In this article, we are going to show you how to save on taxes as an independent contractor.
Working as an independent contractor comes with a lot of advantages. You have the freedom to decide who you work with and how you do your job. First, you get to be your own boss. Second, it is not an employer who pays you, but clients, for the finished result of your work. But what about taxes? As an independent contractor you have the full responsibility of filing and paying them, and you may often end up paying more than if you were working as an employee. So read on to know how to make sure you don’t end up paying more than you have to.
What is an independent contractor
Many types of professions and trades come with the possibility to work as an independent contractor (or self-employed). You can work as self-employed if you are an electrician, a builder, a lawn care provider, a roofer, a hairstylist, a freelance writer, or even an accountant, a physician, a lawyer etc.
The main feature of an independent contractor is the control you have over the how you perform the work you receive payment for. Most likely you will be able to choose your hours and the methods you use for your work. The client will pay for the final result.
As an independent contractor you can structure your business in a variety of ways. The sole proprietorship is the simplest of all. Alternatively, you could choose to register an LLC (limited liability company) or a corporation.
How taxes work when you’re an independent contractor vs. an employee
When you’re an employee, your employer withholds your taxes from your paycheck, and pays them to the IRS, state or other tax authority on your behalf. These taxes are your:
- federal income tax
- state income tax (if you’re in a state that has state income tax – Texas doesn’t)
- Social Security contribution
- Medicare contribution
But there’s a catch. For your Social Security and Medicare contribution, the portion withheld from your paycheck is only half of what is owed. The other half is paid by your employer on top of your paycheck. So basically, on Social Security and Medicare, you split the bill with the employer.
On the other hand, when you’re self-employed, on top of your income taxes, you will have to pay your Social Security and Medicare contributions in full, yourself. This combination of Social Security and Medicare contributions is also known as “self-employment tax”.
How to save on taxes as an independent contractor
Now that we saw how taxes work when you’re your own boss, let’s see what are some ways to make sure you don’t pay more than what you rightfully (and legally!) owe.
Know and document all your business expenses
When you work as an independent contractor, you are basically a business. As a business, taxes you owe are a percentage of your taxable income. Moreover, your taxable income is calculated by subtracting your business expenses from your gross income. This is why it’s very important to know what you can consider a business expense, and to document all these expenses throughout the year.
Here are some examples of business expenses that you can deduct from your income.
Accounting, legal and other professional fees
You can deduct these expenses if they were for services provided to your business (and not to you as a private individual for personal reasons).
Marketing and advertising expenses
Here you can deduct everything from advertising and publicity to meals and entertainment at public events for advertising purposes.
You can deduct the costs of driving for business purposes, but you must put extra attention in how you keep your records.
Home office expenses
You can deduct the cost of running your business from home if the home is your main place of business and if you use the business area in your home regularly and only for business purposes.
You can deduct business related meal expenses at 50% – but only if you or an employee of yours were personally present at those meals.
Education and training expenses
You can deduct education and training expenses incurred by you or by your employees. Your business must meet certain requirements to qualify for this deduction.
Commissions paid to employees and non-employees
You can deduct expenses like commissions to insurance agents or real estate agents who provide services to your business. You can also deduct commissions paid to your employees (such as sales commissions).
Fees paid to clubs or organizations
If your business is a member of clubs and organizations can also be deducted. But be careful: this is a deductible expense only if the clubs or organizations have specific business purposes. Some examples would be trade organizations or business organizations.
Books, professional journals, and software
Professional journals, business reference books, and software that is necessary for you to conduct your business, are all deductible.
Other deductible business expenses
Depending on your field of activity, there can be lots of other business expenses you may be able to deduct. For example, you can deduct: internet-related expenses, utilities, licenses and regulatory fees, parking fees, moving machinery, office and business equipment, repairs and maintenance, bank fees, etc. You may even be able to deduct your health insurance premiums. To see the conditions to qualify for each expense deduction, make sure you check the complete, constantly updated list on the IRS website.
A note about startup expenses: you cannot fully deduct some expenses right away if they were part of your business startup costs. In this case, they will be amortized or depreciated.
Deduct your self-employment tax
To reduce what you owe overall in taxes, make sure you deduct between 50 and 57% of your self-employment tax on your personal tax return.
See if you can benefit from a Qualified Business Income Deduction
A qualified business income deduction (or a QBI) allows you to deduct up to 20% of your qualified business income on your taxes. This deduction is accessible to you if you conduct business as a sole proprietor, an LLC, an S corporation, or within a partnership. The IRS defines qualified business income as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business. Generally, this means your business’s net profit.
There are some types of income that the IRS excludes from the “qualified business income” category, such as: capital gains or losses, dividends, interest, income earned outside the US, and certain wage and guaranteed payments that you receive as a partner or shareholder.
In order to qualify for this deduction for the 2021 tax year, your total income (business + personal) needs to be below $164900 if you are a single filer, and below $329800 if you are filing jointly.
Need more details on how to save on taxes as an independent contractor?
The world of tax deductions is an ever-changing system. You might get overwhelmed with the details and you surely don’t want to miss on any saving opportunity. This is why, whether you’re just starting out or you already have an established business, it’s a good idea to have a tax preparer help you. The small amount you spend in fees, which, by the way, are a deductible business expense, will be way worth it. That is because a professional tax preparer (like us!) will help you get saving opportunities that you didn’t even know existed.
If you are in Texas and you haven’t filed your 2020 tax return yet, remember, it’s not too late to contact us for help. This year you have until June 15 to file your taxes!