Starting a Small Business

Want to Be Your Own Boss? Here's What It Means for Your Taxes

6/22/2020

Have you noticed that your new, pandemic-driven work-from-home routine has led to higher expenses? If so, you're not alone. We're all spending time at home, driving up utility usage that was once paid for by our employers. Worse still, according to a recent news story, Nord VPN's analysis of server activity has determined that the average work day has expanded by three hours since we're all working from home.

Between working longer (and in many cases harder if you're also homeschooling kids) and not being able to write off your extra home-based expenses, it's enough to make one consider making the shift from employee to independent contractor. However, make sure you fully understand all of the ramifications, because being self-employed has some serious pitfalls in addition to benefits.

There's no doubt that being able to write off a percentage of your household expenses is a big perk of being your own boss, and it might feel smart to approach your employer to see whether they'd be interested in converting you from employee to contractor. After all, they might end up saving money, including what they have to pay for your health insurance, your worker's compensation insurance, and payroll taxes. Let's take a closer look and see if it really represents a win-win.

The Taxes You Save As an Independent Contractor

One of the most important things you need to understand before making the decision to leave life as an employee and switch to being your own boss is the impact on your taxes. Even if you are being paid the same exact thing as an employee as you are as an independent contractor, your taxes will be different.

When an employer pays an employee for their work, they withhold both income taxes and payroll taxes. They are also responsible for providing employees with a Form W-2 that reports all of the compensation paid and taxes that have been withheld on their behalf over the course of the tax year so that they can more easily file their income tax return. In some cases the amount that the employer has withheld is not enough and the employee will be responsible for making up for the shortfall: in other cases the amount withheld will be too much and the employee will be entitled to a tax refund.

Take the same worker doing the same job but put them in the position of an independent contractor and things change dramatically. The company paying for the work will be responsible for preparing a Form 1099-NEC reflecting the amount that they've paid to the contractor. No taxes will have been withheld. Instead, the contractor is responsible for paying for their taxes themselves, and in fact they have to submit them on a quarterly basis, calculating the amount that they submit based on their expectation of total annual income.

In calculating the amount that they owe, self-employed individuals have to estimate annual income, then calculate and add up 2.9% for Medicare, 12.4% for Social Security and 15.3% for self-employment taxes. This is double what they would normally have to pay, as employers shoulder half of that particular burden.

Of course, this increase in taxes is the price you pay for being able to take valuable tax deductions and write offs for home office expenses like electricity, phone and internet costs, for the greater amount that you can put into a retirement account (where employees max out at $19,500 tax deferred for 401(k) contributions and an additional $6,500 if they're over the age of 50, self-employed individuals can set aside up to $57,000 in 2020, or 25% of their net earnings into a SEP IRA, or simplified employee pension plan.

There are also significant tax advantages involving health insurance costs. While employees get the benefit of having their employers contribute towards their health care premiums and can exempt those contributions from federal income and payroll taxes, independent contractors have to pay for their own insurance premiums but are able to deduct 100% of their premiums.

Perhaps most valuable of all for entrepreneurs operating pass-through entities is the 20% qualified business income deduction. Pass through entities include limited liability companies and S-Corps, as well as sole proprietorships, but those who are eligible for this deduction are limited in several ways, and it is a good idea to check with an accounting professional before assuming that you would be eligible to take it.

Speaking of eligibility…

For those considering the benefits of shifting from their current situation as an employee to doing the same work as an independent contractor, you also must consider whether you will be able to effect this change legally. There are significant legal differences between employees and independent contractors, and if you and your employer only consider the tax advantages before engaging in this bit of transformation, your employer could end up in legal jeopardy.

Misclassifying employees as contractors is subject to significant penalties at both the federal and state level. If you are determined to be in violation of the rules, your employer will be required to pay back payroll taxes, even if you have already paid the tax due as part of self-employment taxes.

How can you tell whether you are considered an employee or an independent contractor? According to the IRS the difference lies in whether the company paying the worker has the right to direct and control the work being done. This refers to how you do your work, when and where you do the work, and more. The rules are particularly complicated in some states, and recently the state of California has passed legislation that makes most individuals ineligible for independent contractor status.

If you and/or your employer are debating the merits of switching from an employer/employee relationship to a client/contractor relationship, it will be well worth your time and money to spend a few minutes talking to a labor attorney or tax professional to make sure you are doing the right thing.

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Steward Financial

Jon Osborn is a tax preparer based in San Dimas, California. His company, Steward Financial Services, offers a broad range of tax preparation, accounting and business consulting for small businesses. He loves to work with clients who are looking for answers to complex tax and business planning issues. He has owned several small businesses and worked with over one hundred small business owners. He helps his individual and business tax clients find the best ways to spend their money in order to minimize IRS tax. Small businesses looking to grow, sell or just increase cash flow are one of Jon's specialties.

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Liability Limitation and Usage Guidelines for TaxBuzz AI:
Limitation of Liability:

TaxBuzz AI is a tool designed to provide tax professionals with assistance in generating responses to tax research questions. While we strive to maintain the accuracy and reliability of the information provided, it is imperative to recognize that tax laws are dynamic and subject to change. Therefore, the use of TaxBuzz AI should be complemented by professional judgment and consultation with legal and tax experts.

By utilizing TaxBuzz AI, you acknowledge and agree that the information generated should not be considered as a substitute for professional advice tailored to your specific circumstances. We explicitly disclaim any liability for the consequences arising from the use of advice generated by TaxBuzz AI. Users are encouraged to independently verify the information and seek professional advice before making decisions based on the AI-generated responses.

Usage Guidelines:
- Professional Judgment: TaxBuzz AI is a tool to aid tax professionals in research and analysis. It is not a replacement for professional judgment, and users should exercise their expertise when interpreting and applying the information generated.
- Consultation with Experts: While TaxBuzz AI provides valuable insights, it is crucial to consult with legal and tax experts to ensure the advice aligns with the latest legal developments and specific nuances of a particular situation.
- Verification of Information: Users are responsible for independently verifying the information provided by TaxBuzz AI, especially in instances where the advice generated is critical to decision-making.
- Educational Purposes: TaxBuzz AI is intended for educational and informational purposes only. It is not intended to provide specific legal or tax advice tailored to individual circumstances.
- Non-Endorsement: The use of TaxBuzz AI does not constitute an endorsement or guarantee of the accuracy of the information provided. Users are encouraged to corroborate the advice with other reliable sources.
By accessing and using TaxBuzz AI, you agree to abide by these terms and acknowledge the limitations outlined herein. We reserve the right to modify these terms at any time, and your continued use of TaxBuzz AI constitutes acceptance of any such modifications. If you do not agree with these terms, please refrain from using TaxBuzz AI.

TaxBuzz.com is a service of CountingWorks, Inc., 2549 Eastbuff Drive., #448 208, Newport Beach, CA 92660

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