Freelancers and contractors may enjoy greater flexibility and independence than full-time employees, however, this autonomy brings increased tax responsibility. Unlike W-2 employees, freelancers and independent contractors are responsible for managing their own tax obligations, which can be a complex process.
A key difference lies in how income is handled. W-2 employees have taxes withheld from their paychecks, while freelancers receive a 1099 NEC (or 1099 MISC) with no withholding, making them responsible for calculating and paying their own income tax, Social Security, and Medicare taxes.
This fundamental difference in tax structure is the source of a number of tax filing errors. In this guide, we’ll outline the most common tax filing mistakes that freelancers and contractors make.
Table of Contents
- How Does the IRS Know If You’re Self-Employed?
- Do Freelancers Have to Report All Their Income?
- How Much Should Freelancers Set Aside for Taxes?
- Do Freelancers Need to Pay Quarterly Estimated Taxes?
- What Happens If You Miss a Tax Deadline?
- What Tax Deductions Can Freelancers Claim?
- When Should You Incorporate as a Freelancer?
- Why Should Freelancers Keep Business and Personal Finances Separate?
- How Do You Know If Someone Is an Employee or a Contractor?
- What State and Local Taxes Do Freelancers Have to Pay?
- Will the IRS See Your Work as a Business or a Hobby?
- What Are the Best Tax Tools for Freelancers and Contractors?
- How Harness Can Help with Freelancer Taxes
- FAQs: Common Tax Questions for Freelancers and Contractors
How Does the IRS Know If You’re Self-Employed?
Simply working independently and receiving 1099 income isn’t enough to establish your self-employment status with the IRS. You need to actively inform the IRS of your new status. A key first step is creating a clear, written contract with each client, explicitly stating your status as a freelancer or independent contractor. This contract serves as documentation for the IRS, substantiating your self-employment.
Legally, your clients are only legally required to issue a 1099-NEC for payments exceeding $600. That said, all income, regardless of the amount or whether a 1099 was received, must be reported to the IRS.
Without a contract, you could encounter difficulties proving your self-employment status, bringing up potential tax disputes, penalties, or even misclassification as an employee, which carries its own set of tax implications.
Do Freelancers Have to Report All Their Income?
Failing to report all your income is a serious offense and can lead to major penalties and audits. It’s important to remember that the IRS requires you to report all earnings, including cash payments, online transactions processed through platforms like PayPal or Stripe, and any other form of income related to your freelance work.
When it comes to transactions via PayPal, Venmo, and Stripe, etc., more freelancers will receive 1099-Ks from this year due to the new $600 reporting threshold. Freelancers need to pay special attention to this as some might mistakenly think they only need to report income from 1099-NECs.
Whatever transaction platforms you use, the IRS has sophisticated systems to track income through banks, payment processors, and other financial institutions. Underreporting, even seemingly small amounts, is easily detected and can trigger an audit, often leading to substantial fines and back taxes.
How Much Should Freelancers Set Aside for Taxes?
This is perhaps the most common and damaging mistake that freelancers and contractors make. Unlike W-2 employees, taxes aren’t automatically deducted from your earnings. You’re solely responsible for setting aside sufficient funds to cover your self-employment taxes (Social Security and Medicare) as well as income tax.
It’s easy to underestimate this burden, particularly since you’re responsible for paying both the employer and employee portions of Social Security and Medicare. This combined rate is 15.3% (12.4% for Social Security and 2.9% for Medicare).
A good rule of thumb is to set aside at least 30% of every payment you receive to cover your estimated tax obligations—however, this percentage may need to be adjusted based on your individual tax bracket. On the whole, it’s advisable to consult a tax advisor to develop a dependable tax plan.
Do Freelancers Need to Pay Quarterly Estimated Taxes?
The IRS expects self-employed individuals to make estimated tax payments on a quarterly basis. These payments cover both your income tax and self-employment tax liabilities. If you expect to owe $1,000 or more in taxes for the year, you’re required to pay estimated taxes, the deadlines for which are typically January 15, April 15, June 15, and September 15.
Failing to pay quarterly can result in penalties, even if you ultimately pay your taxes in full by the annual filing deadline. As a general rule, freelancers are advised to set aside 25-35% of their income to meet their estimated tax payments (or base the amount on their previous year’s tax liability).
That said, the IRS offers a safe harbor provision—if you pay at least 90% of your tax liability for the year or 100% of your tax liability from the previous year, you may avoid penalties for underpayment.
What Happens If You Miss a Tax Deadline?
Missing any tax deadline, whether it’s a quarterly estimated tax payment or the annual tax filing deadline, can lead to penalties and interest charges. These penalties can pile up quickly, adding to your overall tax burden. It is crucial to stay organized and mark these deadlines on your calendar,
What Tax Deductions Can Freelancers Claim?
Freelancers and contractors can deduct a wide range of legitimate business expenses, reducing their taxable income. It’s important to make sure you’re maximizing your allowable deductions and recording your costs. Even expenditures like office supplies, which may seem small at the time of purchase, can add up to a relevant amount over the course of a year
Common deductions include:
- Home office deduction: For the portion of your home used exclusively and regularly for business, you can deduct expenses like rent, utilities, and internet.
- Business-related travel: Costs associated with traveling for business purposes, including transportation, lodging, and meals (subject to limitations).
- Office supplies: Expenses for items like paper, pens, software, and other necessary office equipment
- Marketing and advertising: Costs incurred for promoting your freelance services, including website development, social media advertising, and business cards.
- Professional services: Fees paid to accountants, lawyers, consultants, or other professionals for business-related advice.
- Health insurance premiums: You may be able to deduct a portion of your health insurance premiums if you are self-employed.
- Retirement contributions: Contributions to SEP IRAs, SIMPLE IRAs, or other qualified retirement plans can reduce your taxable income.
- Education and training: Expenses related to maintaining or improving your skills in your freelance field.
- Depreciation: You can deduct the depreciation of business assets over their useful life.
Freelancers and contractors are often subject to IRS audits, so having solid evidence to back up your deductions is essential. Keep all receipts, invoices, bank statements, and other documentation.
When Should You Incorporate as a Freelancer?
As your freelance or contract work grows and you become more established, you may need to consider structuring your business more formally. This could involve forming an LLC (Limited Liability Company), S corporation, or other business entity.
These formal structures can offer several benefits, including legal protection, limited liability, and potential tax advantages. For example, an S corporation can allow you to separate your salary from your business profits, potentially reducing your self-employment tax burden.
Forming a business entity comes with added administrative requirements, however, so it’s advisable to consult with a tax professional to determine the best business structure for your specific circumstances.
Why Should Freelancers Keep Business and Personal Finances Separate?
Mixing business and personal finances is a recipe for tax problems and can make it difficult to track income and expenses accurately. Open a dedicated business bank account and use it exclusively for business income and expenses.
This separation simplifies tax preparation, provides clear evidence of business deductions in case of an audit, and makes it easier to track the financial health of your freelance business.
How Do You Know If Someone Is an Employee or a Contractor?
If you hire other freelancers or contractors to assist you with your work, it’s important to correctly classify them as independent contractors, not employees. Misclassifying workers can have serious legal and tax consequences. The IRS has specific criteria for determining whether a worker is an employee or an independent contractor. Generally speaking, however, independent contractors are defined as:
- Having more control over their work
- Setting their own hours
- Providing their own tools and equipment.
What State and Local Taxes Do Freelancers Have to Pay?
While federal taxes often take center stage, it’s important to understand your state and local tax obligations. These can include state income tax, sales tax (if you sell taxable goods or services), and other business taxes.
State and local tax laws can vary a great deal. For example, some states tax remote work differently, with freelancers living in one state but working with clients in NY or CA still potentially owing taxes there. It’s vital that you research the specific tax regulations in your area.
Will the IRS See Your Work as a Business or a Hobby?
The IRS has specific rules that distinguish a legitimate business from a hobby. To be considered a legitimate business, you must demonstrate a profit motive—with the IRS generally requiring you to show a profit in at least three out of five consecutive years for most businesses.
If the IRS determines your activity is a hobby, you won’t be able to deduct losses, which may significantly increase your tax bill.
What Are the Best Tax Tools for Freelancers and Contractors?
Effectively calculating a freelancer or contractor’s tax obligation and tax education can be a complicated process. Online tax calculators are a common tool that can help you estimate your tax liability, calculate deductions, and determine your quarterly estimated tax payments.
Consulting with a qualified tax advisor can provide you with the personalized guidance you may need to maximize deductions and minimize your tax liability. They can also represent you in case of an IRS audit.
How Harness Can Help with Freelancer Taxes
At Harness, we connect businesses and individuals—including freelancers and contractors—to qualified tax professionals. Our network of tax advisors can provide the personalized guidance you need to manage the complexities of self-employment taxes, ensuring you maximize deductions, minimize your tax liability, and stay compliant with IRS regulations.
They can also advise you on the best course of action should forming an LLC or other formal business entity be in your best interests.
FAQs: Common Tax Questions for Freelancers and Contractors
What are the key differences between how a W-2 employee and a freelancer/independent contractor pay federal income taxes?
W-2 employees have federal income taxes, Social Security tax, and Medicare tax withheld from each paycheck. Freelancers and independent contractors, on the other hand, are responsible for calculating and paying these taxes themselves. They do this by making estimated tax payments throughout the year and filing an annual tax return.
How do I calculate my net earnings as a freelancer?
Your net earnings are your gross income from freelancing minus allowable business expenses. It’s vital to accurately track all income and expenses to determine your net earnings, as this figure is used to calculate your tax liability.
What kind of tax deductions can freelancers take?
Freelancers can take a variety of tax deductions for legitimate business expenses. These can include deductions for home office expenses, business-related travel, office supplies, marketing costs, professional services, health insurance premiums (under certain conditions), and more. Accurate record-keeping is essential to substantiate these tax deductions.
How do I pay self-employment tax?
You pay self-employment tax by calculating it based on your net earnings and including it with your estimated tax payments throughout the year. Self-employment tax covers both the Social Security tax and Medicare tax that would normally be paid by both an employer and an employee.
What is the self employment tax rate?
The current self-employment tax rate is 15.3%. This comprises 12.4% for Social Security tax and 2.9% for Medicare tax. Remember, as a freelancer, you’re responsible for both the employer and employee portions of these taxes.
How does self-employment tax affect my adjusted gross income (AGI)?
Your net earnings from self-employment, after deducting allowable business expenses, are added to any other income you have (e.g., interest, dividends) to calculate your gross income. One-half of your self-employment tax is then deductible, and this deduction reduces your gross income to arrive at your adjusted gross income (AGI). Your AGI is a central figure used to determine eligibility for certain tax deductions and credits.
Am I eligible for the earned income tax credit (EITC) as a freelancer?
The earned income tax credit (EITC) is a refundable tax credit for low-to-moderate-income individuals and families. Freelancers and independent contractors may be eligible for the EITC, but the eligibility criteria, including income limits and filing status, must be met. It’s important to consult the IRS guidelines or a tax professional to determine your eligibility.
How does Social Security tax work for freelancers?
As a freelancer, you are both the employer and the employee when it comes to Social Security tax. You pay the full 12.4% Social Security tax on your net earnings up to the annual Social Security wage base limit. This tax contributes to your future Social Security benefits.
How do estimated taxes work, and why are they important for freelancers?
Estimated taxes are payments you make to the IRS throughout the year to cover your income tax and self-employment tax liabilities. Because taxes are not withheld from your freelance income, you must estimate how much you will owe and pay it quarterly. This prevents a large tax bill at the end of the year and helps avoid penalties for underpayment.
Where can I find more information about federal income taxes for freelancers?
The IRS website (irs.gov) is the best resource for information about federal income taxes. You can find publications, forms, instructions, and other helpful resources specifically for self-employed individuals. Consulting with a qualified tax professional is also highly recommended for personalized advice.
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