Being what the Internal Revenue Service (IRS) classifies as an “independent contractor” means you have different tax obligations and deductions than do employees. This contingent workforce is growing because it gives organizations the flexibility to only use labor when it needs it and also not have to pay the benefits which employees expect to receive. In addition, freelancers are finding that the tax advantages often allow them to net more and work less. Here’s how the IRS defines “independent contractor” and what the tax responsibilities and deductions these independent contractors have.
In essence, the IRS determines that you are an independent contractor based on the criteria of control. Unlike employees, independent contractors are in control of how many organizations you will do work for or not work for, how you will do that work, for how many hours and in what location. Of course some organizations might have specific terms and conditions, such as performing the tasks onsite during traditional business hours, but you are free to take that offer or not. If the employer tells employees they have to relocate to China or work the night shift, they have to do that.
Employees often also work as independent contractors for other organizations in order to earn additional income, increase their professional credentials and avail themselves of the tax advantages of being a freelancer or free agent.
Despite the many attempts at so-called “tax simplification,” the regulations tend to be complex and are continually changing, as they did for 2013. Not following them to the letter of the law can result in criminal and financial penalties. The good news is that in this digital era there are software programs which can help explain the general rules and exceptions. These types of software include Simply Accounting, Peach Tree, Turbo Tax and Quickbooks.
Independent contractors, especially because of the myriad deductions open to them, tend to be audited if the IRS is suspicious of what is being claimed. Therefore, it is imperative to maintain detailed records and hold on to receipts. There is no reason to fear an audit if you have tracked expenses.
Independent contractors earning $1,000 or more have to pay estimated quarterly taxes, federal and state, on the 15th of April, June, September and January, as well as an annual filing. The exception for state taxes is operating a business in those states such as Texas without an income tax. Failure to pay taxes can result in criminal and civil actions. Organizations using your services which pay you $600 or more annually will file a 1099-MISC with the IRS and you will receive a copy, meaning that the IRS is aware of this income.
You will pay your own “self-employment” tax on what has been earned for that year for your Social Security and Medicare. What the percentage for that tax is depends on the latest regulations in the tax code.
Some have observed that the tax code in the U.S. has tended to favor the business owner, one type of which is the independent contract. You may not be running a large company, but you still are eligible for significant tax advantages. Those involve both the direct and indirect costs of doing business and they are deductible. On the other hand, employees, although they may receive benefits, such as vacation and partial payment of medical insurance, have more limited kinds of deductions associated with their professional life.
Among the key deductions for independent contractors are:
Home office: The percentage of your residence which is used exclusively for the business can be deducted. That includes portions of the rent or mortgage, real estate taxes, insurance, painting, utilities and furniture.
An exception could occur if, for a while, you are performing the tasks onsite for the organization. That, not your home office, is your primary work area and there’s no write-off for that time. However, when you return to operating on your own site, you prorate the time you do that. For example, you worked on the employer’s site for six months. That means that the other six qualify for the home-office deduction.
The situation is dicey for full-time employees who do some freelance work at their residence. They may need a tax expert to guide them about the possibility of a deduction. This item on a tax return often sends up a red flag for an audit.
(Also read: Tax Deductions For Those Who Have A Home Office.)
Equipment: Freelancers usually have to supply their own equipment, ranging from computers to saws to cut down trees. The cost of those is tax deductible and the depreciation will be factored in.
Travel: Every mile traveled for the direct and indirect needs of the business is tax deductible. That travel could be by car, train, or plane and could include prospecting and sales, doing work on-site for the organization or conducting a review with the client, shopping for equipment and books, doing research at the library, attending a course, delivering a guest lecture and participating in a panel. Also a percentage of the cost of meals consumed while on business is deductible.
Employees cannot deduct their commuting costs.
Reference material: Books, subscriptions to trade magazines and internet sites, and newspapers are write-offs. Attending a Broadway play might be considered necessary if you publish reviews for the media. The cost of your ticket is tax deductible.
Cell phone: This can be written off without tracking business versus personal calls and prorating the amount.
Internet connection: If that is necessary for the business, it is deductible.
Education and training: The definition is broad, ranging from a certificate program or college degrees to an online course in one subject or six weeks training in public speaking. However, it has to be directly related to your ability to perform in your business.
Medical insurance: Premiums for the self-employed, spouse and dependents are deductible. If you pay a percentage of employee premiums you can also deduct a percentage of the cost.
Retirement plans: Up to 20 percent of net earnings, up to a specified limit, can be reduced for tax purposes by putting that amount in a retirement fund such as a Simplified Employee Pension Plan (SEP) or a Keogh plan.
Children’s wages: Putting the children to work, as long as it is not against the state law, results in a deduction for their wages, without incurring Social Security tax if they are under 18 or unemployment tax if they are under 21.
There are diverse kinds of tax advantages associated with self-employment. However, when choosing between this way to make a living or being an employee, other factors have to be considered such as the emotional comfort of the regular paycheck employees receive as well as the benefits of paid time off.