Tax Guide For Independent Contractors

By Michael Diaz. May 7th 2016

Independent contractors have more freedom than traditional employees. They can set their own hours, choose who they work with and generally be their own boss. However, this additional freedom comes with a price. And that price is special tax rules that independent contractors are subjected to. Here are the important tax considerations that you need to know about if you are an independent contractor.

What Is An Independent Contractor?

If you are in business for yourself (including part-time business) or self-employed, then you are probably an independent contractor. This includes sole proprietors and partners in a business. Freelance writers and photographers are also common examples of independent contractors. If you are not sure if you are an independent contractor, visit the Self-Employed Individuals Tax Center on the IRS's website.

Employee Taxes Vs. Independent Contractor Taxes

The major tax difference between independent contractors and standard employees is that standard employees have taxes (including Medicare and Social Security taxes) automatically taken out of their paychecks by their employer, while independent contractors do not have these taxes taken out.

There are two consequences of taxes not being taken out of independent contractors’ paychecks.

First, because Medicare and Social Security taxes are not taken out of the paychecks of independent contractors, they are required to pay the self-employment tax in addition to the standard income tax. The self-employment tax goes to support the Social Security and Medicare programs.

Second, because independent contractors do not have taxes taken out of their income, they are required to calculate their own taxes (both the income tax and the self-employment tax) on a quarterly basis and send them to Uncle Sam. These quarterly tax payments are estimated, which means you might owe more or less in tax payments at the end of the year depending on how much income you actually made. If more is owed, you’ll have to send the IRS additional money. If less is owed, you should receive the excess back in the form of a refund.

How To Calculate The Self-Employment Tax?

In order to figure out how much your self-employment tax will be, you need to figure out your net earnings. Your net earnings are calculated by subtracting your total annual business expenses from your total annual business income. If your net earnings are $400 or more (or $108.28 if you are a church employee), then you will have to pay the self-employment tax. Note that the IRS only makes you pay the self-employment tax on 92.35 percent of your net earnings.

The actual tax rate you will pay is broken down by Social Security and Medicare. The rate is 12.4 percent for Social Security and 2.9 percent for Medicare.

It is important to note that you can deduct 50 percent of your total self-employment tax for your income tax. In other words, before calculating your income tax, you can reduce your taxable income by 50 percent of your self-employment tax.

If you don’t want to deal with calculating your self-employment tax yourself, you can always hire a tax professional or use online tax software to do it for you. (For more information on hiring a tax professional, see How To Select The Best Income Tax Preparer. To learn more about online tax software, see Online Tax Preparation: TurboTax Vs. H&R Block.)

Estimated Tax Payments

If you expect to owe $1,000 or more in taxes (including both income and self-employment taxes) at the end of the year, then you will likely be required to make quarterly estimated tax payments to the IRS. The purpose of these required payments is to make sure that you don’t spend all of your income during the year and have nothing left over to pay your taxes at the year’s end.

The IRS has tools to help you figure out and send your estimated quarterly tax payments here.

Be aware that if you do not make these quarterly tax payments or if you do not calculate them correctly, you may be subjected to an IRS tax penalty. Therefore, it behooves you to take the time to make sure you are making the correct estimated payments every quarter.

Tax Deductions Available To Independent Contractors

The IRS has special tax deductions that self-employed individuals can take advantage of to reduce their tax burden. These include:

  • Self-Employment Tax Deduction: As mentioned above, you can deduct 50 percent of your self-employment tax from your net business income.
  • Health Insurance Costs Deduction: If you are self-employed and pay out of pocket for your health insurance, you can deduct 100 percent the costs of the insurance from your net business income. Note that this deduction can reduce your income tax, but not your self-employment tax.
  • Home Office Deduction: If you regularly work out of a home office, you can deduct a portion of the expenses of using this space. According to TurboTax.com, qualified expenses include the business portion of real estate taxes, mortgage interest, rent, utilities, insurance, painting, repairs and depreciation. 
  • Using Your Car For Business Purposes: If you use your car to see clients or to perform other tasks related to your business, you may be able to deduct a portion of your driving costs. You will need to hold on to your receipts and may need to show them to the IRS. (To learn more, see Use Your Car For Business And Get A Tax Break.)

If you are self-employed, you need to get up to speed on the special tax rules for independent contractors. Doing your homework ahead of time will help you to avoid costly tax penalties and might even help you to reduce your overall tax bill.

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