One of the things you may miss about being employed (aside from office snacks and the annual Halloween costume contests) is someone else withholding your taxes.
As an employee, taxes are automatically withheld from your salary and filed by your employer, leaving you to simply report them in your paperwork. As a self-employed individual, however, your tax season will be a bit different.
Self-employed individuals must pay federal income taxes, plus Social Security and Medicare taxes, either through quarterly estimated tax payments or when filing their annual tax returns. Taxes are paid on what you earn as you earn it — on your own.
Taxes are one of the many new things you have to learn now that you’re working for yourself. It will help you project future profits, keep tabs on your expenses, and give you a good picture of how you’re doing financially. This article will help guide you through how to properly fulfill and file your taxes when you’re starting out as a self-employed individual.
Who Is Considered an Independent Contractor
The work done by an independent contractor spans a wide range — from professionals, like doctors, lawyers, accountants, carpenters, and electricians, to freelancers, like graphic artists, guest speakers, babysitters, and writers.
What separates an independent contractor from an employee is not what the particular job is, however, it’s how the job is set up.
Independent contractors do work for others, but not as an employee. Although they do provide services, the details of these services — what will be done and how it will be done — aren’t controlled by someone else.
According to the Internal Revenue Service (IRS), “the general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
How an Independent Contractor Is Taxed
The IRS considers independent contractors to be self-employed and therefore, subject to self-employment tax.
This is the same category as sole proprietors and partnerships. So whether you’re running your own small business, you’re in a partnership, or you’re a member of a limited liability company (LLC), your self-employment income will still be taxed the same way.
Whenever an independent contractor gets paid for their work, these payments are not salaries or wages — they’re regarded as business income.
All business income is directly received or deposited into your bank account in its entirety, without any deductions or income tax automatically withheld.
The Taxes an Independent Contractor Needs to Pay
As an independent contractor, any income you receive from a client is reported on a Form 1099-MISC, also referred to by the IRS as “non-employee compensation.” (This is the equivalent of the Form W-2 that an employee usually receives.)
Any client who has paid you more than $600 must file Form 1099-MISC, as well as furnish you with a copy, usually by January 31. If they don’t send it by then, they will be charged a penalty by the IRS, so it’s a good idea to reach out and ask when you can expect to receive your form.
One thing you’ll notice on the form is that the income received is not subject to employment-tax withholding, as it usually is for employees. This does not mean, however, that you’re exempt from paying taxes. It just means you have to calculate and pay them yourself.
Generally, an independent contractor has to pay three types of taxes: federal and state income tax (based on earnings), self-employment tax (to cover Social Security and Medicare), and any other state or municipal tax (which varies by location). The process for filing these includes submitting an annual return, as well as making quarterly estimated tax payments throughout the year.
These are all accomplished using Form 1040, and its associated attachments, which are called “schedules” and range from 1-6.
When an Independent Contractor Must File Taxes
Independent contractors, or anyone who is self-employed, are required to pay their taxes four times a year. This is usually referred to as “estimated quarterly taxes” or “estimated taxes,” as you’re essentially gauging how much income you expect to make in the year and paying taxes on that amount.
There are some cases in which an independent contractor doesn’t need to file estimated taxes. These, however, are very specific — if you had no tax liability the prior year for a complete 12-month period and were a U.S. citizen or resident for the whole year, then you don’t have to pay estimated tax.
But for everyone else who expects to pay at least $1000 in taxes, paying estimated tax is a requirement.
Steps for Filing Your Independent Contractor Taxes
The first step to filing taxes is to figure out your expected adjusted gross income, taxable income, taxes, deductions, and credits for the year (which are explained below). Then, you can simply apply a few calculations to determine how much you need to pay per quarter.
Fortunately, the IRS provides an easy way to calculate this amount. Simply download the Form 1040-ES, which is a 12 page document with thorough instructions on how much tax you need to pay, as well as an Estimated Tax Worksheet to guide you through each step.
Step 1: Calculating Your Income Tax
To calculate your income tax, you must first figure out how much income you made for the year. Do this by taking every Form 1099-MISC you received during the year and adding them all together — this is part of your taxable income.
Note that you have to report all your income, even if it doesn’t appear on a Form 1099-MISC. If you’ve earned less than $600 on a particular job (which doesn’t require a Form 1099-MISC) or a client has simply failed to file or send you a copy, you will still need to include any and all earnings when tallying your income.
The only time a self-employed individual is not required to report income is if their total earnings from all sources is less than $400 for the year. Those who under-report their income may face serious penalties.
State and Municipal Taxes
Most states and municipalities are also likely to require independent contractors to pay taxes.
Depending on what kind of work you do, this may include certain business taxes, registration fees, licenses, or sales tax (for those selling products).
Every state and municipality is different. Find out exactly what you need to pay in addition to federal taxes by checking with the tax authorities for your state and municipality. If you’re still unsure about the actual tax preparation and amount, it may be a good idea to consult with a CPA or tax professional.
Step 2: Claiming Any Tax Deductions
One of the perks of self-employment is being able to minimize how much of your money goes towards taxes. This is done through deductions, or tax write-offs, which are certain predefined business expenses that you can subtract from your income.
Your income minus deductions will result in your “adjusted gross income.” This number is then multiplied by your specific income tax rate for the year in order to get your “taxable income.” (On the federal level, income tax rates for independent contractors start at 10% and increase all the way up to 37%, depending on your income bracket.)
To qualify as an acceptable, deductible expense, it should be for something both “ordinary” and “necessary.” An ordinary expense is one that’s common and accepted within the industry, while a necessary expense is one that helps you fulfill your intended business purpose.
This includes a comprehensive list, including 100% of advertising and promotions, 100% of further education, 100% of any move that’s required for work, 50% of business meals, salaries, transportation, $5 per square foot for a dedicated home office (up to a maximum of 300 square feet), and many others.
Deductions are all made on Schedule C, also titled “Profit or Loss From Business,” or the simpler Schedule C-EZ, called “Net Profit From Business,” and used for expenses of $5000 or less. Both are part of Form 1040 and should be included when file your annual tax return, along with your first quarterly estimated tax payment.
When filing your own taxes, you want to take as many legitimate deductions as you can. However, not all of the deductions may be available for your situation. As always, it’s best to verify with a certified public accountant (CPA) or tax professional before claiming a deduction on your tax return.
Step 3: Calculating Your Self-Employment Tax
Self-employment tax is paid in addition to your income tax. When you’re an employee, part of your salary is withheld to pay for the Federal Insurance Contributions Act (FICA) tax, which covers your contribution to Social Security and Medicare. The amount you pay is then matched by your employer.
When you’re an independent contractor, however, you are obligated to pay the entire FICA amount — the half you would normally pay as an employee, as well as the half normally paid by your employer.
To help you quantify this, self-employment tax rate is 15.3% of your net income. This is a combination of Social Security tax, which is 12.4% (for incomes up to $127,200), and Medicare, which is 2.9%.
The actual amount you’re required to pay is based solely on your net income (not any earnings received from investments, asset sales, or the like), and will be calculated at the time of filing, using Schedule SE (Form 1040).
Step 4: Estimating Your Quarterly Taxes
As implied by its name, estimated quarterly taxes are divided into the four quarters of the year, each with its own specific due date. Quarterly taxes are usually due on April 15 (for January 1 to March 31), June 17 (for April 1 to May 31), September 16 (June 1 to August 31), and January 15 (for September 1 to December 31).
To estimate your quarterly tax payments, simply add together your income tax and self-employment tax for the year, and divide this number by four. This is how much you should pay for each quarter.
Step 5: Filing Your Taxes
Compared to calculating your taxes, filing them will be the easiest step. There are two methods to file your income tax return: by mail or online. To file by mail, simply order the required forms from the IRS website, fill them out, and submit them back to the IRS. You can pay your taxes using a check or money order.
To file online, you must create a secure account on the IRS website, and transfer funds directly from your bank, credit, or debit accounts. Filing online is the quicker and easier method. Your information and payment history are also stored in your IRS account, which is useful for record keeping.
Till Next Tax Season
Congratulations, you made it through your first tax filing season. Naturally, the first year of completing tax forms as an independent contractor usually requires the most work. But once accomplished, they will serve as a useful guide for any future taxes and get easier in time.