August 26, 2014
Employers looking to cut costs will occasionally offer to treat workers as independent contractors instead of employees. This may seem like a win-win situation at first. The employer often offers a higher pay rate to a contractor than an employee. In turn, the employer saves money on employee costs such as unemployment insurance. In a 2013 article, we discussed the risks faced by an employer in this situation. In this article, we will outline what you should be aware of if an employer offers you a position as an independent contractor.
If you have always received income as an employee in the past, you might have given little thought to the need to make tax payments. Employers are required to withhold taxes on your behalf, and remit not only the amounts withheld, but also pay in a matching amount of the Social Security and Medicare taxes. Income you receive as an independent contractor is subject not only to all the taxes that would normally be withheld from your paycheck, but also the matching portion of Social Security and Medicare tax normally paid by an employer. This can be a significant amount of tax when accumulated for an entire year!
Federal and state taxes must generally be paid during the year totaling 110% of your prior year total tax, or 100% of your current year tax. If you do not have enough tax paid in from other sources, you should make quarterly estimated tax payments. Few of us want to provide the government with an interest free loan, so a calculation can be done to determine how to delay tax payments as much as possible without paying penalties. However, as a contractor, you may owe more tax than ever before on your personal tax return. The temptation may be to pay 110% of your prior year tax, and see how things turn out on your tax return at the end of the year. Although this avoids penalties, this strategy can result in a large tax ‘surprise’ at the end of the year. Independent contractors should consider setting up a separate savings account as a ‘tax account’, and deposit a percentage of each check you receive into this account based on your estimated tax liability.
Although you may not think of yourself as a business owner, an independent contractor is treated by the IRS as a small business owner. Income you receive as a contractor is typically reported on Schedule C of your Form 1040. One advantage of being treated as a business owner is the ability to deduct business expenses. Did you use your vehicle for unreimbursed business use (other than commuting to and from work)? Did you pay health insurance premiums for yourself and/or your family because you were not eligible to participate in an employee sponsored health plan for you or your spouse? Did you incur any other unreimbursed business expenses such as office supplies, postage, or liability insurance premiums? All of these expenses may be deductible to some degree to offset your business income. You may also be able to defer up to 20% of earnings, or a maximum of $52,000 for 2014 by making a contribution to a Simplified Employee Pension (SEP) plan.
Independent contractors should also be aware of potential risks. You should contact an insurance agent to determine what potential liabilities you may face based on your line of work. Additionally, employees who are laid off are typically eligible for government unemployment benefits. However, unemployment benefits are typically not available for independent contractors.
Being treated as an independent contractor is not always a win-win situation. If you have the option to be treated as an employee, or an independent contractor at a higher pay rate, you should look at the big picture to determine both the additional costs and benefits available. As always, you should contact a competent tax advisor to assist you in making any tax planning decisions.
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