Tax Consequences for Independent Contractors: How Much You Pay as a Self Employed Individual?

Many people today are accepting jobs with companies who have elected to pay them as independent contractors rather than as typical payroll employees. Companies do this for a variety of reasons, not the least of which are the tax savings they benefit from by not paying social security and Medicare taxes for their “employees.” Individuals in the 16-25 year old age bracket are the ones most unaware by the tax consequences of accepting independent contractor income.

Many individuals who are new to the independent contractor business are unaware that the tax savings of their new “employer” actually become tax expenses for themselves. These new independent contractors are often surprised at tax filing time of the amount of federal tax they owe as a result of enjoying the freedom of being self employed, especially since most companies do not withhold any federal or state taxes from the monies that they pay to their independent contractors.

Independent contractors typical file a schedule C with their individual federal tax return to report their self employment income. Often they have little or no expenses that they can legitimately write off to help offset their taxable income. Self employment income is subject to income tax at the same tax rate as any other wages and compensation the individual has received throughout the year, but the income tax is not the only tax they are responsible for.

In addition to the income tax is the self employment tax, which is 15.3 percent of net business income when net self employment income is over $400 for the tax year. This additional 15.3 percent tax is what takes many people by surprise. For example, say Bill receives $12,000 a year as an independent contractor and has only $2,000 worth of legitimate business expenses to write off. Bill now has $10,000 worth of taxable self-employment income.

If Bill is in the 15 percent tax bracket for federal taxes for the year, he will owe approximately $1500 in federal tax (before adjustments, deductions, and credits) and will owe an additional $1500 in self employment tax. It is important to note that the typical tax credits including child tax credit, retirement savings credit, child and dependent care credit, and education credits do not reduce the amount of self employment tax owing.

Additionally, independent contractors must beware of a potential penalty tax. The federal penalty tax typically kicks in when the taxpayer has not paid through withholdings and quarterly estimated tax payments at least 90 percent of the current year’s tax balance or 100 percent of the previous year’s tax balance.

Finally, preparing a federal tax return that includes self employment income reported on a schedule C is more difficult and time consuming than a tax return without a schedule C and often requires the assistance of a paid tax professional. The cost of preparing a schedule C with a federal tax return at a professional tax preparation firm can be quite high, often bringing the total tax preparation bill to between $200 and $400 dollars. Also bear in mind that federal returns with a schedule C are more frequently audited than returns without a schedule C.

If you have been offered an independent contractor position it is very important that you calculate the ultimate cost to you as a taxpayer to see if the salary being offered is worth the time and effort. For example, if you are being offered $15 an hour as an independent contractor and $12 an hour as a payroll employee, you may initially be tempted by the fact that your “take home” pay will be $15 an hour with the first offer and probably be less than $10 an hour (based on average state and federal tax withholdings) with the second offer. However, if you have little to no business expenses to write off then your “take home” with the first offer after paying income and self employment tax drops to only $9.75 an hour and brings with it the additional stress of correctly reporting the self employment income on a schedule C.

All in all, the tax consequences of being paid as an independent contractor can really add up. It is important that anyone who is considering accepting a position as an independent contractor calculate the tax consequence to see if the income offered is worth the cost to the taxpayer. If in doubt, speak to a tax professional (H&R; Block tax professionals, as well as many others, will offer free tax advice) regarding the tax consequences for your unique tax situation.

Reference:

• www.irs.gov/publications/p334/index.html