Being self-employed often means being an independent contractor—that is, an independent business person. It’s really just another way of getting paid for your work, just not as an employee. If you have been an employee, and you're now self-employed as an independent contractor, you'll find that taxes are different.
In this article, you'll find out about how to pay yourself, how you must pay taxes on your business income, and how you can save money on your business taxes by deducting business expenses.
What Is an Independent Contractor?
An independent contractor (IC) is simply someone who works for someone else but not as an employee. An employee is someone who works for a business, and the business controls what will be done and how it will be done.
An independent contractor is considered to be self-employed, because the independent contractor carries on a trade or business and is in business for himself or herself, including on a part-time basis.
The IRS says an independent contractor is someone who offers services to the general public. This person is hired to do specific work. You are not an independent contractor if someone else controls what will be done and how it will be done; in other words, the details of how the services are performed.
Are Independent Contractors Sole Proprietors?
For income tax purposes, you're probably considered a sole proprietor if you're an independent contractor. A sole proprietor is the sole owner of a business that isn't a partnership or a corporation.
The designation of “sole proprietor” is the default form of small business. You don’t have to pay to register your business with your state, but you might want to register your business trade name with your locality or the U.S. Patent & Trademark Office (USPTO).
Independent Contractor, Sole Proprietor, and Self-Employed Person
- The term "independent contractor" describes how the person works and how much control the worker has over their work. The independent contractor isn't controlled by an employer as an employee is.
- Independent contractors are considered self-employed, because they are in business for themselves.
- The term "sole proprietor" is a tax designation. It's how a single business owner, including an independent contractor, that is not a corporation pays taxes.
How Does Being an Independent Contract Affect My Pay?
You can still get paid for the work you do in your business, but your payments are taken from your business income, not a salary or wages. The money you receive for your work or your products goes into your business checking account. (Yes, you should have a separate business bank account.) You can take money out of the business (it's called a "draw"), but not as a salary, because you are an owner—not an employee.
The amount you take out of your business as an owner doesn't affect your taxes. You must pay tax on ALL the income of your business, whether you take it out or not.
The payments you receive from your business don't have any federal income tax withholding taken from them, because you're not an employee, and there are no deductions for Social Security or Medicare. You'll pay these in the form of self-employment taxes.
How Does an Independent Contractor Pay Income Tax?
Federal Income Taxes
When you prepare your personal income taxes, you must use a specific schedule with your Form 1040 or 1040-SR. This form, called "Schedule C," lists all the sources of your business income and all your business expenses.
Your net income (profit) from Schedule C is then included on your tax return, along with other income you receive and your self-employment taxes to get your total taxable income.
State Income Taxes
Most states have income taxes, and, yes, you must pay those state income taxes on your income as an independent contractor.
How Is Self-Employment Tax Calculated?
The net income amount (the “profit”) from your Schedule C determines the amount of self-employment tax you owe. This calculation is done on Schedule SE. The result of this calculation is a tax amount that's added to the total income tax you must pay.
What Expenses Can I Deduct as an Independent Contractor?
You can deduct the typical business expenses that you've paid. You must have excellent records made at the time of the expense to show the business expense and the amount, in case of an audit. Here's a list of business tax deductions from A to Z. You also can refer to IRS Publication 535 for more information on business expenses.
You want to take as many legitimate deductions as you can, but you must be able to prove that the money was spent and that it was for business purposes. That's why good recordkeeping is so important.
How Do I Know What Expenses Are for Business?
The IRS says you can only deduct expenses that are both "ordinary and necessary" for your business. Ordinary expenses are those common expenses in your type of work (like drafting tools for a draftsperson). Necessary expenses are helpful and appropriate. If you want to deduct expenses, they must meet this "ordinary and necessary" test and not be personal expenses. Be sure to document the expenses with the date, amount, and business purpose.
Will I Have to Pay Quarterly Estimated Tax?
You don't have a paycheck as a business owner, and you don't have withholding for federal income tax, state income tax, or self-employment taxes. You must therefore make quarterly estimated payments if your business has a profit, to pay your income taxes on your business income and other income and for self-employment taxes.
Quarterly estimated payments are normally due four times a year: April 15, July 15, Oct. 15, and Jan. 15 of the following year.
Independent contractors in Texas, Louisiana, and Oklahoma have until June 15 to make their first payment in 2021 without a penalty. The IRS extended this and other deadlines in response to the 2021 severe winter storms. The IRS also extended the individual tax filing deadline from April 17, 2021, to May 17, 2021, for all other Americans, but their estimated taxes are still due April 15.
You can use your income from the previous year as a basis to calculate your estimated tax bill, base it on your monthly earnings after potential deductions times 12, or work with a tax preparer.
If you have another source of income as an employee, you may be able to increase your withholding on income from a job to account for the additional business tax and self-employment tax you might have to pay.
Will I Have to Pay Someone Else to Do My Taxes?
You might be able to use one of these online business tax preparation services if you have a simple business tax return, with no employees or product inventory.
Will I Get a W-2 for Income Tax Purposes?
Instead of receiving a W-2 in January of each year, you'll receive a form called a 1099-NEC from any client or customer that paid you $600 or more during the year. If your payments from any single client are less than $600, you won’t receive a 1099-NEC form from them, but you still must include the amount you were paid on your business tax return.
How Do I Pay Income Taxes on My Income as an Independent Contractor?
First, you must determine the net income from all of your business activities. The income from your work as an independent contractor is recorded on Schedule C. Income from your work as an IC is listed, then any deductions are taken, to get a net income number. This number is brought to Line 3 of Schedule 1, and to line 2 of Schedule SE. The information on these schedules is included on Form 1040 to calculate your total adjusted gross income.
Tax returns are normally due on April 15 (May 17 for 2021), but Texas, Louisiana, and Oklahoma residents can extend this deadline as well to June 15, 2021, due to the winter storms.
Can I Get a Qualified Business Income Deduction?
The 2017 tax law included a tax deduction for small business owners, called the "Qualified Business Income (QBI) deduction." This deduction is 20% of qualified business income in addition to your usual business expense deductions. Independent contractors can take this deduction for tax years between 2018 and 2025. The deduction may be limited or not applicable for higher-income business owners. Check with your tax preparer for more information.
Taxes for an Independent Contractor—An Example
An independent contractor works for several clients in 2020, and they earn in total $27,000 for the year, as shown on the 1099-NEC form they received from their clients for their 2020 work. They have no other income, but their spouse has a full-time job, and they file a joint tax return.
They complete a Schedule C for their 2020 business taxes, and their net income from their business is $18,000 after deducting allowable expenses. This amount goes on Schedule 1, Line 3, then to Form 1040.
They must also pay self-employment tax on $16,623 (93.5% of $18,000) of their business income. The result of the Schedule SE calculation shows they owe $2,543.32 (15.3%) for self-employment tax. They get credit for this amount of Social Security benefits. Half of this amount ($1,271.66) is deducted.
To avoid tax penalties for late payment, the spouse could increase their withholding from their work, or the independent contractor in our example could begin making estimated taxes, taking the full amount and paying one-fourth each quarter (April 15, July 15, October 15, and January 15, 2021).
Again, they have until June 15, 2021, if they reside in Texas, Louisiana, or Oklahoma, or any other area that's declared to be a disaster due to the severe winter storms of 2001.
This is just one example of how independent contractor taxes might work. Your situation might be different, so check with a tax professional or use one of the tax preparation software programs to help you prepare your taxes.