Striking out on your own as an independent contractor comes with its own set of tax hurdles. Follow these tips to help you file your taxes the right way.
In recent years, the rise of the gig economy has given way to a growing number of independent contractors in the American workforce. As more people add side gigs to their main sources of income or seek to become their own bosses, they create a tax situation that requires more consideration than filing a simple tax return.
As the federal deadline to file taxes with the Internal Revenue Service on April 15 draws closer, it's paramount that you properly report your earnings as an independent contractor. Failing to do so could bring serious repercussions to your personal and professional life that could take months or years to dig out of.
To help you avoid the pitfalls that lead to problems with the IRS, we've created a primer to help you properly handle your small business taxes as an independent contractor. By the end of this guide, you will hopefully be armed with the knowledge needed to navigate this year's tax season.
According to the IRS, an independent contractor is a self-employed individual. Generally, people who work in an independent trade or business, such as doctors, lawyers, accountants and subcontractors fall under this category since they "offer their services to the general public." Whether that basic rule of thumb applies varies on a case-by-case basis.
The general litmus test that can be applied to whether or not your profession falls under the government's definition of an independent contractor is whether or not "the payer has the right to control or direct only the result of the work and not what will be done and how it will be done." If that's the case, the person doing the work is an independent contractor and required to pay self-employment tax.
How to determine if you're an independent contractor
If you're still unsure whether you're an independent contractor or not, the IRS says there are a handful of questions you can ask yourself to determine your status.
- Does an outside company have any say over your work and how you conduct your business?
- Do you have a say in how you're compensated for your work and how your business expenses are reimbursed?
- Have you signed any contracts, or are you receiving any benefits such as healthcare or vacation time?
- Will your relationship with the payer continue, and is your work a key aspect of the payer's business?
Whether answering "yes" to any of those questions means you're an independent contractor relies on extenuating circumstances that may be unique to your position. According to the IRS, there is "no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor."
The key, the IRS says, is to "look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination."
For those still wrestling with whether they're an independent contractor or not, the IRS has a form you or your payer can fill out to have the IRS determine your status. Form SS-8 is available on the IRS' website, though the government agency estimates that it will take six months to get a determination. If you live in California, you may want to double-check your status as well, since the state legislature passed Assembly Bill 5 last year.
Handling your small business taxes as an independent contractor
If you fall under the independent contractor category, remember one thing: The IRS considers you a self-employed individual, and as such, you may be responsible for more federal taxes than if you were a normal employee receiving a W-2.
"As an independent contractor, you are treated the same as any other business where you have to pay the employer and employee share of federal payroll taxes," said Luke Sotir, a financial advisor at Equitable Advisors and founder of Highland Financial Group.
To do that, you'll need to file an annual return and pay estimated quarterly taxes. As a self-employed individual as defined by the IRS, you'll likely be responsible for paying the self-employment tax (SE tax) in addition to your income tax. The SE tax covers Social Security and Medicare costs at a current tax rate of 15.3%, with 12.4% going to the former and 2.9% going to the latter.
To determine whether you'll be on the hook for the SE tax or not, you must first determine your business's net earnings. You do that by subtracting your business's expenses from its income. If your net earnings as an independent contractor are $400 or more, you must file an income tax return. If your earnings are less than $400, you still have to file a return "if you meet any other filing requirement listed" on the Form 1040 and 1040-SR instruction sheet.
If you're operating at a net loss, you can usually deduct those losses from your gross income, though those business tax deductions are limited in some cases according to the IRS.
Regardless, you will have to pay the SE tax and your income tax directly to the IRS by filing an IRS Schedule C or C-EZ in addition to your tax return. When it comes time to pay your self-employed tax, you'll typically do so in quarterly estimated tax payments throughout the year. You may also receive a Form 1099-MISC from companies you've done business with.
"It's kind of like a mini-tax return that you would attach to your regular return because there's no other business entity," Sotir said. "It does make your tax return a little more involved because you basically have to demonstrate all of your income and all your expenses from that business in order to calculate the tax."
To report your Social Security and Medicare taxes, the IRS requires that you file a Schedule SE, which uses your income and loss figures found on the Schedule C form to calculate how much you owe for those taxes.
Thanks to the Tax Cut and Jobs Act, some new small business tax deductions have cropped up, while other tax cuts have seen changes. If you qualify for it, there's a pass-through deduction where you can deduct up to 20% of your "qualified business income." There are other business tax deductions for expenses like interest, rent, legal and professional fees, travel and meals, and the use of your home for business purposes. What you can deduct varies greatly based on their limitations and what you qualify for.
Tax deductions and expenses to keep up on
When preparing your tax return, consider which potential tax deductions and expenses you may want to include in your filing. Properly filing these deductions lowers your overall tax burden and saves you money in the long run.
If your work requires you to travel regularly, remember that many related expenses can be deducted. For example, if you drive a car to travel between work sites, you can deduct your mileage at a specific rate. Last year, the rate was 59 cents per mile, according to the IRS. Other deductible travel expenses include parking and tolls, as well as the cost of public transportation.
Outside of travel, independent contractors can deduct the following items:
- Self-employment taxes
- Health insurance taxes
- Cell phone costs
- Construction industry taxes and licenses
- Meal and entertainment deductions, with some exceptions
- Occupational operating expenses like web hosting fees and phone lines
- Supplies and materials
What you can and cannot deduct depends on your individual business. Since that's the case, you may want to hire a tax professional to ensure you get the most out of your tax return.
Making quarterly payments
Unlike most small business owners and individuals who likely file their taxes once a year, self-employed individuals usually have to file their small business taxes on a quarterly basis, just as you would if your income came from a rental property, pass-through entity or sole proprietorship. Since there's no overarching employer to withhold your taxes for you, you're on your own in this regard.
"If all your income comes from your independent contracting, then it's kind of easy to figure out how your revenues are going to look like for the year and whatever deductions you have in order to figure out – roughly – what your federal and state income tax liability is," said Sotir. "That way, you can set aside money to pay for that and avoid dealing with a huge tax bill at the end of the year."
According to the IRS, you should plan to pay taxes on a quarterly basis if you expect you'll owe $1,000 or more in federal taxes when you file your return. Using Form 1040-ES, you can use the included worksheet to calculate what your estimated tax liability will be. How much you'll owe the federal government will depend on your anticipated gross income, taxable income, taxes, each deduction and tax credit for the year, according to Credit Karma.
If 2020 is the first tax year you'll be self-employed, you need to estimate your taxes based on your expected amount of income for the year. If you over- or underestimate that figure, you can use the 1040-ES form to recalculate your estimated taxes for the next quarter.
You can pay your quarterly payments on the IRS website, by phone or mail. The due dates for each quarterly payment this tax year are April 15, June 15, Sept. 15 and Jan. 15, 2021.
Best practices for independent contractor taxes
As you get your financial house in order as an independent contractor, there are general rules of thumb and best practices that you should consider. According to Sotir, one of the most overlooked things that can make your life easier when it comes to tax preparation is good record-keeping. If you properly document your business's earnings and losses, he says, you can more easily estimate your quarterly tax liability without having to second guess yourself.
"You have to substantiate all of your business expenses, and if you don't, you're going to have problems," he said. "It's not a requirement, but starting a secondary checking account for your business is a great way to track what's a business expense and what isn't."
Such an account can be created in the business's name or as a DBA. With proper record-keeping, it becomes much easier for independent contractors to handle their taxes on their own. "Just being organized is a good starting point with your business records," he said.
Tax management options for independent contractors
Depending on how comfortable you are with finances in general, filing your taxes through the use of online tax software can be reasonably done. That being said, there's no shame in getting help from a professional.
"Generally speaking, the IRS' publications and documents are written in a language that most people find confusing," Sotir said. "It doesn't mean you can't [file your own taxes], but the more involved it is, the more likely it is that you will do something wrong."
Something you should avoid at all costs, Sotir said, is waiting until the last minute to handle your tax requirements.
"If you handle your taxes over the course of the year, you will be able to do things at the end of the year, like taking advantage of deductions to mitigate income tax," he said.
One way some taxpayers mitigate their income tax requirements is by purchasing equipment at the end of the year. Since the equipment they'd purchase is likely to be written off, those spent funds can come out of your tax burden. And while that can be a legitimate way of lowering your tax requirement, it can also be a liability – especially if the equipment wasn't needed in the first place.
"Oftentimes, you see people lose their business at the end of the year because of tax season. They buy equipment to reduce their income tax, but maybe they didn't need all that equipment," he said. "You still spent the money. You may have saved 30 cents to the dollar in taxes ... but the other 70 cents are still gone. If you didn't really need that equipment, then the tax deductions may not have been worth it."