November 22, 2024
Filing taxes as an independent contractor: A step-by-step guide #CashNews.co

Filing taxes as an independent contractor: A step-by-step guide #CashNews.co

Cash News

When you have a traditional job, your employer withholds part of your paycheck for taxes, but when you’re an independent contractor, you’re responsible for withholding tax money on your own.

If you expect your tax liability to exceed $1,000 for the year, the Internal Revenue Service (IRS) expects you to make quarterly estimated tax payments. You’re also responsible for self-employment taxes, which pay for both the employee and employer’s share of Social Security and Medicare taxes, on top of federal income taxes and any applicable state and local taxes.

Paying independent contractor taxes requires solid planning and record-keeping, but it doesn’t have to be overwhelming. Read on to learn how taxes work for independent contractors, how you file, and some important tax deductions to be aware of.

What is an independent contractor?

Independent contractors can be referred to by a number of terms: You may be an independent contractor if you’re a small business owner operating as a sole proprietorship, you do gig work, or you’re a freelancer.

Determining whether someone is an independent contractor vs. an employee can get tricky. Companies that misclassify a worker as an independent contractor instead of an employee could be on the hook for paying self-employment taxes on the worker’s behalf.

The IRS uses a three-pronged common law test to determine whether a worker can be classified as an independent contractor. The test consists of the following factors:

  1. Behavioral control: Does the company have the right to control when and how work is performed? If a company dictates a work schedule, requires you to report to a specific location, or provides training or extensive instructions, it’s likely that you should be classified as an employee instead of an independent contractor.

  2. Financial control: How much discretion does the business have to determine the economic aspects of the worker’s job? Independent contractors often invest significant amounts in their own tools and equipment, have unreimbursed business expenses, can incur profits and losses, and can usually seek out other work opportunities. A traditional employee is usually paid a salary or an hourly wage, whereas independent contractors are more likely to get paid a flat fee per project — though billing on an hourly basis isn’t unheard of.

  3. Type of relationship: Employees often receive benefits like a 401(k), health insurance, and paid time off that aren’t typically afforded to independent contractors. Usually, workers are classified as employees if their role is expected to continue indefinitely, whereas independent contractors are more likely to be hired for a specific project or timeframe.

When you get hired for a job, a business may spell out whether you’re an employee or an independent contractor in the contract. However, a contract alone isn’t enough to determine whether you should be classified as an independent contractor. If the IRS determines you should be an employee instead of a contractor based on the level of control you have over your work, a business could be required to pay self-employment tax on your behalf.

Example of an employee vs. independent contractor

Suppose you’re a web designer who’s hired by a business to perform services. Let’s look at how your role would look based on whether you’re an employee vs. an independent contractor.

If you’re an employee: The business could tell you when and where you need to perform your design duties. You’d receive a regular paycheck with federal taxes withheld. You may be eligible for benefits like health insurance, a retirement plan, and paid vacation and sick leave. Your employer would provide your laptop and other equipment. They may also pay for training to help you advance your skill set. Your company may or may not allow you to pursue outside work.

If you’re an independent contractor: As an independent contractor, you’d have greater control over when and (often) where you perform your work. When you’re paid, you’re responsible for tax withholdings. In addition to regular income taxes, you’d be on the hook for self-employment taxes. You’re unlikely to receive employee benefits or company equipment. If you want to learn a new skill, you’d need to pay for your training. But if you want to pursue other design clients, you’d typically be free to do so.

Read more: Here are 7 free tax filing options

Tax requirements for independent contractors

Independent contractors are generally required to withhold taxes from their earnings to pay self-employment tax and federal income tax, as well as state income taxes and local taxes, if applicable.

Income thresholds

If you’re an independent contractor, you’re required to file a tax return and pay self-employment taxes if you have net earnings of more than $400 in one tax year.

Additionally, if you earned more than $600 from any individual client or business, they must complete Form 1099-NEC, which is used to report non-employee compensation. They’ll need to furnish you with a copy and send one to the IRS.

Quarterly estimated taxes

Independent contractors need to make quarterly estimated tax payments if they expect a tax bill of at least $1,000 for the year. You could face an underpayment penalty if the taxes you pay throughout the year don’t add up to at least 90% of your tax liability for the current year or 100% of your tax liability for the previous year.

These are the quarterly estimated tax deadlines for tax year 2024 that independent contractors must adhere to:

  • April 15 (for income earned Jan. 1-March 31)

  • June 17 (for income earned April 1-May 31)

  • Sept. 16 (for income earned June 1-Aug. 31)

  • Jan. 15, 2025 (for income earned Sept. 1-Dec. 31)

Independent contractor tax forms

Here are some common independent contractors can expect to deal with:

  • Form 1040-ES: Use this form to calculate and make quarterly estimated tax payments.

  • Form 1099-NEC: You should receive Form 1099-NEC from any individual or company that paid you $600 or more during the tax year. Prior to 2020, Form 1099-MISC was used to report independent contractor payments, but this IRS form is no longer used for these purposes.

  • Schedule C (Form 1099): You’ll use Schedule C to report business profits or losses on your 1099 form if you’re an independent contractor who operates as a sole proprietorship.

  • Schedule SE (Form 1099): You’ll use this form to file and report your Social Security and Medicare taxes, also known as self-employment taxes or SE taxes.

  • Form 1099-K. You may receive Form 1099-K if you’re an independent contractor or small business owner whose clients pay via Venmo and other third-party platforms. Eventually, the IRS will require these services to send you Form 1099-K if you receive payments of $600 or more. However, the IRS is taking a phased-in approach to implementing this rule. For 2023, the platforms generally weren’t required to send the form unless you earned $20,000 or more and had at least 200 transactions. For tax year 2024, they’ll need to send the form if you earn $5,000 or more using the platform.

Deductions for independent contractors

One upside of being an independent contractor at tax time: You may be eligible for small-business tax deductions you wouldn’t qualify for if you were traditionally employed. Some examples include:

  • Home office deduction: If you have a space in your home that you use solely for business purposes, you may be able to deduct a fraction of expenses like rent, mortgage interest, insurance, maintenance, and repairs.

  • Automobile deduction: If you use your car for business, you can either deduct your actual expenses for using the vehicle for work purposes or take the standard IRS mileage deduction. The standard mileage deduction is 65.5 cents per mile driven in 2023 and increased to 67 cents per mile in 2024. This deduction could be especially valuable if you use your vehicle to drive for a ride-share service, like Uber or Lyft, or make deliveries since drivers for app-based services are usually classified as independent contractors.

  • Cellphone, internet, and laptop: You can deduct these expenses if they’re necessary to perform your work as an independent contractor. You can only deduct the percentage of the expense that corresponds to your usage, though. For example, if you use your home internet 40% for business and 60% for personal activities, you could only deduct 40% of the cost.

  • Business travel expenses: Business travel costs, like airfare, baggage fees, and lodging, may be tax-deductible. However, the IRS warns that you can’t deduct travel expenses if they’re “lavish or extravagant” or for personal purposes.

  • Health insurance: If you’re an independent contractor, you can often deduct the cost of your health insurance premiums for yourself, your spouse, and your tax dependents. You’re only eligible for this tax write-off if neither you nor your spouse qualifies for employer-sponsored health coverage.

  • Self-employment taxes: Independent contractors are responsible for self-employment tax that usually amounts to 15.3%. (We’ll discuss in greater detail below.) However, you can deduct 50% of the self-employment tax you pay.

  • Qualified Business Income (QBI) deduction: As an independent contractor, you can deduct up to 20% of your taxable income, though this deduction phases out at higher income levels.

The deductions above are all above-the-line, meaning you can take them regardless of whether you take the standard deduction or itemize.

Read more: Expecting money back? Here are 5 smart ways to use your tax refund

Self-employment taxes

As an independent contractor, you’re required to pay a 15.3% self-employment tax on 92.35% of your net earnings if you earned more than $400. Self-employment taxes are similar to FICA taxes you pay toward Social Security and Medicare when you have a traditional job.

With a regular job, most people pay 6.2% of their wages for Social Security taxes and another 1.45% for Medicare taxes, or 7.65% total. Then, their employer matches that 7.65% in what are collectively known as payroll taxes. But when you’re an independent contractor, you pay both the employer’s half and the employee’s half of those taxes, which is why the self-employment tax is usually 15.3%.

There’s a limit on how much of your earnings are subject to Social Security tax, though. This is known as the Social Security wage cap. In 2024, you won’t owe Social Security taxes on earnings above $168,600, up from $160,200. However, you may face an additional Medicare tax of 0.9% if you earn more than $200,000 as a single filer or $250,000 as a married couple filing jointly.

How to file taxes as an independent contractor

Tax filing gets a bit more complex for self-employed people like independent contractors and sole proprietors. Be sure to keep good records so you’re prepared at tax time. These are the general steps you’ll need to follow:

  1. Compile your documents: To calculate your earnings, you’ll need your 1099 forms and any other income statements. To calculate your business expenses, you’ll need your receipts and possibly bank account and credit card statements.

  2. Calculate your net profit or net loss: Next, you’ll use these documents to calculate your net profit or loss. If you earned more than you spent on business expenses, you have a net profit; if your expenses are more than you earned, you have a net loss. You’ll use Schedule C for Form 1040 to report your net profit or loss.

  3. File your self-employment taxes using Schedule SE. You’ll use Schedule SE of Form 1040 to calculate and report your self-employment taxes. Report what you owe in the “Other taxes” section you’ll find on Form 1040.

  4. Start making quarterly tax payments. Use IRS Form 1040-ES to calculate how much you should pay in estimated quarterly taxes. This amount will be based on your projected adjusted gross income, taxable income, tax obligations, and any tax deductions or tax credits you qualify for.

You may be able to file your return on your own using tax preparation software if your situation is relatively straightforward. But if you’re a taxpayer with multiple income streams or you’re claiming large deductions, it may be worth hiring a tax professional to make sure you follow the IRS rules and take advantage of any available tax breaks.

Read more: Need more time to file? Here’s how to file a tax extension.

FAQ

Do independent contractors get a W-2?

No. Companies give a W-2 form to employees at the end of the year. Self-employed individuals who work as Independent contractors typically receive Form 1099-NEC.

What is the IRS tax rate for independent contractors?

Most independent contractors pay a 15.3% self-employment tax in addition to federal income tax, as well as state and local taxes, depending on where they reside. The overall tax rate for independent contractors will vary based on their tax bracket.

Do you pay more taxes as a 1099 employee?

You’ll often pay more taxes as a 1099 worker because you’re responsible for the self-employment tax. Essentially, 1099 workers pay both the employer’s and employee’s share of Social Security and Medicare taxes, amounting to a self-employment tax of 15.3%. However, as a 1099 worker, you’ll often qualify for tax deductions you wouldn’t be able to claim as a regular W-2 employee.