The gig economy is here to stay, and study shows that 35% of today’s workforce are freelance. The tax rules for those earning money through independent employment must evolve. Tax deductions can help with this transition, but it is easy to miss out on potential opportunities without proper records.
Tax deductions are a valuable tool for managing the financial side of an independent contractor’s business. Tax professionals take the tax deductions before calculating your taxable income. This means that they reduce the amount of money you owe in taxes by lowering your total income. Both operating expenses and capital expenditures are eligible for tax deductions.
In this article, we will discuss the top five tax deductions for independent contractors and how to take care of them.
What Are Independent Contractors?
Before discussing the top five tax deductions for independent contractors, it is important to understand what an independent contractor is.
An independent contractor is a self-employed business owner who provides goods or services to clients. They are not considered employees of the company but as freelancers or consultants. This distinction means that they are responsible for their taxes and do not have the same benefits as employees.
Independent contractors commonly generate and use the 1099 form to report their income to the IRS. This form reports the income from independent contractors, freelancers, and other self-employed individuals.
An independent contractor is a person or company that provides services to another person or company. Both parties sign a contract defining the contractor’s tasks, salary, job type, work quantity, and other specifics. The contract is concerned with the work rather than how the contractor completes the task.
Independent contractors are distinct from typical workers who have gone through the hiring and onboarding processes of a corporation. Contractors are paid by the firm, but they are not employees. Independent contractors, on the other hand, are self-employed (sometimes known as a “business for self”); they can operate and work for several clients at the same time.
Companies frequently use independent contractors to avoid recruiting full-time employees for short-term purposes.
The Top Five Tax Deductions for Independent Contractors
There are many tax deductions that independent contractors can take, but the following five are the most common:
Self-Employed Tax Deductions
A self-employed tax deduction allows you to write off a percentage of your earnings as business expenses. This can be a big help in reducing your taxable income, as an independent contractor. You can generate a form W-2 to help you determine your earnings so that you can calculate this deduction accurately.
The amount you can write off depends on your business’s net profits, which is the profit after all the deduct business expenses.
You can claim this deduction on Schedule C of Form 1040. Be sure to keep track of all your business expenses throughout the year to calculate this deduction accurately.
Yes, self-employment tax can be deducted as a business expenditure. It’s really one of the most popular self-employment tax deductions. Self-employment taxes are calculated at 15.3% of net earnings. This rate combines a 12.4% Social Security tax plus a 2.9% Medicare tax on net earnings. Income tax is not the same as self-employment tax deductions.
What you may deduct: On your income taxes, you can deduct half of your self-employment tax.
Home Office Deduction
Instead of having your business take up space in your house, you can instead designate a specific room for business use.
Having an office means that if you work an average of four hours per day in this room or at least ten hours per week, then half the square footage of the home office can be deducted as part of your tax deductions.
As long as you meet these requirements and calculate this deduction accurately using Form 8829, you can remove $5 per square foot up to 300 square feet (a max total deduction of $750) from your taxable income each year.
If you work from home or utilize a portion of your house for commercial purposes, self-employment tax deductions like this one might save you money on the expense of keeping the lights on.
What you can infer: A percentage of your mortgage or rent; property taxes; utilities, repairs and upkeep; and other related costs. In general, this deduction is only accessible to self-employed individuals; workers are often not eligible for the home office deduction.
Health Insurance Tax Deductions
If you are self-employed, you can deduct the cost of your health insurance premiums from your taxable income. To deduct the cost, simply calculate the total amount you paid for premiums during the year and write it off on Schedule C. This deduction can be a big help in offsetting the cost of health insurance. Health insurance can be expensive for self-employed individuals.
Business Mileage Tax Deductions
If you use your car for business purposes, you can deduct the cost of mileage from your taxable income. This deduction can be calculated by multiplying the number of miles driven for business purposes by the standard IRS deduction rate of 56 cents per mile.
Hence, keep yourself updated on the latest rates to ensure that you’re taking the deduction accurately. It’s also important to keep track of all your business mileage throughout the year, and be sure to write it off on Schedule C.
Capital Expense Deduction
Capital expense deduction allows you to write off the cost of certain capital expenses incurred in running your business. These expenses can include the purchase of equipment, furniture, or software.
To claim this deduction, simply record the amount spent on each item and its corresponding depreciation schedule.
Credit Card Interest
If you use a credit card for business expenses, the interest you pay on this card is deductible. This includes both your personal and business credit cards.
The interest amount to be deducted depends on how much money the business uses for company growth. For example, if you charged $500 from your business on a personal credit card but only $300 was actually applied towards business usage. You, or a tax professional, can deduct only $300 worth of interest from your taxable income.
Why Are Tax Deductions Important For Independent Contractors?
Taxable income basically refers to how much money you make during the year, which is subject to taxes. The deductions made from the taxable income are important for independent contractors because they lessen the amount to be paid to the IRS, leading to increased financial freedom and security.
Hence, it is important to find as many tax deductions as possible to keep your taxable income low.
What are the distinctions between independent contractors and employees?
The DOL and IRS both have important definitions and guidelines governing independent contractor status:
IRS: An individual is deemed an independent contractor if the payer only controls the outcome of the work, not how it is carried out. The independent contractor fills out IRS Form W-9, whereas the employee fills out IRS Form W-4.
DOL: When assessing whether someone is an independent contractor, the DOL considers the nature of employment and the degree of control over the job. It also considers the worker’s profit and loss potential, the stability of the partnership, and other factors.
Differences between independent contractors and employees.
Contractors who work on their own
- Independent contractors are self-employed, and the money they earn as such is subject to self-employment tax. They must provide their own work tools and submit invoices for payment.
- Employees provide services that an employer controls, such as what work must be done and how it should be finished. This term also applies to exempt personnel, who have the freedom to perform their duties how the employer deems fit as long as the outcome is satisfactory.
The DOL is concerned with whether the employer has the legal power to direct how and when services are provided.
Here are some basic facts:
- An employee cannot be both an employee and an independent contractor for their employer.
- Employee earnings are often exempt from self-employment tax deductions.
- Employee earnings may be subject to FICA (Social Security and Medicare taxes) and income tax withholding, which is normally deducted by the employer during payroll processing.
- The employer supplies the required tools and equipment for the job.
- Employees may complete timecards, but they may not submit monthly bills for payment.
What steps can you take to avoid misclassifying independent contractors?
Misclassifying independent contractors may land firms in hot water with the Department of Labor and the Internal Revenue Service. It is vital to correctly categorize all of your employees. If you misclassify a worker, you might face severe penalties and fines.
Previously, the IRS used a 20-factor test to assist businesses in determining whether someone was an independent contractor or employee. The agency has now divided these 20 variables into three categories:
Behavioral control: Can the company guide and regulate what work gets done and how it is done?
Financial management: Does the company guide or control the financial parts of the employee’s job?
The parties’ relationship: Does the company provide any advantages? Are there any formal contracts or oral agreements in place regarding the work?
Tax deductions are important to independent contractors because they help them reduce their taxable income each year, saving money on taxes and increasing financial security. Keeping track of all your business expenses throughout the year is the best way to accurately calculate these tax deductions and reduce stress when dealing with financials.