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If you're a freelancer or independent contractor receiving a Form 1099 instead of a W-2 at the end of the year. You need to be aware of key tax issues related to 1099 income reporting. 1099 professionals can work for one employer or multiple companies. They can also work from home or at the company's office, similar to full or part-time W2 employees. However, their income is reported differently to the IRS and state tax authorities, specifically via Form 1099 instead of a W-2, which reflects significant legal distinctions.
The main difference lies in how the taxes are managed. W2 employees receive a paycheck with deductions already made for income taxes, social security, Medicare, and other necessary payments. Independent contractors, on the other hand, don't have these taxes withheld from their earnings. Instead, they're responsible for the entirety of these payments, including self-employment taxes, which apply to all local, state, and federal taxes owed. Keep reading as we discuss 5 common tax mistakes 1099 workers make.
Mistake #1: Not Setting Aside Enough Money
The major mistake that independent contractors and freelancers make is forgetting to set aside enough money to pay self-employment taxes. If you’re an independent contractor who works exclusively or primarily for one employer for months at a time, it can be easy to forget that you are basically self-employed. Taxes for independent contractors seem higher than taxes for employees because the self-employed person is paying both the employer and employee portions of the taxes.
In addition to any state and federal income taxes, freelancers and independent contractors must pay self-employment taxes to help finance Social Security for retirement and Medicare for health-related benefits. Some states also require payments for other things that are withheld from employee paychecks. For details about calculating what you owe to the IRS, start with the IRS Self Employed Individuals Tax Center website.
It’s important to set aside money from every check you receive to cover your taxes. Because self-employed independent contractors are responsible for the employer and employee portion of federal taxes, you must set aside more than an employer would have withheld from a paycheck. For example, independent contractors pay a social security tax rate of 12.4%, while employees pay only half that and their employers cover the other half.
Mistake #2: Not Paying Quarterly
Think of your quarterly tax payments as a kind of “pay as you go” system that lets the IRS and your state’s treasury department collect taxes almost as quickly as the businesses and individuals earn the money.
You will have to make estimated tax payments to the IRS if you are:
Estimated tax payments must be made at least four times a year (quarterly) to the IRS, including income tax and self-employment tax (Social Security and Medicare) payments.
The rules for estimated tax payments for sales taxes, business, and franchise taxes (note that you don’t have to own a franchised business in order to owe a state franchise tax – it’s what some states call the business tax charged to all businesses), and local and state income taxes in your home state may be different.
There is a penalty for underpaying the estimated tax. But the IRS has a safe harbor rule: if you pay at least as much as your previous year’s liability or pay within 90 percent of your actual tax liability, there is no penalty for underpayment. You can learn more about the importance of paying attention to quarterly tax payments here.
Mistake #3: Missing a Filing Deadline
Quarterly estimated tax forms and full payment of your estimated taxes are due every year on the following dates. If these dates happen to fall on a Saturday, Sunday, or holiday your payment will be due on the next business day.
Missing a filing deadline is a short trip to IRS trouble. The only exception is if you expect to owe less than $1,000 in taxes for the year.
Mistake #4: Overlooking Deductions
Independent contractors can deduct relevant business expenses unavailable to regular employees. There are limits and rules, but the deductions can help you hold on to more of what you earn if you keep the proper records.
For example, independent contractors can deduct:
The IRS loves to flag tax returns from freelancers and independent contractors for audit, so be sure you can back up your deductions with evidence such as receipts, dates, and business purposes. Here's more info about 8 commonly missed tax deductions for independent contractors.
As a sole proprietor and independent contractor, you have unique tax advantages. Firstly, if you hire your child, you can deduct up to $5,000 from your earnings. This also remains tax-free for your child due to the standard deduction. Secondly, you can provide your employees, including family, with a health care reimbursement account. While you can't deduct this for yourself, it's a substantial tax-saving benefit for families with high healthcare costs.
Mistake #5: Not Becoming a “Real Business”
Are you really a freelancer – or are you actually running a small business? Depending on your circumstances, income, and state of residence, that answer can make a big difference in how much you pay in taxes each year.
For instance, independent contractors can subcontract work to other independent contractors, or even hire someone to work for them. But once your workload expands to the point that you need to hire help, it might be time to consider creating a business structure that offers some legal protections.
Partner With Tax Professionals Who Specialize in 1099 Taxes
Working with a tax professional specializing in independent contractor taxes offers significant benefits. They can help navigate complex tax laws, ensure compliance, and optimize deductions, saving you time and potential financial pitfalls. Their expertise can lead to significant tax savings and peace of mind, freeing you to focus more on your work.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.