Are you an employee of the company you work for, or do you work as a contingent worker, temporary employee, independent contractor, or “flexible associate” at your company? You’re not alone if you’re among the growing ranks of the self-employed worker.
More than 7.4% of the U.S. workforce is classified by the U.S. Department of labor as independent contractors – that’s over 10 million working Americans. The actual number of contingent workers – those whose livelihoods depend on temporary or contract jobs – may be much higher.
Fox News recently reported that companies are increasingly turning to temps and to a much larger universe of freelancers, contract workers and consultants. Combined, these workers number nearly 17 million people who have only tenuous ties to the companies that pay them — about 12 percent of every U.S. worker with a job. Many analysts expect the trend to continue, with up to 18% of the U.S. workforce made up of independent contractors or temps by the end of 2013.
Nearly 3 million of those contingent or temporary workers have been hired in the last four years. Before the recession, the IRS says that there were 2.7 million fewer taxpayers filing tax returns based on income reported on Form 1099.
About half of the independent contractors surveyed say that they had no choice about their hiring status. They say the choice was to accept work as a contractor, or not work at all. That means the other half chose the flexibility of contingent, temporary, or freelance work.
Regardless of the reason, there are serious tax and financial issues that should be considered before accepting a job as an independent contractor. These include taxes, retirement planning, health insurance, worker’s compensation or liability protection for on-the-job injuries, and an agreement specifying payment terms, taxes, and employment status.
1-800Accountant offers three white papers that provide practical information for independent contractors that can help them keep more of the money they earn and protect their families. The three white papers can be downloaded at these links:
- What Small Businesses and Independent Contractors MUST Do After April 15: A Tax Planning Guide (A year-round guide to key deadlines and record keeping for independent contractors who want to pay lower taxes.)
- Taxing Questions: What Makes An Artist a Professional? (A guide for artists, actors, models, musicians, singers, and variety or circus performers on qualifying for tax deductions with tips on minimizing tax liability.)
- A Guide to Tax Deductions for Writers, Freelance Journalists, & Bloggers (A myth-bursting guide to how the IRS views income earned by writers of all kinds, with money saving tips and tax planning guidelines.)
Common Tax Mistakes to Avoid
There are many potential mistakes any taxpayer can make when trying to understand the complexities of the tax code. But at 1-800Accountant, we talk to freelancers and independent contractors every day, and we’ve identified the three mistakes that can be the most costly to those who are accepting their first contract position. They include:
1. Not Securing a Written Agreement – Or Not Reading One
The first major mistake that newly hired independent contractors make is not securing a written agreement that specifies the terms and conditions of employment. Before you engage in long term contract work (more than 30 days), sign a contract that spells out your status as an independent contractor and not as an employee. Most large companies will ask you to sign their standard agreement before you start work. Be sure you understand it, and get legal advice if you are uncertain about the specifics.
It typically costs $300-500 to have a lawyer review an employment agreement, but if you are a high-income professional taking your first contract position, it could be money well spent. How the IRS classifies you makes a big difference in the types of taxes you’ll owe.
Consider the case of a Texas woman named Cynthia. She’d been a mid-level manager at a telecommunications company that was sold. She was laid off, and then offered her old job back on a temporary, contract basis.
She realized that she’d have to purchase health insurance, and pay taxes so she negotiated a higher wage than she’d had as an employee. But she didn’t realize that the agreement she signed defined her not as a temporary worker but as a “qualified small business operated by a sole proprietor”. That made her liable for a state franchise taxes as a small business owner.
Because she’d never worked as a freelancer or contractor before, she was also unaware that her new status made her liable for both the usual withholding amounts plus the employer portion of the Medicare and Social Security deductions. The result was that she agreed to a year-long contract that reduced her disposable income by nearly half, even though it appeared at first that she was being paid slightly more than she had been making as an employee.
Her failure to read the agreement caused even more problems a few months later when a maintenance worker (also a temporary independent contractor) failed to properly secure a light fixture over her desk after changing a light bulb. The fixture fell, breaking her arm and causing other injuries.
That’s when she discovered that she wasn’t covered by worker’s compensation insurance because the agreement she’d signed specified that she carried her own insurance and indemnified her “client” from any injuries that occurred on their premises. She not only had to pay her own medical costs, she lost her contract job because she was unable to work for several weeks.
Don’t make the same mistake: read the employment contract or agreement carefully, and understand the terms and conditions. Get legal advice and verify that all of the clauses in the contract are legal in your state. If you’re not sure, consult an expert before signing.
2. Forgetting to Pay Estimated Taxes
Independent contractors, the self-employed, and freelancers must pay estimated taxes to the IRS and any state tax authorities four times a year. While employees can wait until April 15 to file an annual tax return and pay any monies owed, that’s not the case for independent contractors.
In fact, today – September 16, 2013 – is one of the tax payment deadlines for independent contractors. That’s because this year, the normal due date of September 15 fell on Sunday.
There are four dates that should be circled in red on the calendar of any independent contractor:
- January 15
- April 15
- June 15
- September 15
Not filing and paying quarterly estimated taxes on these dates is a shortcut to problems with the IRS and state tax authorities for any freelancer, independent contractor, or self-employed individual who expects to owe $1,000 or more when filing an annual return.
Many factors (filing status, standard deductions, itemized deductions, tax credits, etc.) go into calculating the amount of taxes owed, but the income threshold that triggers the requirement for quarterly tax payments is probably lower than you think. According to the IRS tax table for 2013, a single taxpayer with an adjusted gross income of just $9,950 will owe $1,061 in taxes for 2013, and a married couple filing jointly with an adjusted gross income of just $10,000 per year will owe $1,003 in taxes for tax year 2013.
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. So check your state’s laws – or talk with an experienced tax adviser who understands the rules for small business – in order to avoid problems.
3. Not Documenting Deductible Business Expenses
In order to take advantage of all the business expenses that can reduce the amount of taxes you owe, you need the right records. And that means a bookkeeping system and procedures that will help you manage the money that you earn as a self-employed independent contractor.
One of the most common reasons that freelancers run into tax trouble is not sufficiently separating their personal and business expenses. If you are a high-income independent contractor, a separate business bank account may be an important tax planning tool.
Tax deductions can be quite valuable, because they reduce taxable income for the year. For example, someone in a 25% tax bracket can save $25 in income tax for every $100 in deductions, while also saving as much as $15 in self-employment taxes for every $100 deduction from taxable income.
Meticulous records and receipts are the keys to allowable tax deductions. To be deductible business expenses, a cost must be:
- Incurred in connection with your trade, business, or profession.
- Ordinary and necessary expenses (as defined by the tax authorities).
- Must not be lavish or extravagant under the circumstances (as defined by the tax authorities).
General business expenses include:
- Advertising and publicity that helps you acquire work or contracts
- Equipment and supplies required for your business
- Union dues, license fees and business registration fees required for your self-employment activities
- Home office expenses or rent paid to a third party for the place where you work
- A flat rate or per-square foot deduction for a room (or rooms) in your home used exclusively for business.
- Telephone bills for a second phone line used exclusively for your business, including the cost of an answering machine or service and long distance.
- Legal, tax, accounting, and professional services for your business
- Training required to improve or maintain your skills
- Travel expenses for meetings with potential clients (but not commuting costs to and from a place where you perform work)
- Meals (“Necessary business-related meals” are 50% tax deductible if they include direct business discussions. You must document the specific business purpose, place, date, time, and include the names of each person you met with and their business role.)
There are many other deductions that are specific to certain kinds of businesses. For example, writers can deduct the cost of research, performers can deduct fees paid to agents, and artists can deduct the cost of materials and supplies, including model fees. Carpenters, plumbers, and hair stylists can deduct the tools of their trade. Talk to your tax adviser for specifics of allowable deductions associated with your profession.
Clothing is one of the first areas the tax auditors look at when auditing a tax return. Only clothing that is primarily worn for protection (such as a welder’s mask and gloves) is generally tax deductible. Always check with a tax professional before deducting clothing.