How to Avoid Paying Taxes as an Independent Contractor

Editorial team of TFX

• 24.09.21 • 5 min read

Good tax planners learn to ask good questions, keeping in mind the short-term and long-term. Does your tax professional recognize your unique challenges such as cash flow and growth phase of your business? Your tax professional should encourage dialog important to you!

Avoiding paying taxes on your business income, is that possible? 

If you incorporated the business, would your taxes go down? 

Is it a good idea to avoid taxes altogether in the current year? 

Tax rates increase with the bracket of income, so would paying a deductible expense save more tax next year?

We begin with looking at incorporating your business, which could remove business income from the Form 1040, moving it to your corporation’s Form 1120.

Shifting the Business to a Corporation

Our rules don’t normally tax the shareholder just because he or she owns a successful corporation. There is a Subchapter S election that would flow through corporate income to the shareholder’s individual return, the Form 1040. But it is generally possible for the individual to incorporate and have the corporation pay the income tax on its Form 1120.

Per 26 US Code Section 11, the current federal tax rate for corporations is 21%. In 2021, there aren’t “brackets” of corporate tax rates as we find in the tax tables for individuals. The “brackets” for individuals currently start at 10% and go as high as 37%. If you’re already in a high individual tax bracket, shifting income to a C corporation may shift income from a high individual rate to the lower corporate rate of 21%.

If you shift a tax-profitable business to a C corporation, the corporation pays the tax. There is a sense in which you avoid paying tax on your business income. But as owner, you indirectly bear the tax being paid by your corporation.

Avoiding Double Tax if You Incorporate

Shareholders generally pay tax on dividends as corporate profits get distributed or pay their personal expenses.

Avoiding “double taxation” when you own a C corporation can sometimes be achieved by paying the shareholder rent for realty or other assets being used in the corporate business. A corporation can normally deduct reasonable compensation paid to the shareholder for services rendered to the corporation, which achieves a deduction to the corporation while creating income to the shareholder. Payroll taxes also enter the picture at this stage. Shareholder loans may enter into the planning.

Incorporating quickly becomes a bit complicated.

But is it possible for an independent contractor to avoid paying taxes directly? Yes, if the successful corporation doesn’t distribute dividends or salary or rent to the owner. This can also be advantageous when the corporate tax rate is lower than your individual tax rate that would apply to added income.

Timing Is Important if You Incorporate

New businesses may have quite a few deductions in the early stages, so also consider operating a new business as an individual, and then incorporate later when the business turns profitable.

Another Caveat: When the business has deductions that exceed income, the tax loss might save taxes in your Form 1040 if you have other income. Losses inside the new C corporation just carry over without being a current help to the owner or the corporation.

We turn to presume you own and operate the business directly as a sole proprietor/contractor.

Deferring Income if You Are an Independent Contractor

Business income may be reported later if you use the cash method rather than the accrual method of accounting. The cash method looks at when cash or property is received. The accrual method recognizes income when it is earned. The accrual method is sometimes required of bigger companies.

Consistency of the method is generally required. Taxpayers can’t just use one method and switch to another whenever it might save tax. Taxpayers sometimes will need to file IRS Form 3115, Application for Change in Accounting Method. Taxpayer method changes sometimes run to the overall method of accounting but may involve the treatment of a single item.

You have to report your business income, whether or not you received a Form 1099 from your client/customer.

Maximizing Deductions if You Are an Independent Contractor

If the business is making large capital expenditures, the tax rules may allow quick write-offs, within limits.

For tax years beginning in 2021, US Code Section 179, How to Depreciate Property, allows an expense deduction of as much as $1,050,000. “The limit is reduced by the amount by which the cost of section 179 property placed in service during the year exceeds $2,620,000.”

The provision doesn’t apply to buildings and their structural components. This fast-write-off provision generally reaches tangible personal property.

You can review with your tax adviser how to maximize other business deductions, such as business interest, employee benefit plan contributions, supplies, business auto, advertising, staff training costs, business travel.

Home office deductions are possible but subject to rather strict limitations, such as regular and exclusive use.

In general, maximizing your business deductions will also reduce your self-employment tax.

The Balanced Perspective in Planning

Your tax adviser can also help you consider such issues as the impact your decision may have on other years and whether deductions might be even more valuable in another year. Balancing deductions between years can sometimes be advantageous when it shifts deductions to higher tax brackets.

The best tax planning has a focus on reducing taxes in the long term.