Independent Contractor
WHAT IS AN INDEPENDENT CONTRACTOR?
How does a business determine whether you are an independent contractor or an employee? The IRS has rules and tests to help make the decision. At a high level, if a business only has the ability to control the result of the work you perform, not how you perform the work, you might be considered an independent contractor.
If you are an independent contractor, the IRS considers you to be self-employed. You aren’t an employee of any company. As an independent contractor, you can operate as a sole proprietor, a limited liability company (LLC) or an S-corporation. The majority of businesses in the U.S. are run as sole proprietorships, so we’ll focus on that structure in this article.
HOW DOES AN INDEPENDENT CONTRACTOR PAY TAXES?
Things get a little more complicated with your taxes when you’re an independent contractor. You’ll have additional forms to file and you’ll need to file estimated taxes regularly. There are four main differences between filing taxes as an employee and filing taxes as an independent contractor. These include:
- Reporting self-employment income and deductions on Schedule C.
- Paying self-employment tax on Schedule SE.
- Paying quarterly estimated taxes.
- Receiving form 1099-MISC rather than a W-2.
How you report the income you earn as an independent contractor is different than how you’d report it as an employee. As an independent contractor, you’re required to file Schedule C along with your personal tax return. Schedule C details your profit and loss from business. Remember that an independent contractor is considered to be self-employed, so in effect, you are running your own one-person business. Any income that you earn as an independent contractor must be reported on Schedule C. You’ll then pay income taxes on the total profit.
While being an independent contractor means you have to pay more in self-employment taxes, there is an upside: You can take business deductions. These business deductions reduce the amount of profit you pay income taxes on. You’ll report these deductions along with your income on Schedule C. There are a number of business deductions you can take as an independent contractor, including health insurance, home office deductions, mileage and deductions for your phone bill.
The Tax Cuts and Jobs Act also created another deduction that some independent contractors may qualify for: the qualified business income deduction. This may allow you to deduct up to 20% of your business income.
SELF-EMPLOYMENT TAXES
A big financial drawback of self-employment is paying self-employment taxes. These taxes are equivalent to the Medicare and Social Security taxes you’d pay as an employee. But as an employee, your employer covers half the cost of the taxes. As a self-employed person, you’re required to pay the entire tax yourself.
And these self-employment taxes really add up. The current self-employment tax rate is 12.4% for Social Security and 2.9% for Medicare — a total of 15.3% just in self-employment tax. The good news is that while you need to pay the entire 15.3% tax, you can take half of what you pay as a deduction from your income.
You’ll report self-employment taxes by filing Schedule SE with your personal tax return. These taxes are in addition to any income tax that you’ll owe.
QUARTERLY ESTIMATED TAX PAYMENTS
The U.S. tax system is a pay-as-you-go tax system, meaning you need to make tax payments regularly throughout the year. When you’re an employee, your employer is responsible for withholding income taxes from your paycheck and sending it to the government.
So, how does an independent contractor pay taxes? When you’re an independent contractor, paying the government regularly throughout the year is your responsibility. You do this by making quarterly estimated income tax payments. You can estimate how much you need to pay the government each quarter by guessing what your total income for the year will be or by using the amount you’ve paid in estimated taxes the previous year.
You won’t know exactly how much tax you owe until you file your personal tax return at the end of the year. But you’ll want to spend time estimating this because if you underpay your estimated taxes, you could be subject to penalties.
And don’t forget to pay estimated taxes to your state. Aside from making federal estimated income tax payments, you’ll be required to pay your state throughout the year as well.