Your tax liability isn’t just dependent on your income—it’s also contingent on your business structure. Independent contractors are each unique, and can actually exist as a number of different business structures.
Common types of business structures
This is the most common business structure for entrepreneurs (73% of US businesses are registered as sole proprietorships). It’s very easy to register as a sole proprietor, and if you’re not formally registered as anything else you’ll be treated as a default sole proprietorship.
Limited Liability Corporations (LLCs) are allowed and regulated on a state-by-state basis. An LLC can be comprised of a “single member” or multiple individuals. LLCs can be treated as a corporation, partnership, or a disregarded entity dependent upon the size of the LLC.
The IRS defines an S-corporation as one which passes “income, losses, deductions, and credits through to their shareholders for federal tax purposes.” The goal is to have the taxes paid and assessed by the individual shareholders.
Part-time entrepreneur/part-time employee
Many entrepreneurs work their business as a side hustle while still working as a W-2 employee. These individuals will file a Form 1040 on their own, and their employer will file a Form W-2 for them.
Independent contractor vs. freelancer
There are a variety of ways to define a contractor, independent contractor, and freelancer. But for the purpose of taxes… it doesn’t really matter. All that matters is your business structure (sole proprietorship, LLC, S-corp).
What taxes do independent contractors pay?
Essentially independent contractors pay the same taxes as everyone else, but they pay the entire portion of their FICA taxes for themselves (which can then be partially deducted).
Everyone is required to pay income tax—including independent contractors. The amount you pay is determined by the income you received this year minus your eligible deductions. Then you’ll use your tax bracket to determine the percentage of taxes you’ll need to contribute.
Self-employment tax (or SE tax) is required whenever employers aren’t paying FICA taxes. FICA taxes are federal Social Security tax which accounts for 12.4% and Medicare tax which accounts for 2.9%, totaling 15.3% of your income. Normally an employer will pay half of the FICA taxes (7.65%), but as an independent contractor you are your own employer, so you’re responsible for the entire 15.3%.
SE tax is required on all income, so even if you’re a regular W-2 employee with FICA being deducted from your employment income, you’ll need to pay SE tax on your side hustle income.
State and city taxes
Your state will have their own requirements for taxes, and may include sales tax on any good sold by your independent contracting business. Work closely with your accountant or financial team to determine the tax obligations for your state and city. Sometimes these taxes are paid on a quarterly estimated tax schedule, or annually.
Tax deductions for independent contractors
Since self-employed individuals and independent contractors end up paying more in taxes, it’s important to maximize your tax deductions. You’ll claim small business tax deductions on the Schedule C of Form 1040, so it’s important to regularly read through the paperwork and keep detailed categorized expenses. When it’s time to submit these deductions you’ll be able to easily total and document your deductible expenses.
Deductible business expenses include:
- Mileage and vehicle expenses
- Entertainment expenses
- Rent and utilities
- Marketing expenses
- Employee pay and benefits
- Miscellaneous or general office expenses
When in doubt, carefully document your expenses and consult a tax professional to maximize deductible expenses.
How to calculate taxes as an independent contractor
Use the IRS Form 1040-ES for the most current guidelines, rules, and methods for calculating quarterly taxes as an independent contractor.
1. Determine tax bracket
The 2020 Tax Rate Schedule is first determined by your filing status (Single, Married filing jointly, Married filing separately, and Head of Household) and your income. Your federal income tax bracket will determine how much you should be paying as a general foundation.
For example, someone making $95,000 annually and filing jointly as a married couple has a 22% tax rate. They’ll owe $9,235 plus 12% of the amount over $80,250 (which comes out to 1,770), totaling $12,775 in taxes for 2020. But that’s without any deductions or credits, so you can reduce your taxable income.
- For single individuals: Up to $9,950
- For married individuals filing joint returns: Up to $19,900
- For heads of households: Up to $14,200
- For single individuals: $9,951 to $40,525
- For married individuals filing joint returns: $19,901 to $81,050
- For heads of households: $14,201 to $54,200
- For single individuals: $40,526 to $86,375
- For married individuals filing joint returns: $81,051 to $172,750
- For heads of households: $54,201 to $86,350
- For single individuals: $86,376 to $164,925
- For married individuals filing joint returns: $172,751 to $329,850
- For heads of households: $86,351 to $164,900
- For single individuals: $164,926 to $209,425
- For married individuals filing joint returns: $329,851 to $418,850
- For heads of households: $164,901 to $209,400
- For single individuals: $209,426 to $523,600
- For married individuals filing joint returns: $418,851 to $628,300
- For heads of households: $209,401 to $523,600
- For single individuals: $523,601 or more
- For married individuals filing joint returns: $628,301 or more
- For heads of households: $523,601 or more
2. Determine deductions & credits
For the year 2020 the standardized deductions are:
- $24,800 for married filing jointly
- $18,650 for head of household
- $12,400 for single or married filing separately
Standardized deductions are automatic, much faster, and easier. However, if you think that your itemized deductions will total more than the standardized deduction for which you qualify, it may be worth the extra time and forms to file itemized deductions. Some business expenses can still be deducted via Schedule C in addition to a standard deduction, so you’ll want to ask your tax preparer to clarify what you are eligible to deduct.
Once you decide on your deduction strategy, you can total and subtract that amount from your taxable income. Using our prior example, if the individual making $95,000 and filing jointly with their spouse decided to take the standard deduction of $24,800 then their taxable income would decrease to $70,200. This would drop them to a 12% tax bracket. They would owe $1,975 plus 12% of the amount over $19,750 (which comes out to $6,054), totaling $8,029 in taxes for 2020.
3. Add self-employment taxes
For the year 2020 self-employment tax is 15.3% up to $137,700 and 2.9% on any net income above that threshold. You can claim half of that on your deductions, since usually the employers pay half of Social Security and Medicare taxes for regular employees. As a general rule 92.35% of your net income is taxable for self-employment.
So our married couple making $95,000 would multiply that income by 92.35% to determine their taxable net earnings for self-employment (which comes out to $87,732.50). That amount is subject to the 15.3% tax rate, totaling about $13,424 in self-employment taxes owed. They will need to add that to your taxes paid throughout the year, but then they can deduct 50% of that ($6,712) when they file at tax time, dropping their taxable income from $70,200 to $63,488.
4. Calculate final taxable income, tax liability, and estimated quarterly tax payment
After jumping through these many hoops we can land on the final taxable income, deductions, and taxes due. Using our example couple, the $95,000 income minus standard deductions and self-employment deduction leaves them with $63,488 taxable income which assigns them a 12% tax rate. They’ll owe $1,975 plus 12% of the amount over $19,750 (which comes out to 5,248.56).
- $1,975 + $5,248.56 = $7,223.56 income tax
- $13,424 in self-employment taxes
- Total $20,647.56 owed in taxes annually
- Quarterly payments of $5,161.89
Need some help? Try the TurboTax calculator!
Safe Harbor method
If your head is spinning, you’re not alone. In order to simplify quarterly taxes the IRS has outlined three methods that provide “safe harbor,” meaning that even if you’ve underpaid you cannot be penalized as long as you use one of these formulas. If you’ve grossly underpaid you will still owe, but safe harbor protects against the penalties you’d normally face.
90% of tax you owe for the current year
Calculate what you will owe and then pay 90% of that in quarterly payments. This can be difficult if you are a new contractor or if your deductions are irregular.
100% of last year’s taxes
You can pay 100% of the taxes you paid last year (found on Line 63 on your Form 1040), so long as your income is fairly stable and predictable.
Annualized income installments
Many freelancers and small businesses have very seasonal income, making quarterly payments uneven. Instead you can annualize the payments over 12 months to pay as you go instead of uneven and punitive quarterly payments.
How to file independent contractor taxes
Quarterly estimated tax payments can be mailed using the printable vouchers in Form 1040-ES or use IRS Direct Pay to pay online. State and local taxes may not require quarterly filing, and may have their own procedures for payments, so work with a tax professional to be sure you’re paying taxes correctly.
If you are working with employers or clients, be sure they are filing a Form 1099-MISC on your behalf. If you hire subcontractors or freelancers to work for you, you need to file a Form 1099-MISC on their behalf. The Form 1099-MISC must be filed with the IRS before February 1st.
Planning your quarterly estimated taxes
Once you have a total for your estimated taxes, you need a strategy for setting the money aside so you’re not surprised each quarter, or worse—at tax time. Here are two tried-and-true strategies for managing your quarterly estimated tax payments.
Monthly: Divide your annual estimate by 12 and transfer that amount into a separate tax or savings account each month.
Percentage: Figure out the percentage of your income that will be required, then transfer that percentage of each payment to your tax or savings account. For example, if you will be paying 20% of your income in taxes, you’ll take 20% of each paycheck and transfer it directly to your tax or savings account.
The strategy that works best for you will depend on the stability of your freelance income and any expenses that offset that income. Play around with the numbers to determine which makes more sense for your situation.
FAQs about taxes and independent contractors
Can you get a tax refund as an independent contractor?
Yes—if you have overpaid your quarterly estimated taxes throughout the year, you may receive a tax refund after filing your annual tax return. It is important to note, however, that many independent contractors do not expect any tax return.
Who must file self-employment tax?
Self-employment tax is required of any individual who earns income throughout the year, will owe at least $1,000 in federal taxes, and who does not have an employer withholding FICA taxes.
Is there a difference between being self-employed and being an independent contractor?
Being self-employed indicates a lack of a formal, permanent employer. Independent contractors may work permanently with an employer and even receive benefits and payments via W-2 status, so they may or may not identify as being self-employed.
When are taxes due as an independent contractor?
Quarterly business taxes are due on April 15th, June 15th, September 15th, and January 15th (or the next business day if those are weekends or holidays).
Keeping track of your expenses and carefully managing your spend categories is a key piece of your business tax strategy. Tackle it more effectively with BILL’s seamless platform. Sign up today.