Updated October 2, 2021
Most working Americans are employed by a business. This business sets the schedule and salary of their employees and issues their paychecks. But what about the increasing number of individuals who are self-employed, providing freelance services to businesses or individuals?
What is an Independent Contractor?
- Sets Schedule
- Provides Sools
- Sets Salary
- Ability to Refuse Work
- Uses Personal Methods
- Pay Own Taxes
Most employed individuals fall into the worker classification of an actual employee, which means that they perform work for a business and receive wages or a salary in return. Being an employee does have its perks, including employee benefits such as health care or a retirement plan, as well as workers’ compensation insurance for each and every employee who could get injured on the job.
However, not all companies offer perks like health insurance and a 401(k). A small business owner may not have the financial resources of a large conglomerate, and in some instances may not be able to provide an employee with a salary above minimum wage or working conditions that meet the requirements of laws like the fair labor standards act. Moreover, an employee is beholden to the business owner in terms of schedule, and the profit from their labor belongs to the business.
This is why some enterprising people choose to work as a self-employed individual, also called a self-employed person. These individuals are not employees of any company, but do perform work for clients.
Do Independent Contractors Have to Pay Taxes?
A self-employed individual operates as a sole proprietor, meaning that they operate their business under their own name, with no special legal, business, or tax formations. Though these self-employed individuals do not enjoy the perks of working for a company, they enjoy the freedom of setting their own schedule and working with clients they want to work with. However, they still carry a tax responsibility to pay taxes, such as the Social Security tax, just like a typical W2 employee would.
In fact, those who are self-employed often have to pay more taxes because employers are required to pay payroll taxes for employees, which takes some of the burden off workers. However, self employed individuals are, in a sense, business owners. This means they have to pay their own taxes, but they can lower their income tax with tax deductions from the expenses of operating their business.
When a self-employed individual performs professional work for another business owner or company, they are said to be in independent contractor status, which is not the same as an employee-employer relationship.
What is an Independent Contractor Agreement?
An independent contractor agreement spells out the nature of the work being performed and the price to be paid, but the person soliciting the work cannot control the schedule of the person performing it or how it is done, because an independent contractor is not an employee.
An Independent contractor is a self-employed worker. The independent contractor relationship, in many ways, is like a customer (the client) making a purchase from a business (the contractor). Just like a customer cannot control how a company makes the product they sell; a client cannot control how an independent contractor performs their work.
It’s important to note that an independent contractor is operating in a professional or business context. In some cases, they are called gig workers or freelance workers who participate in a gig economy. Sometimes an employee will fall into the category of a statutory employee, which is sort of a halfway status between an employee and an independent contractor—these employees will receive both a W2 and a 1099-MISC. Examples of a statutory employee include certain types of commission-based salespeople (insurance brokers, real estate agents, stock brokers, etc.), delivery drivers, and individuals who are employees but work from home.
What is a 1099 Contractor?
Clients who utilize the services of a nonemployee are legally required to issue a Form 1099-MISC if the dollar amount of the value of services rendered exceeds $599. This form will detail the earnings obtained by the client, without necessarily going into detail about the nature of the services rendered. This is why both parties to a transaction should retain invoices for accounting and auditing purposes. In any case, the 1099-MISC form has given rise to the term “1099 contractor” to describe a nonemployee who performs work for a company or another individual.
Please note that not every instance of a self-employed individual rendering services triggers the need for a 1099-MISC. Only services that are of a business nature require this paperwork. This exception rules out professionals such as doctors, personal lawyers, and tutors (to provide a few diverse examples).
For instance, if you hire a lawyer to provide defense counsel against a lawsuit filed by a neighbor, you do not need to issue them a 1099. However, if you hire a lawyer to provide mediation services to resolve a dispute with a disgruntled client (the mediation cost more than $599) you or your business will need to issue a 1099 because the lawyer rendered business services as an independent contractor.
Is an Independent Contractor Self Employed?
Remember that an independent contractor can be an individual or another business entity that is a nonemployee. That said, a company rendering services and paid as an independent contractor is not necessarily considered self-employed in the usual sense of the word.
The term self-employed generally connotes an individual person who has their own business or works under the guise of a sole proprietorship. Think of doctors, lawyers, insurance salespeople, and other professionals who are hired to perform specific tasks based on the nature of their personal expertise.
It is worth noting that many of these individuals may have created a legal business structure, even if they work for themselves, by themselves. If you’re self-employed and want to know how to pay less taxes, you need to learn how to property structure your company. Moreover, as previously mentioned, the title of independent contractor is only relevant to services provided in a professional context (such as marketing, consulting, or even cleaning an office). This rules out personal services rendered by a self-employed individual, such as a doctor or even an accountant providing personal accounting services.
It’s also important to note that a contract worker or gig worker is actively employed, but since they don’t need to report to a workplace as part of an employee-employer relationship, there may be periods of time when they are not working.
Gainfully employed independent contractors often spend downtime marketing their business and looking for new clients. Generally speaking, independent contractors are not able to collect unemployment insurance because that benefit is typically reserved for employees who lose their job. In some instances, though, (such as the current COVID pandemic and its economic fallout) a self-employed worker may be able to collect unemployment insurance if they are underemployed due to economic downturn that affects their client stream.
How to File Taxes as an Independent Contractor
When self-employed individuals file their taxes, they report their income on a Schedule C of their Form 1040. In many cases, they must also submit quarterly taxes to the IRS using Form 1040-ES. These taxes are based on their estimated income and the taxpaying individual can request a reimbursement at the end of the year.
Schedule C is essentially a profit and loss sheet where the self-employed individual will deduct their business expenses from their gross income. The dollar amount at the end of this accounting will determine how much a self-employed individual will pay in taxes. Employers pay some of the taxes that self-employed individuals must shoulder themselves, such as FICA taxes (Federal Insurance Contributions Act). These taxes, taken out by employers, cover government programs like Social Security and Medicare.
However, an individual who works on their own as a self-employed independent contractor will need to pay these taxes themselves. That means 12.4 percent on the first $142k of income towards Social Security, and 2.9 percent in Medicare taxes on all income. Single filers pay an additional 0.9 percent for Medicare on income over $200k, and married couples filing jointly pay that same additional tax on any amount over $250k.
As you can see, this can add up to a lot of taxes for a self-employed independent contractor. Even if the contractor creates a limited liability company (LLC), the business will still be a disregarded entity, and all the income from the business will need to be accounted for on the taxpayer’s individual tax return.
In the current job market, it seems like more and more individuals are finding rewarding careers as remote workers, gig workers, and freelance workers. These individuals would do themselves a great favor by consulting with a tax advisor to structure their business operations along the lines of a corporation, which will reduce the independent contractor taxes they would otherwise need to pay.
What is an Independent Contractor?
There are some instances where you may not know whether a worker meets the legal classification of an independent contractor or employee. That’s why it’s important to consider these seven factors:
An individual that can be classified as an independent contractor is self-employed. This means they need to find their own clients, create their own agreements, and perform the necessary functions for running a business.
Thankfully, an independent contractor can write off many of these expenses, including a home office deduction, on their tax return. Individuals classified as employees generally do not qualify for the same tax deductions. That’s why it’s important to consider the overall nature of the company/worker relationship.
One of the most attractive benefits of working for oneself is the ability to set your own schedule. While most employees are obligated to follow a set work schedule, self-employed individuals are free to work when they want. Moreover, they can work as much or as little as they want (while understanding that this may have a direct bearing on their income).
Many people who are not self-employed look at this as a compelling benefit, but most self-employed individuals will tell you that setting your own schedule does not mean you get to sleep in every day and work a five-hour workweek. In fact, generally speaking, self-employed individuals may work more than company employees because they have to take care of many of their own business concerns.
Employees are not legally required to furnish the tools of the trade that help them with the performance of their job.
For example, a janitor employed by a cleaning company that services office buildings does not need to provide their own broom and mop. However, if the janitor were an independent contractor—setting the price for their cleaning services and finding their own clients—they would need to invest in their own set of cleaning supplies.
Similarly, an individual with a team of employees working for their cleaning business will also need to supply their employees with cleaning supplies, unless those employees are also independent contractors. As mentioned, there is a category of employee called statutory employee, and in regard to tools of the trade, they are more like an employee than a freelance worker (meaning they do not have a substantial investment in the tools used to perform their work).
An employee’s earnings are subject to the discretion of the employer. Employers set a salary and determine when it will be raised (and sometimes lowered, say, if hours are reduced). Salaries are typically based on experience, expertise, job performance, and government guidelines. In some professions, such as sales, employees may also get bonus payments for meeting certain milestones.
However, a self-employed individual is free to earn however much they would like to earn, provided they are able to. If they have formed an S-corp or other business structure, they can hire an accounting firm and write themselves a paycheck reflecting a set salary. This is a fairly common practice among self-employed individuals to avoid paying onerous FICA taxes on the entirety of their income. For example, even if they make $300,000 in gross annual income, they can write themselves a salary of $80,000 and treat the rest of the income separately from their own personal income, for tax purposes.
Ability to Refuse Work
An employee is required to perform the work asked of them, within reason. This means that they must perform the duties assigned to them by their employer or they risk being fired.
However, an independent contractor answers to no one in terms of what work they are required to perform. If they don’t want to work with a particular client, they don’t have to.
It should be noted that once an independent contractor has started working with a client, they are often legally required to fulfill the contractual duties they have agreed to perform. That is why it is important to make sure contracts and legal agreements are clear and specific.
It’s not something to take lightly. A contract can make or break a business. The agreement needs to be structured in a way that protects the independent contractor from having to perform work they don’t want to do or that would present financial difficulty.
For example, a graphic designer will want to set terms in regards to design revisions to set client expectations and time constraints. This protects the designer’s time and finances, allowing them to pursue other paying opportunities.
Uses Personal Methods
An independent contractor is the expert in whatever trade they are engaged in. This means the client cannot direct the contractor to use a particular methodology to perform work—they are only paying for the end results.
It should be noted that certain professions do have legal requirements that they have to adhere to. If a self-employed professional violates those laws or principles, they face revocation of any licensure that allows them to practice their skills in their given locality. Moreover, if a client does not like the work of the independent contractor, they are also free to terminate the contract and look elsewhere for similar services to be rendered by a different independent contractor.
Pay Own Taxes
Finally, self-employed independent contractors must pay their own taxes. None of the clients they work with will issue a W-2 statement of wages because the independent contractor is not on their payroll. This means that the independent contractor is responsible for filing their own income taxes entirely—which includes the FICA taxes paid by employers.
At the time of this article, employers shoulder half the burden of FICA taxes, paying 6.2 percent for Social Security and 1.45 percent for Medicare, for a grand total of 15.3 percent (employees making over $137,700 will trigger different tax rates). This means that while self-employment carries many benefits in terms of income potential and flexibility, one of its detrimental factors is that the self-employed individual needs to pay twice the amount of taxes on their income. As previously mentioned, many self-employed individuals get around this by forming a company on paper, even if they are the only one in the company, and issues themselves a salary on a payroll.
How Much Can You Make on a 1099 Before You Have to Claim It?
Any company or individual you work with needs to issue a Form 1099-MISC if the work you perform totals more than $599.
Companies and businesses with an established HR department are generally pretty good about issuing this paperwork. However, some individuals and small businesses may not be. It will be up to your discretion as a self-employed individual or freelancer if you want to request your clients deliver a 1099-MISC. You will need to report your income on your tax return anyway, even if you are paid in cash. Your best bet is to speak with an accountant who understands your business. They can help you reduce your tax burden by writing off business expenses.
Independent Contractor Status Has Its Perks and Drawbacks
As the gig economy continues to grow, more individuals will need to know about the independent contractor classification as it relates to employment taxes.
A 1099 Contractor is a name given to self-employed individuals who trigger the need for a company to issue a Form 1099-MISC to document earnings paid to this person for services rendered, beyond $599.
An independent contractor is a nonemployee of the company. They set their own hours, use their own tools and methods, set their own salary, and work at their discretion. Such individuals are often also called gig workers, freelancers, or freelance workers. There are many types of jobs that involve providing services as an independent contractor, including truck driving, cleaning, legal counseling, accounting, babysitting, and marketing (among others).
If you’re an independent contractor looking for more tax tips and business deductions, join us for our weekly Tax Tuesday webinar. It’s a great place to ask our tax experts questions about self employment tax issues.
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