December 30, 2020
Independent contractors often panic every April when it comes time to fill out their annual tax returns. Many haven’t set aside enough money to pay their taxes, nor have they made quarterly payments to the IRS, leaving them facing debts that are subject to both penalties and interest. The best thing that you can do as an independent contractor is understand the tax structure, as well as seek out the help of a tax professional, so your returns can be filled out and filed properly. In addition, saving and setting aside enough money to pay your taxes each year is important as well. Here, we’ll clear up some of the mysteries surrounding independent contractors and federal tax rates, so you can better understand your actionable next steps.
Are You an Independent Contractor?
The first step towards understanding how the IRS taxes independent contractors requires you to realize whether or not you fall into this category. To put it simply, an independent contractor is someone who receives a 1099 at the end of the calendar year. Taxes are not taken out of any paychecks that you receive from the employers that you work for.
Freelancers fall into this category the most often. Many have a handful of clients that they work for or accept general projects for hire. The money that they receive, their gross payments, do not have taxes taken out, so they need to account for their income and expenses as the year goes by. Freelancers do not receive a regular paycheck.
With that said, some small business owners are considered to be independent contractors as well. For example, doctors, lawyers, craftspeople, and even the owners of your local small “mom and pop shop” or restaurant are also independent contractors, if they don’t use a payroll service or calculate and take taxes out of their own paychecks.
Different Tax Rates for Independent Contractors
Independent contractors are taxed at a different rate than those who work for a standard company that takes taxes out of their paychecks. While it’s true that independent contractors are paying more in taxes, the situation is actually more complicated than that.
When you work for a corporation that takes taxes out of each check, you only need to pay a portion of the federal taxes that you owe to the IRS. Your employer pays half of what you owe for you, withholding the other half from your check and sending it to the IRS on your behalf. Since independent contractors have no one doing this for them, they need to pay the entire amount on their own. This is called self-employment tax.
As a result, independent contractors end up paying 15.3% of their income to the IRS every year. Some of that percentage (12.4%) is for social security, while the remaining 2.9% is for Medicare. Employees of a standard company only pay half of this, or roughly 7.65%. For independent contractors, the amount due can vary, depending on the tax bracket that you fall into, since some high earners have to pay an additional .9% Medicare surtax. However, this only is required for single people who earn more than $200,000 per year, or those who are married, yet filing separately and make more than $125,000. For married couples who need to pay self-employment tax, those who make more than $250,000 combined need to pay that surtax.
Taking Business-Related Deductions
One of the good things to note is that independent contractors, due to the nature of their work, are eligible for business-related tax deductions. This can lower the amount of taxes that they need to pay each year, because they are able to subtract certain business expenses.
Although the deductions that independent contractors qualify for can vary quite a bit, many of them fall into the following categories:
- Insurance Premiums – If you have to carry any business insurance, such as liability, then it may be deductible.
- Vehicle Costs – Things like gas and mileage tend to be deductible, as long as you use your vehicle for a certain percentage of the time to meet with clients, travel to conferences, or for other business uses.
- Fees – Any fees that you pay to belong to professional organizations tends to be tax deductible. The same goes for any attorney or accounting fees for services that you need to have completed throughout the year.
- Home Office – The area of your home that you use for business purposes, such as your home office, can be an expense that you deduct from your taxes. However, there are many specific rules that you need to follow here. Enlisting the help of a tax professional is highly recommended to ensure that you follow the tax guidelines appropriately.
- Meals – If you entertain clients or need to eat while on the road traveling from one business meeting to another, then those costs may be deductible as well.
These are just a few examples of what you can usually deduct from your taxes if you’re an independent contractor. There are certainly others that your tax preparer can help you determine.
Making Planned Estimated Tax Payments
Any independent contractor who expects to owe the IRS more than $1,000 in taxes at the end of the year can make planned estimated tax payments. These payments are due at certain times of the year, including:
- April 15
- June 15
- September 15
- January 15
Prior to each of these deadlines, you need to calculate the amount of taxes owed to the IRS based on the amounts made during the previous set of months. For April, that consists of January through March. In June, you pay for April and May. September’s payment is for June through August, and January’s payment is from September through December. Note that the amount of months in each period can vary. Again, a tax professional can help you calculate your estimated payments, so that you are not surprised at the end of the year.
If You Owe the IRS
Independent contractors who owe money to the IRS must either make quarterly payments throughout the year based on their gross receipts or plan to send in a payment when they file their yearly return in April. If that amount is not paid, the IRS will charge interest and penalties on it, adding on to the debt. This leaves some independent contractors feeling panicky and financially overwhelmed because they did not appropriately plan for this expense throughout the previous year.
Thankfully, the IRS accepts payment plans from both individuals and businesses, including those run by independent contractors. Reaching out through your tax preparer and filing for a monthly payment plan will prevent the IRS from making additional collection efforts. It’s best to either set up a payment plan or ask for an extension on your tax return, if you feel as though you cannot gather the amount due prior to the extended deadline.
Don’t Forget About Local Taxes
In addition to having to pay taxes to the IRS, an independent contractor is also responsible for paying state and local taxes. These amounts vary, based on the state and location that you reside and work in. Your income also determines how much you need to pay the state, county, and city. Again, this is where your professional tax preparer comes into play, as they can help you determine these amounts, fill in, and file the required returns.
Using a Professional Tax Preparer
It’s crucial that independent contractors use a professional tax preparer every April or on a quarterly basis to ensure that their returns and payments are sent in on time and are fully accurate. Otherwise, independent contractors can risk getting audited, as well as having to pay fees, interest, and penalties. It can be tough to do this on your own, as you’ll need to know and understand every part of the tax code and have an idea for which particular deductions you qualify for. Using a tax professional makes this much easier, and you’ll have someone to communicate with the IRS on your behalf should you be selected for an audit. It’s always best to have someone professionally prepare your taxes for you, so you can focus on what you do best, regardless of your chosen field.
If you are an independent contractor and have questions or need guidance about making quarterly payments, filling out your yearly tax return, or have received an IRS audit request due to a potential mistake that you made on your own, please reach out to the tax advisors at Enterprise Consultants Group. We can answer your questions, discuss your rights, and provide actionable options. Please contact us online or at (800) 575-9284 today to schedule a free and confidential consultation to see how we can help you.
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