Here's something I experience almost anytime I'm at a party or social event where there are other writers. Upon learning that I'm both a book author and tax accountant, an author will ask me for some free help about the best ways that authors can minimize their income taxes.
If I can, I try to weasel my way out of the discussion, offering up such basic tidbits as, "Well, be sure to look at the home office deduction." And "do use a basic accounting program like Quicken or Microsoft Money so you capture all of your writing business expenses."
Usually, those simplistic answers work. Usually, after dolling out such drivel, the guy waunders off to get another drink and more appetizers.
Everyone once in a while, though, I encounter some writer who's really motivated to save on taxes. Usually, someone now making good money writing... When I can't deflect their questions in some other way, I tell them about the three best ways that authors have to save on taxes.
Technique #1: Smooth Your Income
Whatever you think of the US Internal Revenue Code, you need to know that it's quite progressive. That progressivity means the more you make, the more you pay. The progressivity also means that if your income fluctuates, your income taxes go up even if you make the same money on average as someone else makes whose income is steady.
To give you an example of this, suppose that you compare two writers, John and Jane. If John makes a steady $60,000 a year and has a mortgage, a spouse and couple of kids, he might pay about $1000 over four years (net of tax credits such as for children.)
In comparison, suppose that Jane averages $60,000 a year, but sees her income fluctuate between $30,000 a year and $90,000 a year. She still makes $60,000 a year on average. Yet if she also has a spouse, two kids and a mortgage, she'll probably pay $8,000 to $10,000 in taxes over those same four years.
Please note that over the same four years, then, the two writers make the same amount of money: $240,000. But what they pay in taxes differs radically. Jane pays eight to ten times what John pays! Yikes!
What can Jane do? Well, let's bring this back to the example of working writers. Jane can probably rather easily smooth her income. She can make sure that she's not stacking two big advances in the same year. She can spread out advance payments over two or more years. She can even try to stuff more of her expenses into the good years. In the good years, for example, she can buy new computers, take those graduate classes, or top off her pension.
Technique #2: Setup an LLC and Elect S Corporation Status
I've written and talked much about how S corporations save taxpayers money and how the right way to set up an S corporation is first create a limited liability company and then ask the IRS to treat the LLC as an S corporation for tax purposes.
Let me review the basics here again, however. Suppose that you're making $90,000 a year as a writer or author. If you just treat your writing business as a sole proprietorship, you might pay $12,000 in income taxes on the $90,000 and then another 15.3% self-employment tax, or roughly $13,500, on the $90,000.
If you set up an LLC and have the LLC treated as an S corporation, you'll still pay the same $12,000 in income taxes. But you'll only pay the 15.3% self-employment tax on that portion of the profit that you categorize as wages. If you categorize, say, $30,000 of the profits as wages, you'll pay $4,500 in self-employment taxes. (The other $60,000 in remaining profits, by the way, gets paid out as a dividend-like "distribution.")
Using these example numbers, then, you would save about $9,000 a year in employment taxes by using an S corporation.
Two quick points about S corporations: First, S corporations require some extra tax and accounting so you don't get to spend all of your savings. Some of the savings go to the lawyer, the accountant, and the bank. Second, you absolutely must set your salary to a reasonable level.
Technique #3: Relocate Your Residency
One final, easy planning gambit. Remember that there are states like Alaska, Florida, Nevada, Texas and Washington that don't charge residents state income taxes. Accordingly, if you relocate to one of these states, you'll automatically drop your overall tax bill because you won't have state income taxes.
One of the benefits of writing is that you do get to live wherever you want. Why not choose a place that doesn't tax your writing income?
But a caution: Do be careful that you don't get blindsided by the other taxes a state levies. For example, Washington state where I live charges a four-tenths of a percent excise tax on royalty income. This is still a lot lower tax rate than high tax states like California or New York charge writers. Which maybe explains why during the technology boom in the 1990s many computer book writers making high six figure and low seven figure incomes moved to the Seattle area.