Risk Management for the Self-Employed

When Michelle Goodman began as a freelance writer, she wasn’t savvy to the ways contracts could save her from client-induced stress. “I did some handshake deals that cost me so much time and money,” said Goodman, who now helps self-employed professionals avoid similar mishaps with her book My So-Called Freelance Life. In one frustrating example, Goodman said she neglected to outline in a contract how long the project would last or ask for any upfront payment. Then she slogged along, hoping her client’s demands would eventually stop and she would be paid. “That just reduced my income tremendously,” Goodman said.

About 15 million Americans — one in nine U.S. workers — are self-employed, according to the Bureau of Labor Statistics. “This is a segment that, as far as we can tell, is the most important part of the economy from the gross perspective,” said Ted Devine, CEO of Insureon, an online insurance broker specializing in coverage for small businesses. From financial issues like quarterly tax payments to legal concerns like liability insurance, life as a self-employed professional comes with its own set of perils. But freelancers can take steps to protect themselves from the inherent risks of self-employment.

The preparation for (hopefully) risk-free self-employment often begins before a worker jumps from a full-time job to the freelance life. Instead of starting a business with zero clients on day one, Goodman said, an aspiring self-employed professional should freelance on the side to establish a client base before taking the plunge. It is also smart to compose a standard contract to use with clients. The legal website Nolo.com offers templates, but it is a good idea to ask a lawyer to help you hash it out. Because drumming up clients and drawing up a contract are basically unpaid work for freelancers, Goodman said, try to set up your self-employed shop before leaving a job. “It can take awhile to build up to where you want to be,” she said.

Freelancers might need a license to start their new ventures legally, said Stephen Fishman, a legal writer who authored the book Working for Yourself. If you are planning to see clients in your home, he added, you will need a business license. And it is also worth checking local zoning rules to make sure your community allows its residents to work from home.

A major roadblock for the self-employed — and one that keeps many people from entering the freelance workforce — is health insurance. If coverage under a family plan is not an option, the self-employed are responsible for buying their own insurance, which often proves costly. Some freelancers take the risk and skip health insurance altogether, but for many, like Goodman, that is not an option. “If you don’t have some minimum catastrophic care, say you broke your leg or need an appendectomy, I’m in the camp of ‘it’s better to have some insurance,’” she said.

Fortunately, there are ways to reduce the health care burden. The Affordable Care Act and the advent of health insurance exchanges should make purchasing an individual plan easier, especially for people with pre-existing conditions. In addition, some self-employed workers can deduct the cost of insurance from their taxes.

Another policy for the self-employed to consider, especially if professionals in their field are vulnerable to negligence lawsuits, is liability insurance. From giving a client bad advice to creating a sub-par product to damaging property, imagining the worst-case scenario can help freelancers protect against it, said Devine, whose self-employed clients include web designers, lawyers and contractors. An insurance specialist can discuss risk management concerns and help the self-employed make the right insurance choice.

But for many freelancers, one of the biggest everyday risks is even more basic than establishing a retirement plan or examining insurance policies—it’s getting stiffed. To protect against shady clients and scams, Goodman encourages conducting investigative work, such as Googling a client and scanning freelance message boards, before signing a freelance contract. “It’s really important to find out who you’re getting into bed with,” she said. For lengthy projects, Goodman suggests asking for partial payment up front. And make sure to get the contact information of at least two people at the company just in case someone is on leave when it is time to cut the check.

Once a self-employed worker is paid, it is time to give Uncle Sam his due. Howard Samuels, a tax partner at KDMS, a CPA firm in New York and New Jersey, recommends freelancers maintain a separate bank account for money specifically set aside for taxes. “Generally somewhere between 20% to 40% of whatever money you bring in the door as income as a freelance person is going to wind up going to tax,” he said.

While workers are legally obligated to pay tax on income as they earn it, the government created a system of quarterly taxes for the self-employed to avoid receiving tiny payments on every freelance check. But calculating that figure requires running a mini-tax return. “That’s not a simple calculation,” he said.

Tax deductions for the self-employed can take the sting out of a hefty tax bite. Generally, any expense incurred that is related to a freelance business — from internet and a cell phone to professional dues and subscriptions — is at least partially deductible, he said. Even big-ticket items, like a new laptop, can generally have their full cost deducted in the year of purchase. Potentially the largest deduction for freelancers is a home office, but it must be legitimate. “You’ve got to have a real home office,” said Samuels. “It needs to be your primary place of business.” When claiming the home office deduction, he said, freelancers should take a photograph of the office space as evidence in the event of an audit.

It might be tempting for freelancers to cut cost corners, for example, but Samuels recommends finding a tax professional specializing in the self-employed. An accountant could highlight numbers on a freelance tax return that could trigger an audit and even help the self-employed save money as their business grows. “Once [our freelance clients] are quite profitable,” said Samuels, “maybe there’s an opportunity to save a good amount of tax dollars by incorporating themselves.”