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More people are making the dream of working for themselves a reality. They are leaving corporate America for the freedom of setting their own hours, staying at home in their PJs and turning their couch into their office. This is the path chosen by contractors who make up one in five workers in America, according to a 2018 NPR/Marist poll. And that’s just a small portion of what’s to come. Within the next decade, contractors and freelancers could make up half of the American workforce, according to NPR.
That autonomy also means you are in control of not-so-fun administrative duties like taxes. Those are far more complex for independent contractors. Carefully planning for tax payments and keeping thorough records can prevent large surprises when the tax deadline hits April 15. Scott Shields, a certified public accountant with Shields Blice & Co. CPAs Inc. in Fairlawn and Green, explains what you need to know.
Know Your Standing
Working for yourself means you are the boss. You choose where you work, when and what to do, and then send a bill. Common independent contractor jobs are graphic designers, writers and electricians. Independent contractors have to pay both income and self-employment taxes on their business profits, and usually prepay quarterly estimated taxes.
The forms you receive from companies will tell you what status you are. Independent contractors receive a 1099 reporting their income. Those considered employees will receive a W-2. Employers may push people toward an independent contractor status because it saves them money.
“An employee will pay Social Security and Medicare tax. Social Security is 6.2 percent. Medicare is 1.45. Your employer’s going to match that,” Shields explains. “As a 1099, you’ve got to pay both sides of the equation because you’re not only the employer, you’re the employee.”
So independent contractors pay the self-employment tax, which is 15.3 percent and includes both the employee and employer side of Social Security and Medicare.
As a W-2 employee, your employer is paying into federal unemployment, state unemployment and workers’ compensation. Independent contractors with employees will pay unemployment, as well as workers’ comp that is scaled to the type of work they do.
Some independent contractors choose to file and register with the Ohio Secretary of State to form a business entity. While there are many options with different tax advantages, a popular choice is forming an LLC because it offers flexibility and, within certain requirements, some potential limited liability to help shield your business and personal assets.
“An LLC gets to choose what section of the tax code it’s going to operate under,” Shields says.
Independent contractors who don’t register as an entity may be considered a sole proprietor, which is the easiest business entity to set up and maintain. There are many options, so it’s best to consult with your tax preparer, financial planner or lawyer before making this choice.
Everything Earned
Independent contractors, prepare your file folders. Each person who paid you $600 or more will issue a 1099-MISC form reporting income, so you may be receiving many 1099s and need to keep those forms together. Note there are various versions of the 1099. It may be difficult to track many jobs, but the IRS will hold you liable for any unreported income.
“The IRS computer system will match up a taxpayer’s tax returns with 1099s issued, and if they’re not there, you’ll get a letter that says why not,” Shields says. Those who don’t report may owe penalties and interests. If you realize you forgot to report earnings or deductions, immediately ask your tax preparer to file an amended tax return for up to three years back from date of filing.
When you receive a 1099-MISC, locate your earnings in box No. 7 under nonemployee compensation. The 1099-MISC includes boxes for other forms of income such as royalties and rents, which means business owners paying rent should send a 1099 to their landlord.
Expense Report
Even more sophisticated recordkeeping comes in with the Schedule C form. Add up all your 1099s in addition to any jobs you got paid less than $600 for and put the total under gross receipts on the Schedule C. Note that while you won’t get 1099s for jobs under $600, they still need to get added to the Schedule C.
“It’s your responsibility to keep good accurate records and disclose all your revenue and all your allowable expenses,” Shields says. The top of the Schedule C also allows you to subtract the cost of goods sold if you are selling products, not services.
There are several possible expense deductions on the Schedule C. Thoroughly discuss deductions with your tax preparer because some aren’t exactly what they sound like. Keep track of what expenses you put in each category so you don’t accidentally count them twice. Supplies, for example, could be pencils, paper or printer ink. You shouldn’t put your cellphone or home internet there, because those are often considered as utilities.
To properly deduct phone and internet expenses, keep very detailed records on usage. If you have a work phone and a personal phone, great. Just include the work phone. If you use a cellphone for both, you and your tax preparer have to page through phone records to determine what the allocation is for work use. If someone goes over 90 percent, it’s highly unlikely, Shields says, so it may be time to check the records again. Internet is also split into a work allocation.
With such elaborate records required to receive deductions, Shields recommends tracking expenses monthly using software like Excel or QuickBooks, and bringing that to your tax preparer.
“That way everything is still fresh in your mind and you don’t forget stuff and lose the opportunity to lower your tax bill,” Shields says. “Don’t use the shoebox.”
You may qualify for a home office deduction, but only if it’s used regularly and exclusively for business.
“If you’ve got summer clothes in there, get them the heck out. You can’t have anything in there but business stuff,” Shields says.
Consult with a tax preparer on using the long-form version that calculates the home office deduction by including all home office expenses and depreciating your house, which many people don’t want to do. The simplified way to calculate this deduction involves deducting $5 per square foot for a maximum of 300 square feet.
To complete the Schedule C, subtract your total expenses from your gross income to determine your profit, a figure that is carried over to the Schedule 1, a form where you deduct self-employed health insurance with the independent contractor as the primary insured, self-employed retirement plans and more.
The self-employment tax, which includes Social Security and Medicare, is determined on Schedule SE, which is then carried over to Schedule 4.
The 2017 Tax and Jobs Act brought the addition of the new Schedule 1 through 6 forms. It also introduced the new tax code section 199A. It allows for pass-through entities to potentially eliminate 20 percent of qualified business income from federal taxable income. The threshold is singles making under $157,500 and married couples making under $315,000. While it’s likely those under the threshold qualify, the process of determining qualification is very complicated, so contact a tax preparer immediately.
Depending on your situation, you may have to fill out more forms, so consult your tax preparer.
Payment Plan
You’ve survived the rigors of Schedule forms and are ready to file. It’s time to fill out a 1040, the individual income tax return. The 1040 is where line items from Schedules 1 through 6 feed in to determine your total income, your taxable income and the tax. If the tax is more than the sum of the withholding, credits and estimated taxes paid, the independent contractor has to pay more. If the amount is less, then the independent contractor gets a refund. An overpayment may be refunded, and that refund can be applied to taxes for the following year.
Estimates of taxes to prepay for the upcoming year are specified on form 1040-ES. It’s recommended to pay estimates quarterly, on April 15, June 15, Sept. 15 and Jan. 15, but dates may vary with holidays and weekends. It’s crucial to pay attention to unexpected spikes or drops in income that may affect estimated taxes. If this happens, call your tax preparer right away to avoid owing a large amount or incurring penalties and interest.
Shields likes to meet with independent contractors midyear to do a mini tax return and make sure they are on track with their estimates. With the new tax law and the huge amount of forms and deductions, it’s best to use a tax preparer for independent contractor taxes so you don’t miss out.
“Don’t do this on your own because you’re going to end up paying too much taxes or running up penalties and interest,” Shields says. “Get a trusted professional to help you. It’s worth the money.”
