Lessons Learned from a Freelancer’s Tax Audit

Since the day I opened up shop as a freelance graphic designer, I’ve kept meticulously organized project files. Production records, invoices (along with tax-annotated duplicate invoices) and project-specific expense records all have their place. I’ve read and re-read the tax rules for “Advertising / Creative Promotional Services” in Minnesota. I’ve paid my withholding, sales and use taxes on time for ten years, and have receipts and records of every payment submitted.

On occasion, I had fleeting thoughts of cutting corners to save time on the record keeping, but I never did.

On the day I received the notice that my business was going to be audited for the last three-and-a-half years’ worth of sales and use tax, I sat on the couch contemplating every scenario that could go wrong. I don’t know about other states, but the tax rules for creative service providers in MN are notorious for being complicated — and for being interpreted in different ways by different auditors. Despite all my efforts on organization and compliance, the audit was still a scary prospect.

And just when I was getting comfortable with the reality of the audit, I read an article (“The $100,000 Shakedown” by Tony Carideo, Twin Cities Business, January 2011, pg. 119) that literally made tears of anxiety well up in my eyes. The article talked about how in Minnesota tax audits were on the rise, in part to help close the state’s budget gap. The article even outlined the multi-million-dollar fundraising goals of the ramped-up audits. The two businesses profiled in the article were both creative service providers. At the completion of their audits, one was assessed a preliminary bill of $100,000 and the other received a bill of $35,000.

In the first scenario, once the company submitted additional documentation their bill was reduced to $5,000 — however they accrued more than $7,000 in additional accounting fees to prepare the necessary documents.

I shared the news about the forthcoming audit with others in my network. Several of them had gone through audits in the last year or so; their results ranged from bills of several thousand dollars to amounts people were seemingly too embarrassed to disclose. News of the audit always brought about the response, “sorry to hear.”

Needless to say, the weeks leading up to the audit were spent trying to keep worst-case scenarios out of my head and attempting to sleep at night. When I did sleep, the audit would frequently work its way into my dreams. “Hoorah!” I’d think some mornings after waking up when ten whole minutes would pass before thinking about the audit. Most mornings, though, it was the very first thing I thought about after hitting the alarm.

It is the department of revenue’s policy to send two auditors to home-based businesses. On the first morning, my biggest dilemma was how to greet the auditors. My husband and I have always wanted friends and new acquaintances alike to feel abundantly welcome and comfortable in our home. But in this case, “welcome” wasn’t authentic, nor was “happy to meet you.” “Make yourself comfortable” even seemed like a stretch. In the end, I simply introduced myself and took their coats. We had a brief discussion, then I showed them where the records were. They pulled out their laptops, calculators and sticky notes, and started to work.

Over the course of the next two-and-a-half days they would occasionally ask for help locating a specific receipt, want clarification on services described on an invoice, or they would need guidance matching a receipt to a client project. They even compared non-taxable “preliminary creative” line-items on invoices to the related project’s time sheet to confirm the point in time a client had provided approval on the initial concept. I ended up having to contact two vendors for supplemental documents. By and large, they were in one room reviewing ledger entries and receipts, while I attempted to concentrate on client work in another room.

On the third day we sat down and the auditors presented a list of items where tax was due along with some “corrective actions.” While that term sounded so ominous that my heart initially started racing, “corrective actions” simply meant they had suggestions for some invoice format changes, and on future payments they needed me to change where I was listing taxable courier deliveries.

In the end, I owed $384 in back taxes and interest; a spit in the bucket compared to the worst-case scenarios I had envisioned. A large chunk of what I owed was unpaid use tax on licensed fonts. Fonts are considered taxable software in Minnesota. I didn’t know that (it had never actually even occurred to me), and when I subsequently shared that information to fellow freelancers, they seemed surprised, too.

The auditors complimented me on how organized the job files were and that invoices and tax payments had been so clearly annotated. It made it easy for them to understand my accounting methods and to be able to confirm what taxes had been collected and what, and when, sales and use taxes had been paid.

As they walked out the door on the afternoon of the third day, the voice in my head shouted, “Those corners you considered cutting? Aren’t you glad you didn’t?!” Every moment I had spent over the years on those tedious administrative tasks was worth it. Worth it ten times over, in fact.

So, what would I tell a freelancer who is not yet facing an audit?

  • Operate on the assumption that you will be audited.
  • Make sure you know the tax rules for your state.
  • The time to get organized isn’t when you get the audit notice. It’s the first day of your business.

And, what would I tell a fellow freelancer facing an audit?

  • Be ready and able to talk in detail about your state’s tax rules. When the auditors asked me about a specific sales tax application, I could tell them exactly what I did and outlined the specific reason why. In several cases, they seemed to take my interpretation into consideration.
  • Tap into your network for support. Find out which fellow freelancers have been through an audit. Take them out for lunch and find out about their experience.
  • Take care of yourself before and during the audit. Whatever you do to manage stress, whether it be yoga, walking the dog, cooking, etc., be sure you make time to do MORE of it during this process.

Have you been audited? If so, share your tale here so others can learn from it.

BTW: At the 2008 Creative Freelancer Conference, June Walker, author of “Self Employed Tax Solutions” spoke on “Money-Saving Tax Solutions for Creatives.” Listen to a clip here.

4 thoughts on “Lessons Learned from a Freelancer’s Tax Audit

  1. Laurel Black

    Eeyow – what a nightmare! Good for you, Carolyn, for being so professional in every possible way. I too was audited by my state (Washington) for use tax, but it was nowhere nearly as stressful/scary as your experience. Perhaps that was partly because it happened to me long before all the budget deficits kicked in. I have paper receipts and documents for just about everything my business has spent money on going back to the 80’s, all in monthly envelopes and boxed by year. I started this practice because computers weren’t around when I went into business. Even now that I use QuickBooks, I still have my old habits (and records). So when I got the audit notice, I gathered up the boxes for the years in question, drove them down to the Department of Revenue office and dropped them off. They called a week later to tell me that I was “100% clean” and I could come get my boxes. I still feel sorry for the poor accountant who had to wade through all that stuff. Washington has probably gotten a lot more like your state since then. Your advice to freelancers is right on: when it comes to financial records, cut no corners – sooner or later it will your turn!

  2. Tiana Toso

    I just finished my first year as a freelance designer. I live in the fear of being audited sometime in the future. As you mentioned, it’s not the question of “if” one gets audited, it’s “when”. This fear has definitely driven me to be extra meticulous in saving my receipts, notes, tax paperwork, etc.

    I’m happy to hear you made it out of your auditing experience without having to owe too much. Thanks for sharing the clip from June Walker. I will definitely check into that.

  3. Pat Thompson

    Can you explain more about the use tax on licensed fonts? Were you charging the client for the font, and that was what should have been taxed but wasn’t?

    1. Carolyn Porter

      Hi Pat –

      I can only speak for the rules in Minnesota, but fonts are considered software, and in Minnesota software is taxable. Prior to the audit I did not collect use or sales tax for the fonts I licensed online. Now I’ll pay use tax for fonts I license for my own use, and pay sales tax for fonts I license for use on client projects. For clients, I’ll invoice the fonts as a taxable expense. Does that help? I recently noticed that the online font resource I use most often began collecting sales tax. I think that change just happened in the last month or two, so it is something to watch and track carefully.