A guide to saving money on taxes while staying in compliance for independent (1099) contractors.
Many of us hear about the many advantages of being self-employed or performing freelance work. You get to set your own schedule, choose your workload, choose who you work with, and enjoy flexibility and independence that most people dream of. However, many small business owners and freelancers come to a rude awakening during tax season when they see their taxes owed. This guide will help you avoid a large tax bill by planning for future taxes and using tax savings techniques.
How am I taxed as a 1099 (Independent) Contractor?
Independent contractors are faced with the challenge of keeping up with their own taxes, rather than having taxes withheld on each paycheck. The burden to save for taxes and make estimated tax payments is on you. There are usually three levels of taxes you’ll be paying, federal income tax, self-employment tax (currently at 15.3% on the first $168,600 of “net earnings” in 2024, the sum of a 12.4% for Social Security and 2.9% for Medicare), and state tax (some counties also have a local tax).
1099 (Independent) Contractors are required to pay these taxes quarterly, as we will discuss below, to avoid interest & penalties.
Most are familiar with federal & state taxes, but the self-employment tax feels like a punishment for taking a risk and putting your earning power into your own hands! However, it would be incorrect to classify the self-employment tax as unfair treatment when it simply levels the playing field.
Here is the thing, everyone pays the self-employment tax in one way or another. If you are employed, your employer will pay 7.65% of your Social Security & Medicare taxes, and you will have the other 7.65% taken out of your paycheck to make up the entire 15.3%. As someone who is self-employed, you simply pay the full 15.3% as the employer & employee.
The difference being self-employed is that you feel it more. This makes it very important to have a process for paying your taxes and tracking your deductions, and many times will require a professional’s involvement to make sure things are being done correctly.
Tracking Income
It is important for independent contractors to track their income. Whether you operate as a sole proprietor or single-member LLC, we recommend opening a business checking account to run your income & business expenses through. Income can be tracked most efficiently by using cloud-based bookkeeping software that connects to your business bank account, such as Quickbooks Online.
You’ve probably heard of stories where independent contractors want to keep things “off the books” by collecting income in cash and avoiding a 1099 filing (required to be filed by businesses who pay a contractor over $600 in a calendar year). While this seems like it might save you money, it is an illegal practice and not a scaleable business practice.
From a business growth perspective, first reason you’ll want to track and report all income is so that you can track profitability. If you don’t know how much money you’ve made, it is not possible to analyze investment opportunities or make changes to improve past performance. The second reason is that future loans will be decided based on what you’ve reported on your tax returns. The better you track & report your income, the more it will benefit your future growth.
Tracking Expenses
Here is where the independent contractor has a tax advantage over the employee. Independent contractors are allowed to deduct business expenses on their tax return against the income they collected. This lowers both your federal, state, and local taxes, and the self-employment tax. The key to properly using business deductions to lower your taxes is to record the expense and save the receipt. Expenses can be tracked most efficiently by using cloud-based bookkeeping software that connects to your business bank account, such as Quickbooks Online. Expense receipts can be tracked most efficiently by using cloud-based expense management software, such as Hubdoc (or if you prefer only one application, Quickbooks Online can track receipts too).
Examples of deductions that you are allowed to deduct against your business income includes:
Advertising
Bank Fees
Car & Truck Expenses (see next section)
Contract Labor
Insurance
Interest
Legal & Professional Services
Office Expenses
Rent or mortgage (see next section)
Repairs and Maintenance
Supplies
Taxes & Licenses
Travel
Meals (50% deductible)
Other ordinary & necessary costs incurred to operate your business
Milage & Home Office Deductions
A couple of special deductions that independent contractors can also take advantage of is the standard mileage rate and the simplified home office deduction. These methods require a small amount of tracking for a big benefit.
The standard milage rate for 2024 is 67 cents per business mile. Milage can be tracked most efficiently by using a mobile phone app such as Mile IQ (or if you prefer only one application, Quickbooks Online can track miles too). You will simply swipe right or left for each trip and the app will record your miles as business or personal. It is important to note that commuting between work and home are considered personal mileage by the IRS, but anything related to meetings with clients, travel to secondary work sites or errands to pick up supplies will count. Only those who have a home office as their principal place of business can deduct milage when driving to and from home for business-related purposes.
The simplified home office deduction is another powerful tax deduction that is easy to track & calculate. Rather than tracking every expense of your home (mortgage interest, insurance, utilities, repairs, etc.) and trying to defend a percentage allocated to business use, the simplified method allows for a deduction of $5 per square foot of your home that is used exclusively for business (maximum 300 square feet or $1,500).
Under both the standard mileage rate and simplified home office deduction, you do not take depreciation. It may be wise to consult with a CPA to determine which method will be most effective for you in the short and long term to best achieve your financial goals.
Quarterly Estimated Payments
Many times independent contractors receive advice to save 15-30% of their income for taxes. This strategy might be effective for being prepared for your tax bill, but it does not eliminate interest & penalties. A better strategy is to make quarterly estimated payments through IRS Direct Pay.
Anyone who expects to owe tax of $1,000 or more when their return is filed should make estimated payments. To avoid interest and penalties, you will need to Pay Safe. To do this, you will pay four quarterly installments that equal 90% of your current year taxes (which requires some income & expense estimates), or 100% of your prior year tax (simply look at last year’s tax owed and divide by 4). If your adjusted gross income (AGI) for last year was more than $150,000, you are required to pay 110% of your prior year tax.
The due dates for 2024 estimated tax payments are:
Q1 - 4/15/2024
Q2 - 6/17/2024
Q3 - 9/16/2024
Q4 - 1/15/2025
It is recommended to consult with a tax professional when deciding on an amount to pay.
Taking it to the Next Level
At a certain level of income, deductions will simply not be enough to avoid high taxes. This is where a cost-benefit analysis can be run for deciding to work with a CPA and possibly electing S-Corporation status. But that is a topic for next month…
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