Some independent contractors are consultants, agents, or brokers. Others might be creative professionals, technical wizards who are part of the start-up culture, models and actors, or even part-time Uber drivers. Whether you own a business or are a freelancer who provides services to other businesses, you are considered self-employed. This means you must handle your taxes differently than regular employees and are required to pay self-employment tax if you have net earnings of $400/year or more…So what exactly are the pros and cons of being an independent contractor?
For income tax purposes, you will automatically be categorized as a sole proprietor, which is simply the default for small businesses. You don’t have to pay to register your legal name with your state or with the IRS, and you don’t need to necessarily form a corporation to file taxes. However, if you are using a name other than your legal name (i.e. Graphic Design by Jane instead of just Jane Smith) then you must officially set up a registered Sole Proprietorship or LLC.
As a 1099 contractor, you must regard everyone who hires you as a client rather than an employer. An independent contractor must treat his or her work like an entrepreneur would, which means considering the formation of a separate business entity.
TAX BREAKDOWNS FOR AN INDEPENDENT CONTRACTOR
Independent contractors should receive a 1099 or W2 from any company using their services. They are subject to paying their own taxes, including self-employment tax (SE tax), which is the Social Security and Medicare tax paid at a percentage of net earnings. If a company neglects to send you a 1099 or W2 (or sends it after the deadline has passed) you should still report the income because it’s likely being deducted as an expense on their end. You don’t want the IRS to come after you years later, asking for clarification and charging a financial penalty for your oversight.
The self-employment tax rate is 15.3% with 12.4% for Social Security and 2.9% for Medicare. However, you can claim a federal deduction for half the SE tax you pay, which helps to lower your taxes.
According to the IRS, additional Medicare Tax applies to self-employment income above a threshold amount of $250,000 for an individual who is married and filing a joint return, $125,000 for a married individual who decides to file a separate return from their spouse, and $200,000 for all other categories.
You have the option to make estimated tax payments during the year to pay your SE tax and anticipated income tax, or you can pay when you file your return along with your business deductions.
The amount subject to self-employment tax is 92.35% of your net earnings. You calculate net earnings by subtracting your business expenses from your gross income.
Depending on the type of independent contractor you are, you may be selling taxable goods that require sales tax to be collected and remitted quarterly to state or local taxing authorities. This is where you may want to consider hiring an accountant to make your life easier.
THE BENEFITS OF SETTING UP YOUR OWN COMPANY
Since independent contractors (1099’s) essentially run their own business, it may be advisable to form a company. A Sole Proprietorship or an LLC are the best options for a freelancer. Filing your taxes won’t be that much more complicated than a personal return, but having a company will prove to the IRS that you’re contracting work as a legitimate business.
The Sole Proprietorship is the most common choice, held by one individual who is responsible for all the operations, assets, and liabilities incurred. Business profits are processed through the owner’s personal tax return and taxed accordingly. If you are providing a product or service without any business partners and have not set up any other type of legal entity for the company, then you’re automatically considered a sole proprietorship.
However, you do need to secure the required local licenses for your type of company and register your trade name with the county clerk if you’re doing business under a name other than your legal name (i.e. Steve’s Landscaping instead of Steve Smith). Processing fees vary according to each state and are relatively low. A Sole Proprietorship structure is ideal for freelancers who mostly work for a single company, low liability businesses, and small online businesses or hobbies that are basically just a part-time job for the owner.
An LLC combines the features of a corporation and a Sole Proprietorship or Partnership in terms of tax efficiencies and business flexibility. Limited liability means you can’t be held financially responsible for more than your investment in the company, which means the owner(s) of an LLC aren’t personally liable for company debts and obligations. The business itself isn’t taxed; rather, the profits run through the LLC member’s personal tax returns at the standard personal tax rates.
LLCs are ideal for independent contractors that need liability protection yet do not need to raise a lot of money from investors, but want flexibility in how the business is being managed and taxed. Note that in addition to the cost of setting up the LLC and publishing a business announcement, there is a yearly fee that ranges from $800-$1,000 for the privilege of doing business in the state of your choice.
The most significant benefit of being an independent contractor is being able to write-off all your business expenses, which can add up so fast that you’ll only have to pay minimal taxes after deductions, or even be lucky enough to get a sizable return.
Deducting expenses means that you must save every single receipt and keep track of how each one is business-related in case you’re ever audited. An expensive dinner with your significant other would not count as a write-off unless you happen to work together, but theater tickets to a Broadway show if you’re an actor, director, writer, or producer within the entertainment industry would be considered a business expense.
The most common tax-deductible self-employment deductions include the cost of a home office (a complicated percentage-based calculation that an accountant can help you with), office furniture, your laptop/desktop, cell phone, internet, business travel, and transportation. Depending on what industry you are in, you may be able to write-off classes, magazine or streaming subscriptions, and even specific types of wardrobe items.
THE DRAWBACKS OF BEING THE BOSS
Everything is your responsibility when you are the boss, and this comes with a variety of advantages and disadvantages.
It’s up to you to make decisions when it comes to your rates, and it requires constantly marketing your services with a view to expanding your business, making sure that clients pay you on time, and balancing overhead expenses for everything from office space to business cards to travel to hiring other freelancers to help when you’re overloaded.
You also won’t get any paid time off for vacations or sick days. Employer-subsidized health, life, disability, and retirement benefits represent part of the “hidden paycheck” for employees that independent contractors obviously don’t get to enjoy. You are responsible for your own health insurance—which is expensive—and if you have a serious medical or dental emergency, you may have a hard time when it comes to paying the bill.
There is also the risk of not having enough income to live on when business is slow, especially when it comes to work that’s seasonal in nature. A lot of companies put off hiring freelancers during the summer when key staff members are on holiday, especially during the “dead” month of August. An independent contractor must be diligent in trying to set money aside to cover basic expenses when clients are scarce, although this can be challenging in the early days before you’re established in your career. You also have to plan for the future so that you won’t still be working when you’re 85 years old.
Setting up a company structure such as an LLC will help you avoid paying both personal and corporate taxes, but you will have to pay the self-employment tax on income generated through the LLC and make quarterly estimated payments to the IRS. Independent contractors must make sure they don’t pierce the “corporate veil,” meaning that they must operate the LLC as a legitimately operating entity with a distinct difference between the LLC and its owner.
Sometimes there is also an emotional toll that comes from feeling isolated as an independent contractor. If something goes wrong for an employee, it may not be so bad because it’s often part of a group failure. Short of termination, the personal financial consequences aren’t devastating because there’s still a salary. But a self-employed person suffers on all fronts. Often the failure is their responsibility, and financial consequences are immediate. If a client pulls out of the contract or if a bid isn’t accepted, there’s no cash flow coming in. Because of the precarious nature of freelancing, you must constantly sell yourself and seek out new clients through networking, just in case.
Ensuring that you spend your time wisely is your responsibility. Managing client expectations is important. You can’t just hope for the best and assume that a client will be impressed by the quality of your work—unfortunately, they often don’t even realize how much effort you’re putting in. You should always negotiate the details up-front so they won’t be shocked when you send them the bill. Guard your reputation because any attacks on your credibility from a dissatisfied client can hurt your business. Go above and beyond the call of duty and don’t allow any room for reproach. It’s important to constantly observe their sub textual cues, reassure any doubts, and be prepared to change direction when something isn’t working.
Sometimes, it’s easy to get caught up in the excitement when there’s an abundance of work. But trying to do everything all by yourself is a surefire path to burnout. Don’t fool yourself into thinking you can produce a huge amount of work on an unreasonable timeline just because that’s what the client wants. And as your business grows, you’ll have to let go of some of the control and learn to delegate responsibility to support staff you can trust.
Whether you decide to be an independent contractor who sets your own schedule or prefer the stability of being a salaried employee with benefits, it’s important to educate yourself on the best way to manage your finances as well as client relations so that you can achieve long-term success.