For independent contractors, taxes are one those unpleasant tasks that requires attention all year long--whether it's planning for taxes, filing taxes, paying estimated taxes or even knowing what documents to save for taxes. This guide to independent contractors' taxes can help you with all of these.
What Is an Independent Contractor?
Independent contractor is a specific term used by the IRS to describe a self-employed person who does work on a project basis (which can be done either from home or in a company's office). The independent contractor's work is not directly supervised by the client on a day-to-day basis. Freelancers, for example, are independent contractors.
Taxes--calculating and paying both self-employment and income taxes--are the responsibility of the independent contractor, who doesn't have taxes withheld from pay like an employee. Often independent contractors are sole proprietors. However, independent contractors can structure their businesses as LLCs, corporations or partnerships.
The Independent Contractor Tax Form: 1099-MISC
Though the 1099-MISC form has many other purposes, for the independent contractor it documents self-employment income. Just as an employee receives a W-2 from her employer, the independent contractor receives a 1099-MISC from each client for whom she worked. In box 7 it gives the amount of nonemployee compensation paid during that tax year (if it was $600 or more). In order to file their taxes, independent contractors should receive a 1099-MISC by January 31 of the following tax year (i.e., you should receive your 2011 tax year's 1099 by January 31, 2012).
The independent contractor who is also a sole proprietor totals income on all his or her 1099s and enters it on a Schedule C to calculate income tax. However, the compensation information on the 1099 is also used to calculate self-employment tax for the sole proprietor and for self-employed people with other business structures.
The self-employment tax is different from--and additional to--income tax. However, you file them together on your income taxes. Self-employment taxes are the contributions made to Social Security and Medicare that employees have taken out of their pay checks through payroll (or FICA) taxes.
By definition, all independent contractors--whether structured as a sole proprietor, partnership or LLC--must pay the self-employment tax because they are not employees. In an employment situation, employers pay half of the FICA taxes due and deduct the other half from each pay. The self-employed person pays both halves. The good news is the employer half is deductible.
What Is Considered Self-Employment Income?
For the independent contractor, calculating self-employment income is usually fairly easy. We simply add up the amounts on our 1099. However, it's not always that simple for everyone who has self-employment income. Anyone who sells items has it more difficult that the the independent contractor. But as an independent contractor, sometimes the question is: Would I be better off as an employee?
Paying Estimated Taxes
When it comes to paying taxes, employees have it easy. As mentioned above, employers actually pay half the costs that independent contractors incur as self-employment tax. But also, the employer conveniently calculates the payroll taxes (based on the W-4 submitted by the employee) and then sends to the federal and, if applicable, state governments both the employer's and employee's contributions.
Independent contractors, on the other hand, are responsible for sending in their own withholding, often in the form of quarterly estimated taxes. This withholding must cover both income taxes and self-employment taxes. Quarterly taxes are due April 15, June 15, September 15 and January 15 (but these can vary slightly from year to year).
While it is not necessarily required that independent contractors pay quarterly estimated taxes, a certain amount of tax must be withheld during the year in order to avoid a tax penalty. If you or your spouse is employed, you may be able increase your withholding from that job's pay to cover the income and self-employment taxes on your independent contractor earnings. (See more strategies to save for estimated taxes.) States may have different withholding requirements than the federal government. It's a good idea to check with a tax professional if you are unsure about how much to withhold.
Home Office Deduction
So we've covered the negatives about independent contractors' taxes--self-employment tax and quarterly estimated taxes. Now for a positive: the home office deduction! This is, of course, if you work at home. Some independent contractors do work on site, but for those who use a home office consider the following:
Other Self-Employment Deductions
Not all the tax deductions available to independent contractors are located on Schedule C, like the home office deduction. As mentioned above, half of self-employment tax is deductible. This is deducted on your 1040. Knowing what is and isn't deductible is important to making informed business decisions.
Organizing Your Taxes
When it comes to taxes, independent contractors have to keep a lot of balls in the air. A good organization system to keep track of tax documentation all year long will make tax time a lot simpler. And big box in the corner of your office is really not what I'm talking about (though it is probably better than nothing).
These are some of the types of items you might need to save (and when you might receive them) in order to get your taxes organized. Create a file for each.
- 1099s (by January 31)
- W-2s (by January 31)
- Copies of your invoices to clients (all year)
- Copies of receipts for goods sold (all year)
- Receipts for product, materials, supplies and other expenditures related to the cost of goods sold (all year)
- Investment and bank account statements (all year)
- Receipts for equipment, supplies (all year)
- Meals and travel receipts (all year)
- Documentation for vehicle use (keep track all year)
- Credit card bills or loan statement detailing interest costs for your business (all year)
- Mortgage interest statements (by January 31)
- Rent receipts (all year)
- Utilities bills (all year)
- Records of home improvement costs (all year)
- Property tax bills (varies, but many municipalities send them in January and June)
- Records of quarterly estimated federal taxes paid (April, June, September, January)
- Records of sales tax (all year)
- Records of state taxes paid (varies, often April, June, September, January)
- Records of foreign taxes paid (all year)
- Records of business taxes (all year)
I am not a tax attorney, CPA or tax preparation specialist. The information here is meant as a general guide. For specific questions about your own taxes, please refer to IRS publications or consult a tax specialist.