A surprisingly large number of workers in today’s economy are classified as independent contractors, flexible associates, contingent employees, or just a temporary employee. Almost 7% of workers in the United States fall under this classification, equaling out to around 10 million people. The trend of keeping workers on a provisional or temporary basis is expected to continue to increase in the coming years according to many analysis experts. It is no surprise that employers are continuing to prefer contracting work out, they do not have to provide benefits, insurance, or social security for that employee. However, despite this initial appeal, it is important for employers to not misclassify employees as contractors, which we will discuss more later.
One additional point these types of contractor workers have in common is that they do not have their taxes withheld automatically from their paychecks. This is good news for the company that pays them because they are not required to match taxes that the independent worker pays. Contractors file a 1099 instead of a W-2, and need to put in a little extra effort during tax season. There are plenty of exemptions and write-offs to be had though, and these need to be sought after to maximize the profits for contractors. Below is a checklist of mistakes to avoid and things to do while filing your taxes as an independent contractor to maximize take-home pay.
Your Company says that you’re a Contractor, but Are You Really?
Don’t assume that because the company you’re working for classifies you as an independent contractor or reports your income on form 1099 that you are actually a contract worker. Don’t look to your company to tell you about your status, instead look to the guidelines defined by the IRS. According to the IRS, a business is only entitled to control the direct result of the work done by an independent contractor, but not the methods of accomplishing the result. In other words, a company can tell a contract worker what deliverables they want, not how to how to deliver them. If you’re not sure about whether your contractor status meets the IRS rules, you can file form SS-8 with the IRS, which will look at your situation and make a determination. It is imperative to verify your status with the IRS before you file any taxes because if you take tax deductions afforded specifically to a contract worker, but the IRS doesn’t view your position as being legitimate contract work (but perhaps qualifying as employee work instead), you could be considered liable to pay taxes and penalties.
You are not the only one liable in the event that you are incorrectly classified as a contractor. Your company also bears responsibility for making sure that you are treated and paid according to the type of work you do. Details are explained on the IRS website: “Consequences of Treating an Employee as an Independent Contractor: If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker (the relief provisions, discussed below, will not apply). See Internal Revenue Code section 3509 for more information”.
Mistakes to Avoid
If you are correctly classified as a contractor, you’re not quite out of the woods yet. These are some important points to cover before you start collecting a paycheck.
Mistake 1: Not Securing or Reading a Written Agreement
When it comes to long-term contract work (30 days or more), the first major mistake that newly hired independent contractors make is not securing a written agreement that outlines the specific terms and conditions of employment. It is very important to sign a contract that defines your status as an independent contractor and not as an employee. If a large company has hired contractors in the past, they may have a standard from for you to sign. Make sure you thoroughly understand it before signing. How you are classified in the terms of your contract will heavily influence your status in eyes of the IRS and makes a big difference in the types of taxes you’ll owe.
Contractor-Specific Taxes and Obligations
Depending on how your contract defines you, you may be liable for different types of expenses. For example, if the agreement you sign classifies you as a “qualified small business operated by a sole proprietor”, you will be required to pay state franchise tax. If you are defined as a contractor only, bear in mind that you’ll have to pay the usual withholding amounts plus the employer portion of the Medicare and social security deductions (through your self-employment tax). The result can be that even though it may look like you are being paid a good wage, your take-home pay can be substantially lower than someone earning less gross income as a W-2 employee. You’ll have to pay self-employment tax, which includes social security and Medicare. Self-employment tax is paid at the annual tax filing in April using the self-employment tax form. One of the only bright spots is that is that half of the self-employment expense is deductible on Form 1040. You also probably won’t be covered by workers compensation if you are injured on the work premises. You will also be expected to carry your own insurance and healthcare plan.
Don’t be caught unaware by possible terms and conditions like the ones above. If the contract work is long-term, you may want to consider legal advice and verify that all of the clauses in the contract are legal in your state
Forgetting to Pay Estimated Taxes
Independent contractors are expected to pay taxes to the IRS, not just once a year in April like normal employees, but actually four times a year. The dates for contractors to be expected to pay estimated taxes are January 15th, April 15th, June 15th, and September 15th. Information on paying estimated taxes can be found on the IRS website.
1800’s Accountants, America’s Accounting Firm, explains a scenario of paying taxes quarterly as an independent contractor: “Many factors (filing status, standard deductions, itemized deductions, tax credits, etc.) go into calculating the amount of taxes owed, but the income threshold that triggers the requirement for quarterly tax payments is probably lower than you think. According to the IRS tax table for 2013, a single taxpayer with an adjusted gross income of just $9,950 will owe $1,061 in taxes for 2013, and a married couple filing jointly with an adjusted gross income of just $10,000 per year will owe $1,003 in taxes for tax year 2013.
The rules for estimated tax payments for sales taxes, business and franchise taxes (note that you don’t have to own a franchised business in order to owe a state franchise tax – it’s what some states call the business tax charged to all businesses), and local and state income taxes in your home state may be different. So check your state’s laws – or talk with an experienced tax adviser who understands the rules for small business – in order to avoid problems.”
Getting all the tax deductions you can is crucial as an independent contractor since generally you will most likely owe higher taxes than a full or part time employee. Keeping the right records of things that qualify as business expenses is crucial for getting these deductions. If you are a highly paid contractor it may even be prudent to open a separate bank account to keep track of your business-related deductible transactions. Even if you are a small time contractor, it is still critical to keep marked boundaries between business and personal expenses.
“Tax deductions can be quite valuable, because they reduce taxable income for the year. For example, someone in a 25% tax bracket can save $25 in income tax for every $100 in deductions, while also saving as much as $15 in self-employment taxes for every $100 deduction from taxable income.”- 1800 Accountants
A General List of Deductions
To qualify as a legitimate deduction, expenses must be:
- Incurred in connection with your trade, business, or profession.
- Ordinary and necessary expenses (as defined by the tax authorities).
- Must not be lavish or extravagant under the circumstances (as defined by the tax authorities).
Examples of Expenses that Qualify:
- Travel – Employees do not deduct the cost of traveling to work, but contractors can. If you are self-employed and your home is your principal place of business, you can claim 57.5 cents per mile for 2015, plus the cost of parking and any tolls you paid. It’s important to keep records of this or the IRS can deny your claim if they audit you.
- Home Office – If you use a portion of your home exclusively for business purposes, you can deduct mortgage interest, rent, utilities, etc. from the percentage of the home used for work purposes. See TurboTax for more details.
- General Supplies – This will be industry specific, but if you’ve bought something for your business that meets the general guidelines above, it should be able to qualify as a tax deduction.
Also these Tax Credits:
- Earned Income Tax Credit
- Education Credits
- Child and Dependent Care Credit
- Adoption Credit
- Saver’s Credit
- Small Business Health Care Credit
- Plug-in Electric Vehicle Credit
- Standard Mileage
- Charitable Contributions
- Retirement Arrangements
- Domestic Production Activities
For a complete list, see the link above.