Independent Contractor Taxes Overview

Taxes as a 1099 contractor can be complex, which is why Right Side Up invited Greg and Amita from Harrison Accounting Group, Inc. to join us for an hour-long webinar in early 2020 to share their expertise and answer your questions ahead of the upcoming tax filing season. As a reminder, the 2020 tax filing deadline was recently extended to May 17, 2021.

We’ve transcribed and organized all of the information they shared with us, and we’ve broken it down into three key sections: an overview (which you're currently reading), info about tax deductions, and details about the CARES Act and Paycheck Protection Program. Disclaimer: This is neither financial nor legal advice; please speak with your CPA.

What are the differences between a 1099, W-2, and W-4? 

Generally, if you're an independent contractor, you’ll receive a 1099 form from your contracting companies.

You’ll get a W-2 if you're an employee of a company—in other words, you go into work every day, the company sets your hours and responsibilities, and they likely provide you benefits too.

A W-4 is a certificate you’ll fill out when starting a new job. When you’re a W-2 employee, this certificate tells the employer how much tax you’d like to have withheld from each paycheck. 1099 contractors most commonly provide a W-9, which provides the company with your taxpayer identification number (either your personal social security number or business’s tax ID if you’ve set up a company). No taxes are withheld from 1099 contractors’ paychecks.

Who is the employer for 1099 income?

You’re considered self-employed. In other words, your employer is yourself. That said, it’s important to note that the contracting company is responsible for issuing you your 1099.

Is there a minimum threshold for reporting 1099 income? Are there cases where you would not need to report 1099 income? 

A company likely wouldn’t issue you a 1099 if you earned less than $600 from them. This $600 threshold is the Internal Revenue Service’s (IRS) rule of thumb. That said, even if you only make $200 and don’t receive a 1099, you (as an independent contractor) should still report it as “Other Income” on your tax return. The goal is to submit all income on your tax return, regardless of whether or not you receive a 1099.

Since taxes are not withheld from independent contractors’ paychecks, is there a rule of thumb you’d typically suggest to independent contractors for how much money they should set aside for taxes?

Each profession has different expenses that impact how much independent contractors will owe in taxes—we'll get to that. But using general terms, I typically tell people to set aside 30-50% of their total income for taxes. If it's a high expense business (e.g. you travel to dine with and entertain prospects, you need expensive equipment or raw materials to operate and/or create your product, etc.), then I’d suggest setting aside closer to 25-30% of total income for taxes.

Do you need to pay taxes quarterly if you have 1099 income as an independent contractor?

It's highly recommended to pay your tax estimates quarterly in order to avoid penalties and interest for not having paid anything during the year. When you're a W-2 employee, your employer withholds money from your paychecks for taxes and pays it to the government on your behalf throughout the year.

When you're a 1099 contractor, however, contracting companies aren’t withholding your expected taxes from your paychecks. But you’re still earning money, and the government therefore still expects to receive tax payments from you throughout the year—meaning it’s your responsibility to pay your tax estimates on a quarterly basis, not in one lump sum when you file your taxes. You can use the previous year’s tax payments as a guide to figure out how much you’d owe on a quarterly basis.

That said, if you're a contractor and you didn't work for, say, half of the year, you may not have any taxes to pay. So, it’s understandable to not make quarterly payments sometimes. Alternatively, some people would rather have money in the bank and not pay quarterly taxes, instead opting to pay the penalty.

What is the penalty for not making quarterly payments?

The penalty could be up to $1,000-$2,000 but is often a lot lower. 

If last year's tax was $5,000, the penalty would be calculated based on a monthly basis on the delay. Using rough numbers, the penalties are typically between 5-10% of the underpayment, and then the portion that it's delinquent. So if you made a Q1 payment and then didn't make any other payments for the rest of the year, you're not late a whole year—you're potentially late three or six months on top of the other payments.

I didn’t pay my quarterly tax withholding estimates, and the penalty only came out to about $160 for me. Is that abnormally low?

No, it’s usually only a couple hundred dollars. Many people would rather hold on to the cash and pay the federal government or the state government a couple hundred dollars—it just depends on your comfort level.

The amount of the penalty really depends how low you can get your taxes. If your tax is $1,000 and you didn’t pay quarterly, the penalty would not be as high as $2,000. If your tax is $50,000 however, and you didn’t pay quarterly, then you could end up with a heftier $1,000-$2,000 penalty.

There's a perception that you pay a lot more taxes as a 1099 contractor vs. as a W-2 employee. Is this true? 

If somebody receives a 1099 without any deductions, they would be required to pay a self-employment tax, which includes Social Security and Medicare. They’d pay the portion they’d be responsible for if they were a W-2 employee, as well as the portion that the employer would normally pay for a W-2 employee. This means 1099 contractors are paying twice the taxes for Social Security and Medicare compared to a W-2 employee, though their income tax would remain the same.

With that being said, in my 30+ years of filing, I have seen very few 1099 contractors who don't have at least some modest expenses against that. As long as you're taking advantage of these expenses, you’ll pay, in my opinion, less taxes as a 1099 contractor than as a W-2 employee because you pay the self-employment tax and income tax on your net income, not your gross dollars earned.

Can you explain the self-employment tax a bit more? 

A W-2 employee pays a 7.65% tax for Social Security and Medicare, and the employer also pays a 7.65% tax on behalf of the employee. Because 1099 employees are self-employed, they’d be required to pay the full 15.3%.

For example, say someone has a salary of $100,000. As a W-2 employee they’d pay $7,650 in Social Security and Medicare taxes, whereas as a 1099 contractor, they would pay $15,300.

Now, you pay your income tax based on that same number if you were a W-2. But, let's say that by taking advantage of deductions as a 1099 contractor, you can get that down to $75,000 or so, net. You pay your self-employment tax AND your income tax based on the $75,000, which is a pretty nice savings. 

I live in New York, but my client is based in California and sends a 1099 from there. I received a notice from the FTB in California that I was supposed to file an information return. I didn’t have to pay California state taxes because I said I lived in New York, but do you know what that was?

Any time an entity files a 1099, the federal and state governments share information about it. The Franchise Tax Board (FTB) is the taxing authority in California, and they sent you an information return to see if you were somebody they should be taxing. They were looking to see if you had domicile in California and/or if you were earning your money by having a working presence in California.

So if I don't live in a state, then they generally shouldn't be able to tax me.  

Absolutely right. You earned your money while you were in New York, even though your client was based in California; California has no right to tax you. I would be clear with your response: I reside and work in New York, not California. You don't have to be in New York exclusively, but what they're looking for is called nexus—in other words, they’re trying to see if you work out of California frequently enough to tax you. (Each state has different requirements around how many days you’d have to spend in the state in order to be taxed.)

I consulted for a couple of international clients based in Canada and Singapore. Neither company sent me a 1099, so I just reported it as additional foreign income on my taxes. That’s all I need to do, right? 

That’s all you need to do.

Can you talk a little bit about the pros and cons of setting up an LLC from a freelancer’s point of view?

The number one benefit of an LLC is limited liability protection—you're not putting your personal assets at risk with your work.

If you file as a single member LLC, the IRS is trying to make it as simple as possible for you by not requiring you to file an entirely separate business return. You’d just need to attach Schedule C to your Individual Income Tax Return (Form 1040) when you file. (Two notes: Schedule C is the form you’d use to report profits or losses from a sole proprietorship or single member LLC. You’d also still need to report the single member LLC to the state in order to pay any necessary LLC state taxes.)

If someone wants to file from an aggressive standpoint, they’ll often set up a standard LLC. This creates two Schedule K-1s for the return, shifts the risk off the individual return, and moves it to the LLC—in other words lowering your audit risk. When we have clients who are more creative than others with their deductions, and have riskier LLCs that they don’t want on their 1040 forms, they’ll bring in a spouse or somebody else as a part-owner so they can file a separate return to mitigate the risk on their individual return.

If a freelancer is contracted by a company as an individual, and the individual makes a costly mistake, then the company could come after that person for damages. Whereas if the individual were contracted by the company as an LLC, then the company could only come after the LLC for damages—meaning the LLC would be at risk, but not the individual’s personal assets. Is that a correct interpretation?

Yes—but remember, you don't even have to make a mistake for a company to come after you. You can get sued for doing nothing.

Is it right to conclude that the more personal assets you accumulate, the more important it is to operate as an LLC instead of as an individual to protect those assets?

100%.

Are there any other licenses that freelancers should consider getting? For example, a city license?

Depending on where you live, you may be responsible for your city's business tax. In that case, you would have to register with the city you live in and pay usually a very nominal amount ($10-15) each year.

Cities have the right to go after you, whether you're an LLC or just Schedule-C-self-employed. They have a better chance of finding you when you’re registered as an LLC, since you’re registered with the Secretary of State.

After the 2008 financial crisis, cities became very aggressive going after self-employed individuals. They weren’t trying to penalize anyone, but were just trying to raise capital wherever they could.

What are the pros and cons of a SEP IRA?

If you’re self-employed—and every freelancer is self-employed unless you’re working under an LLC—a SEP IRA is a nice vehicle to consider for retirement savings, especially for its tax deferral aspect.

With a SEP IRA, basically 20% of your net income can be put away into a deferred comp agreement. Unlike a 401k, the difference is there is usually little to no administration cost for a SEP IRA. 

The maximum contribution is based on your profit, meaning you can contribute more to a SEP IRA if you want. There may not be the same income maximum that you have on a Roth IRA. Is that right?

Correct. I think $57,000 is the maximum contribution for a SEP in 2020 ($58,000 in 2021), and the compensation cap is approximately a quarter of a million. There’s no catch-up contribution for SEP IRAs—meaning people who are 50+ won’t be able to save more than the usual annual contribution limits set by the IRS (which they can do with other individual retirement accounts).

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