Points to Note
Becoming an independent contractor can be tempting for employees who work from home, count on the client's work, and claim a large number of tax deductions, including a 20% deduction from eligible business income.
At the same time, employers who want to save money may appreciate hiring service providers because they save them from health insurance premiums, pension contributions, and payroll taxes.
The Internal Revenue Service has a set of rules for classifying independent contractors and employees at the federal level, but some states, especially California, may take a different course. So it is essential to know the laws of your state.
If you are an employee who works long hours and spends more on energy and other costs, becoming your boss may seem more attractive. The average working day for Americans has increased by three hours since employers sent their employees home in mid-March to reduce the coronavirus's spread, according to the analysis of NordVPN server activity.
Meanwhile, the additional costs incurred at home, from the increasing use of Internet services to rising energy costs at rising temperatures cannot be paid on the tax return if you are employed.
So working for yourself can seem like a fabulous idea. In comparison between the independent contractor route or employee, people love that you can take advantage of tax deductions. Independent contractors can be even more attractive to employers who want to save costs.
For starters, employers who want to save a few dollars save on payroll taxes, health insurance, workers' compensation insurance, and more.
Here's what you need to know before you start working for yourself.
Tax Savings for Freelancers
A business can choose to pay the same amount to an independent contractor and an employee, but the differences will occur at tax time. Employees have payroll and income taxes withheld from each paycheck throughout the year. They receive a W-2 form each January from the employer, listing the wages paid and taxes withheld during the previous year.
These workers generally file a tax return on April 15 (or, this year, July 15) and must either receive a refund based mainly on the tax withheld.
In contrast, entrepreneurs receive a 1099 Form from each entity that paid them. This document details the amount received. The compensation received by the self-employed is not retained. On the contrary, they are responsible for paying the estimated quarterly taxes on their income.
Entrepreneurs pay taxes on their account, which is 15.3%. Of this amount, 12.4% of the tax is intended for social security and 2.9% for health insurance. Employees share this tax with the employer. Each party is responsible for a 7.65% payroll tax to cover social security and health insurance.
When tax time comes, independent entrepreneurs can make significant profits in the form of deductible business expenses. They can pay half the tax themselves, Internet and telephone bills, home office expenses, and more. In addition, freelancers can save more aggressively on a retirement account. Note that employees can defer up to $ 19,500 for 401 (k) this year, plus $ 6,000 if they are over 50.
However, if you are your own boss and you opened a simplified pension plan, known as SEP IRA, you could save up to 25% of the net earnings from self-employment to $ 57,000 in 2020. The payment of health insurance premiums also has tax implications for both types of workers.
In employment plans, employers' contributions to health benefits are exempt from federal income and wage taxes. Meanwhile, employees pay their share of the premiums before tax. Entrepreneurs can claim a tax deduction for the premiums they pay for their health coverage.
Here is another tax exemption offered to entrepreneurs: the allowable deduction of 20% of business income. This tax exemption is available for companies with transfer entities, including S corps and limited liability companies. Please, be careful as this deduction is subject to income and sector limits.
Employment law landmines
Although independence may seem excellent from a tax planning perspective, employers should be careful before proceeding. The customs officer can punish employers who wrongly classify their employees as contractors.
Such an agreement would also increase the anger of federal and state labour authorities. The IRS can sue the employer for payroll taxes, whether or not the independent contractor has paid payroll taxes.
According to the IRS, workers are generally considered to be employees when the company that hires them has the right to direct and control the work performed. To further complicate matters, freelancers can still be considered employed under state law. This is the case in California, where contractors can benefit from minimum wages and overtime protections.
It is better for employers to spend $1,000 to speak to a labour lawyer, rather than paying the IRS $ 5,000 in taxes on wages, fines, and interest.
