other source of earned income where you’re not considered to be an employee. Self-employment income may or may not be reported to you on form 1099-MISC depending on how much you earned from the payer during the year. So income reported on a W-2 to you as an employee and self-employment income which may or may not be reported to you are the two basic ways that you can earn income as a musician. For example, if you’re a choir director at a church or a professor at a university or teach at a community college, you’ll most likely get a W-2 from them. If you’re a professional musician that plays outside of that environment, you may receive a 1099-MISC, or no record at all, for income you earn. That being said, it’s important to note that income you earn from self-employment is taxable whether or not you receive a 1099. This is something that’s often misunderstood. If you play a gig somewhere and get payed in cash, some people may think, “Oh, that’s a cash gig. I don’t have to pay taxes on it.” That’s not correct. The IRS views all income whether you receive a W-2, a 1099, or no paperwork at all, as being taxable income to you. If you’ve earned money, it should appear on your tax return somewhere as income.
BD: So what things change when you start paying taxes as a self-employed musician?
MW: Several things. It goes back to the previous question about getting a W-2 versus getting a 1099 or no record at all of your income. If you get a W-2, you are considered to be an employee with respect to that income and the income reported on the W-2 is treated as wages. W-2 income is reported on page one of form 1040. If you have self-employment income, that income gets reported on an entirely different form in your tax return. It is reported on Schedule C which is profit or loss from business. The moment you begin earning income from sources where you are not an employee, you are considered to have - in most cases - your own business. In addition, the expenses you incur relative to income as an employee versus self-employment income are reported in different places. For example, let’s say you have expenses from your job as a choir director where you are considered an employee. Perhaps you purchased music and had travel expenses required for your employment at the church. As I mentioned previously, the income from the church was reported to you on a W-2 and would go on page one of form 1040. The deduction for the expenses would be reflected on Schedule A and Form 2106 which is a supporting form to Schedule A. On the other hand, income from self-employment, for example earnings from gigs or private lessons, is reported on Schedule C of your tax return. The expenses related to that income are also reported on Schedule C. So it’s real important that you keep both types of income separate as well as the expenses related to each type of income.
BD: Keep your W-2 income and your 1099 income separated.
MW: That’s exactly right. The reason that you report them in different places on your tax return is because they are taxed differently. Generally, there are three types of tax you are subject to when your earn income. In addition to income taxes, you are also subject to both Social Security and Medicare taxes - commonly referred to as the FICA tax. Let’s refer back to our example of a choir director who gets a W-2 from the church but also plays some other gigs on the side as a self-employed musician. The income from the choir directing job is reflected on the W-2 provided by the church. Your W-2 will also reflect any income tax withheld by the church plus your portion of Social Security and Medicare taxes withheld on that income. Essentially, the church has calculated the portion of the Social Security and Medicare taxes you owe on your salary from the church, withheld that money from your check, and remitted it to the government on your behalf. So you have, in effect, paid the Social Security and Medicare taxes on your income as an employee at the time you receive your check from the church. The church may also have withheld and remitted some income tax on your behalf. Conversely, when you play gigs or have some other form of self-employment income, no one is withholding any income, Social Security, or Medicare tax for you. Therefore, you must calculate all three of these taxes on you federal income tax return. In a nutshell, on a job where you are an employee and receive a W-2, the employer keeps some of your income and sends it to the government for you. All Social Security and Medicare taxes are paid in full at the time you receive your paycheck. On gigs where you are self-employed and earn non-employee compensation, it’s up to you to calculate and pay all of the Social Security and Medicare taxes in addition to the income taxes and report them on your tax return.
BD: You have to pay all of your Social Security tax when you are self-employed.
MW: Right. If you are an employee and receive a W-2, you pay half of the Social Security and Medicare taxes on that income through withholdings from your check and your employer has to pay the other half of the Social Security and Medicare tax out of their own pocket. When you review your W-2, you’ll see deductions not only for federal income tax withheld but also for Social Security and Medicare taxes. This is your half of the Social Security and Medicare tax on those earnings. Your employer has also paid an equal amount out of their own pocket. If you’re self employed, you have to pay all – both halves - of the Social Security and Medicare taxes.
BD: You pay double the Social Security tax when you are self-employed, right?
MW: More or less. That’s a close approximation- for practical purposes, it’s double. Because when you’re self-employed, you’re considered to be your own employer. In other words, when you are self-employed, you are simultaneously the employer and the employee…you are your own employee…so you’re responsible for paying both the employee portion and the employer portion of the Social Security and Medicare taxes.
BD: That’s a lot to keep up with.
MW: It is. If your only income is as an employee and reported to you on a W-2, you generally don’t have to worry too much about Social Security and Medicare tax. The employer usually takes care of all of that for you through withholdings. But if you have self-employment income, that responsibility becomes yours. You’re responsible for not only paying the income tax but also paying all of the Social Security tax and all of the Medicare tax. Ordinarily this is accomplished by making quarterly estimated tax payments.
BD: What’s the best way to keep good records?
MW: I think the key is not to get things mixed up between income and expenses that you incur as an employee versus income and expenses you incur as a self-employed individual versus personal expenses like going to the grocery store. What I usually advise my clients to do the moment they start earning self-employment income, is to open up a separate checking account exclusively for their business of being a self-employed musician and do not make any deposits to that account except for income that you earned from self-employment – gigs, private lessons, etc. Also, only make payments out of that account that relate to that particular business – music supplies, equipment repairs, etc. If you also have income as an employee, deposit that income into your personal account – not your business account. If you have expenses as an employee, pay those from your personal account – not your business account. From time to time you can transfer money from your business account to your personal account as needed. Just make sure to pay all personal bills out of the personal account. Remember when you earn income as a self-employed person, in the eyes of the government you are now a business and they expect you to run it like a business. So, deposit all your money from self-employment into the business account and pay any expenses related to self-employment out of the business account. Don’t pay your mortgage or grocery bill out of the business account. Don’t deposit your wife’s paycheck or birthday gifts you received into the business account. Go out of your way to make sure that this separate account is used exclusively for the income and expenses of your business as self-employed professional musician. The second recommendation that really helps musicians out is to avoid paying cash for business expenses. If you pay cash for expenses then at the end of the year you’ve got a box full of receipts that you will have to organize which can be a pain. It’s very difficult to pull all of those records together at the end of the year, plus the individual receipts are easily misplaced. To remedy this problem, in addition to having a separate checking account for your business, I recommend that you also get a separate credit card, preferably a visa or master card because they’re accepted at more places than other cards - at least, that’s my understanding. And just like the checking account, you use that card exclusively for expenses related to your self-employment income from music – don’t pay for your groceries with your business credit card. So if you go to a music store and buy some music for gigs or some supplies or have your instrument repaired, use the business credit card to pay for those expenses. Each month when your bill arrives, match the individual cash register receipts to the credit card bill and staple them to the credit card bill. The reason you want to use the credit card in this way is that at the end of the year, you’ll have twelve monthly credit card bills from your credit card company and the credit card company will have done all of your accounting for you. On each of those bills, they’re going to list out everything you bought, and when and where you bought it and you will have already attached your register receipts. And with just those two things, the separate business checking account and the separate business credit card, virtually all of your accounting has been done for you. At the end of the year you’ll have twelve monthly bank statements that will have all of your income and the expenses paid by check, and you’ll have twelve monthly credit card bills that will have all of your expenses paid with the business credit card. On twenty-four pieces of paper, almost all of your accounting is done for you.
BD: Would a bank card work?
MW: You mean like a debit card?
BD: Yes.
MW: Yes it would. You could have the debit card tied to your business checking account. Where some people get into a problem is they set this system up, and then all of a sudden decide, “Oh, gee. I’m out of milk.” and then use the business check, business bank card, or business credit card to buy milk. Then the system loses its value, because personal expenses are mixed in with your business expenses. I usually advise people to put a really bright colored sticker of some kind on the business checkbook and the business credit card to help them remember not to use those for personal expenses.
BD: Just needing something doesn’t make it a business expense.
MW: Right. It must be both an ordinary and necessary expense to be deductible - ordinary meaning that other musicians are likely to have similar expenses. Someone may have the idea that in order to give the proper inflection to the bossa novas they are playing at their weekly gig, spending a few weeks on the beach in Brazil is needed. While a trip to Rio may be needed for them to learn the proper inflection, it certainly is not ordinary and necessary in that most musicians have learned how to do this without going to Brazil. As a result, the trip would not be a deductible business expense. The main thing to keep in mind is the IRS really does consider a self-employed musician to be a business. And they expect you to run it like a business, just like Exxon runs Exxon. The purpose of any business is to make money. Exxon doesn’t waste money on things that do not help it enhance its bottom line and a self-employed musician shouldn’t either. You must have proper records and documentation and spend money for your business prudently.
BD: And we’re not just talking about the IRS. There are state and city taxes too, right?
MW: There may be. That tends to vary by where you live. There are all sorts of local laws and ordinances that you may need to comply with. There are also state laws that you may need to comply with. Let me give you a real simple example. If you record and sell a CD, the sale of the CD may be subject to state and local sales tax. So you may be required to collect sales tax when you sell that CD and remit the sales tax to the taxing authorities. The rates and laws vary from state to state. Some localities may require that you have a local business license. Another thing that can happen is you may- if you’re a street musician – be required to have some sort of a permit to be able to perform on the street. It varies from location to location. But yes, you may in fact be subject to a number of other taxes and fees.
BD: Would a local CPA be able to tell you about these laws?
MW: I would say that would a great place to start because even if they are not familiar with the specific laws as they relate to musicians, they will probably be familiar with whether or not those types of laws exist in your jurisdiction. They should know which agency to contact and they can either do that for you for a fee, or most of them are pretty good about just saying, “You need to call the city business tax office, county business tax office and the State Department of Revenue, etc.” There may be a number of taxes or regulations that apply to you that you’re not aware of. Most people think only about the income tax, but there are other taxes that can impact you. Unfortunately, the way that most people find out about these things is that they don’t comply with them simply because they are unaware of them. Then they are contacted by one of the taxing authorities that says, “Oh, gee we see that you’ve been doing this. You owe us some money…..plus penalties and interest.”
BD: There’s a pricey education.
MW: Yes, indeed.
BD: So how much should a musician put aside for taxes?
MW: Well, it varies from individual to individual depending on a number of factors and relates back to how much of your income is from being self-employed verses being an employee. If you do not have any self-employment income, the employer, as we discussed earlier, withholds income taxes for you, plus your Social Security and Medicare taxes. So you’re pretty much covered as long as you set up your withholding correctly with your employer. At the end of the year you do your tax return, and you probably won’t owe very much, and you probably won’t get very much back as a refund if you set everything up correctly. Unless, of course, if you have sources of income other than your W-2.
If you are self-employed, then all that stuff that the company will be doing for you if you were an employee now has to be done by you. So you have to project what your income is going to be for the entire year in advance and estimate your total tax liability including income tax, Social Security tax, and Medicare tax for the entire year. Then you pay one fourth of that amount to the government on a quarterly basis. April 15th is the first payment date, June 15th is the second payment date, September 15th is the third payment date, and then January 15th of the following year is the fourth estimated tax payment due date. These are considered quarterly payments, but they’re not in even calendar quarters. So what I suggest is, if you have an idea what your income is going to be - and it usually takes a few years of playing gigs and going through this to be able to get the hang of it - you need to come up with some sort of estimate as to what percentage of your revenue you’ll need to set aside to cover your tax burden.
BD: And the percentage can vary?
MW: It can vary greatly.
BD: Depending on how much you earn, your deductions, credits, and things like that?
MW: All those things make a difference, and so it’s not a number that even a CPA can tell you if you walk in on January and say, “Oh, gee. I’ve decided to start playing gigs. How much should I pay in?” There is no way to really know that answer for sure. You have to make a logical and reasonable estimation based on what you anticipate your income and deductions will be and you should refine your estimate throughout the year. If you buy an expensive piece of equipment during the year, that will have an impact on your estimate of taxes due. So it can vary greatly from year to year as well as during the year.
BD: I have friends that tell me I pay more taxes than them because I don’t buy as many tax deductible purchases like instruments. Are they right?
MW: There is a common misconception that, “I’m going to cut my taxes, because I’m going to go out and buy a new amplifier for $1,000.00.” Well, that’s great and you may spend a $1,000.00 on an amplifier, but it may only save you $300.00 in taxes. So, if you really didn’t need an amplifier, you just wasted $700.00.
BD: You spend more money than you save in taxes.
MW: You’re exactly right. If you’re in the music business, or any other business, you should never make a purchase decision - by that I mean the decision as to whether or not to purchase something - solely because of taxes. Tax savings on items purchased are generally a percentage of what you spend, so you never recover the full amount of what you spend in the form of tax savings. Tax savings may need to be considered in terms of the timing of the purchase, however. For example, if you expect to be in a higher tax bracket next year, you may want to delay purchases until next year, if possible, to take advantage of greater tax savings on the purchase than you would receive if you made the purchase this year. In the final analysis, the reason to buy something is not just to save taxes. The reason to buy something is because purchasing the item will improve the profitability of your business.
