By Valerie Rind
For whom do you work? The nature of employment and your relationship to an employer is complex. Most workers are employees, but a growing number are self-employed independent contractors.
In the eyes of the Internal Revenue Service and other taxation authorities, it is critical that you classify yourself correctly and follow the laws when you file tax returns. Get it wrong and you might owe interest and penalties in addition to the amount of unpaid taxes. Plus, you do not want to miss out on some of the legitimate tax benefits to which you are entitled as a business owner.
According to the IRS, you might be considered self-employed if any of the following apply:
-You carry on a trade or business as a sole proprietor or an independent contractor
-You are a member of a partnership that carries on a trade or business
-You are otherwise in business for yourself (including a part-time business)
Independent contractors generally receive a gross amount of pay based on the number of hours they work or a lump sum for a completed project. They do not receive benefits such as health insurance and paid holidays. Self-employed workers have the entire burden of keeping good records, and filing and paying their taxes.
Because the companies they perform services for do not employ them, no tax is withheld from an independent contractor’s paycheck. At the end of the year, the company might file a Form 1099-MISC instead of the Form W-2 rank-and-file employees receive.
Whether you are pulling together information to prepare your 2015 tax return or getting a head start on organizing your 2016 taxes, here are three mistakes to watch out for if you are an independent contractor.
NOT FILING INCOME TAX RETURNS
Not filing an income tax return, particularly when you owe taxes, is the most basic and damaging mistake any wage earner can make.
You will almost certainly owe interest and penalties if you do not file and pay your taxes on time. In addition, the IRS says failing to report all self-employment income can reduce your Social Security benefit in retirement.
Check the IRS website to determine whether you need to file a federal return. It depends on your age, marital status, type of income received and other factors. You might also be required to file in one or more states.
A 2012 report by the U.S. Government Accountability Office found that billions of potential tax dollars go uncollected because sole proprietors fail to report how much income they receive or claim excessive expense deductions.
Research consistently shows that people are more likely to cheat if they think no one is watching them. The fear of being subject to a tax audit likely drives other people to err on the side of honesty when filing their tax returns.
NOT TREATING SELF-EMPLOYMENT AS A BUSINESS
The most common mistake self-employed individuals, including independent contractors, make is not treating self-employment as a business, said Scott Goble, a certified public accountant and founder of Sound Accounting PLLC, based in Chickamauga, Ga.
“When one is self-employed, they are in fact operating a small business,” Goble said. “As a small-business owner, a self-employed individual can deduct many expenses that are not necessarily deductible for employed individuals.”
Business-related expenses include many costs that might be deductible under IRS laws, such as:
-Use of a vehicle
-Personal computer and software
-Meals and entertainment
-Accounting and legal fees
-Professional association dues
NOT PAYING SELF-EMPLOYMENT TAXES
Your liabilities do not end with federal and state income taxes. In addition, if you meet certain income thresholds you must pay self-employment taxes, which include Social Security and Medicare taxes.
“Self-employed individuals are subject to a tax equal to 15.3 percent of their net income from business,” Goble said.
That is because self-employed workers are responsible for paying all Social Security and Medicare taxes, 12.4 percent for Social Security, 2.9 percent for Medicare. By contrast, employees split these costs with their employer.
Fortunately, self-employed workers get some of that money back when they file their tax return.
“You get to deduct half of that amount as an adjustment to income, also known as an ‘above the line’ deduction, on your Form 1040,” said Kay Bell, tax journalist at the blog Don’t Mess With Taxes.
To pay the self-employment tax, you must estimate the amount you owe and pay on a quarterly basis. “The IRS prefers you figure or guesstimate your annual tax bill and then send in four equal payments,” Bell said. For example, your April 15 payment covers your earnings for the first three months of that year.
It is critical to calculate the payment accurately and pay it promptly. “If you miscalculate, or decide you just can’t pay the estimated amount for one segment, when you file your annual tax return you’ll discover that in addition to the taxes due, you’ll owe interest on any amount you should have paid, along with a penalty for underpayment,” Bell said.
Valerie Rind writes for GOBankingRates.com, a leading portal for personal finance news and features, offering visitors the latest information on everything from interest rates to strategies on saving money, managing a budget and getting out of debt.