An independent contractor is a small business. Like every business, the independent contractor has to pay taxes. Like every business, the independent contractor has expenses. And, like every business, it is important to have a plan. Before the tax year begins, do some tax strategizing so you can take advantage of deductions when they will give you the greatest value. You also need to remember that sometimes the biggest tax savings are the interest, penalties, and audit costs you avoid by following the rules.
- create your tax plan at the beginning of the year
- pay attention to timing
- take inventory of supplies, services, and facilities
- put together a list of applicable deductions and credits
- keep organized records of income and expense
- throw receipts in a paper bag
- assume the only tax liability is the federal income tax
- keep income off the books
- forget estimated taxes
Any procrastinator knows that it is harder to do certain things under the pressure of time. For example, it isn’t easy to categorize expenses at the end of the year when you need to file your return. Having a system in place before you incur the expenses allows you to gather reliable information quickly. (This is a great general business practice in addition to being a tax planning tool.)
Certain tax reduction strategies only work if you start collecting the necessary information at the beginning of the year. If you use your personal vehicle to drive back and forth to your client’s offices, you can deduct certain expenses associated with that commute if you keep contemporaneous records from the start of the year. If you have a high-deductible health care plan, you can set up a health care savings account and set aside the money for the deductible each month on a tax advantaged basis.
Most independent contractors keep their books using the cash method, so timing is everything. A cash-basis taxpayer recognizes income when the check arrives and can claim expenses when the money is spent. Deductions are less valuable when they are offsetting lower amounts of income because tax rates increase with taxable income. You can reduce taxes by making big purchases in years when you expect to earn more money. Section 179 of the Internal Revenue Code allows small businesses to expense large purchases that might otherwise be capitalized so the entire cost can be deducted in the year of purchase.
This means a new computer, printer, or copier might result in a handy deduction when a client pays a large outstanding invoice. In addition, cash-basis taxpayers can defer income by billing at the end of tax year so that payments are not due until January of the following year or can accelerate income into a year with a lot of expenses by working with clients (e.g., offering a discount for early payment).
It’s important to take inventory of everything you need for your work. A company operating in an office building deducts the rent for the building or the interest it pays on the mortgage, the cost of utilities and office supplies, internet and IT services—even the cost of the coffee in the break room. Independent contractors may not be able to deduct the coffee, but they can deduct costs associated with the offices they work in, the supplies and services they use and the equipment and tools they need to do their work.
Your first step is to identify what you need in order to do your job. An independent contractor who has a home office or workshop can deduct a portion of the mortgage interest payments as a business expense, depreciate a portion of the house and equipment and furniture, and deduct an allocable portion of the cost of the household utilities. Computer paper and ink purchases can be deducted. If a customer requires you to wear certain safety equipment to go on the job site, that cost is deductible. Automobile expenses and public transit costs are deductible if you go to client offices. Computer repair expenses and web design services that you use to promote your business are deductible. If your son or daughter provides the services, you can pay them and deduct the cost.
Once you know what you need, you can start tracking the right expenses.
There are great resources available to help independent contractors identify deductible and creditable expenses. Many of them are free or at a very low cost. The IRS website has some publications that provide advice for small businesses. The advice is conservative, but thorough. Most tax preparation software packages have a question and answer format that can guide users through the various categories of deductible expenses. Even if you used an accountant to prepare your return, it might be worth taking the time after the filing season is over to buy a software package (at a discount) and go through the steps of preparing a return to see what kinds of deductions are available. A good accountant can also help you identify opportunities for tax savings.
As noted above, it is easier to take advantage of tax planning opportunities if you have good information. The best kind of information is gathered contemporaneously, categorized appropriately, and backed up by documentation. Appropriate categorization involves knowing which kinds of expenses are eligible for different types of tax treatment.
For instance, meal expenses incurred while traveling on business are fully deductible while only 50% of meal expenses incurred for business development purposes are deductible. If you are just starting your business, consider investing in your financial future by having a reputable bookkeeper or accountant help you set up your books with the appropriate line items. Documentation includes usage logs for assets that are used for business and for personal purposes, receipts, and contracts.
You should have your clients sign agreements that specifically set out the expenses they will bear (or you will bear) and travel expectations to support the deductions you take in connection with those contracts. Records should include income as well as expenses. Income records should specify where the income was earned and why it was paid. The source of the payment is important for state and local tax purposes. The reason for the payment is important because not all income is taxable (e.g., insurance proceeds).
Organized records can help in identifying and substantiating deductions. Poorly organized records can cost deductions. This is particularly true when receipts include both personal and business expenditures. It can be difficult to sort them out, and a random classification of receipts will not be respected by an auditor.
For most independent contractors, the federal income tax will be the largest tax they pay each year, but they should not ignore the federal self-employment and Medicare taxes, or state and local taxes. The numbers add up. The self employment tax rate is 15.3% on the first $113,700, and everything above that is subject to the 2.9% Medicare tax. Not all deductions are treated the same way for income tax purposes and self-employment tax purposes; there are planning opportunities if the 15.3% tax rate will apply to every dollar of income earned.
Additionally, not every state has an income tax. Some states have gross receipt taxes. Most state revenue departments audit large businesses and look at their 1099s. If a business located in State X uses the services of an independent contractor who does not file a tax return in State X, the State X revenue department will start asking questions. Similarly, a wage earner might not be subject to tax in a municipality, but an independent contractor might be liable for a business privilege tax.
“Non-filers” can be subject to substantial penalties and interest going back to the inception of the business. It is better to identify the taxes up front and manage the liability through careful planning. Often the state and local taxes are modest, and knowledgeable business people can create agreements and work arrangements that keep them out of high tax states.
Did you ever have a contractor tell you there is one price for cash and another price if you pay with a check? It can be very tempting to avoid tax by keeping certain jobs off the books.
Do not do it.
Report your income, regardless of whether you get a 1099. If you barter with another business for services or goods, figure out if there is a taxable component to the transaction. Failing to report income constitutes tax evasion and the penalties are not just financial. Every year, successful business owners go to prison for failing to report income. Your business may not be large, but if it is audited, you would rather argue over whether or not you were entitled to certain deductions, than whether or not you reported all of your income.
Independent contractors—unlike employees who are paid on a W-2—do not have taxes withheld from their earnings. Instead, clients generally report payments to independent contracts on the Form 1099, usually in block 7 as “non-wage compensation.” The point of wage withholding as shown on the W-2s is to make sure that the government receives its tax dollars throughout the year. The equivalent to the withholding tax for people with non-wage income is the estimated tax regime.
If most of your income is “non-wage compensation” and other income not subject to withholding (e.g., interest received, dividend payments), you must make quarterly payments to the IRS equal, in the aggregate, to the lesser of, 1) your estimated income tax for the year, based on the income you have received or expect to receive, or 2) the amount of tax you paid for the prior year.
The payments are due in 2014 on April 15, June 16, September 15 and January 15, 2015. If the tax due is likely to be less than the tax paid in the prior year, you have to recompute your likely tax liability on a quarterly basis to make accurate estimates. Failure to pay a sufficient amount can result in interest and penalties if the underpayment is substantial enough.
You may not be required to pay estimated taxes if you earn most of your income as an employee and the independent contractor role is on the side. You can adjust your W-2 withholding over the course of the year to pay in enough total tax dollars through your employer’s withholding process to avoid the estimated tax obligation. However, you still need to take into account what you are likely to make as an independent contractor to project the correct withholding amount. Similarly, if you have a spouse who is employed, the spouse may be able to increase his or her withholding to cover a substantial part of your income tax.
For the tax savvy independent contractor, the estimated tax payment regime can provide an advantage. You get to hang on to your money longer than you otherwise would by only having to pay quarterly. And if your business is seasonal and most of the income is earned at the end of the year, you can pay larger estimated payments when the income is actually received. The estimated tax obligation, if observed, can also cushion the financial blow of a large tax bill in April by offsetting a big part of the amount that would otherwise be due all at once.
Note, the IRS Publication 505 provides a great deal of information about the estimated tax. However, the IRS will not notify you that you are subject to the requirement until after you have filed a return that shows a substantial amount of income that was not subject to withholding. This means if you are not aware of the obligation, you will not learn about it until you have already had to pay interest and penalties for a year.
The keys to minimizing taxes are knowledge, planning, and record keeping. You need knowledge about your business and knowledge about the available tax deductions and credits. Planning allows you to maximize the value of tax deductions. Record keeping is the foundation of knowledge, and planning and will be the best defense against an audit.