Self-Employment Tax: Basics for the Independent Contractor
There are many factors that affect whether your work relationship is one of employee or independent contractor. Our focus will be on tax consequences of self-employment.
Obviously, when you visit your doctor, you’re not thinking of the physician as your employee or employer. Nor does the doctor think of you as an employee or employer. On the other hand, we’d almost all agree that the person behind the counter at a large department store is an employee. What is the difference?
IRS Rules State That Control Makes You The Boss!
Before we define what self-employment tax is we need to state who the self-employed individual is. Much can be said about distinguishing an employee from a self-employed person. But the main difference is control, or lack of control. You don’t control your doctor. There is a “boss” in the background controlling the services of the department store employee at the check-out stand.
Words-to-paper often define the employee vs. contractor matter. Laws or contracts can resolve the nature of working relationships. The IRS summarizes:
“People such as doctors, veterinarians, and auctioneers who work in an independent trade, business, or profession which offer their services to the public, are generally not employees. However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.”
IRS Pub. 15-A, “Employer’s Supplemental Tax Guide, Supplement to Pub. 15, Employer’s Tax Guide,” p. 4.
The IRS has many questions it may ask in resolving whether a relationship is one of employer-employee vs. contractor servicing a client. We will discuss some of them.
Contractors tend to work for multiple companies. The following, when answered affirmatively, tend to indicate employment.
- Does the company say where, when and how the work gets done?
- Does the company provide training, tools and materials?
- Are significant services integrated into business services?
- Does the company say who will do the work?
- Does the company control, hire the individual’s assistant workers?
- We know there is often continuity to contractor relationships, but is the relationship continuous?
- Does the company control the individual’s schedule?
- Is the work full-time?
The IRS booklet on our topic goes on to discuss employee classifications typical of different industries, such as the building and construction industry, the legal profession, and many other groups.
Rights and Responsibilities Equal Relationship
So if your relationship with those paying for your work is one an independent contractor, what does that mean in terms of responsibilities?
Being a contractor has its advantages. Contractors get to deduct business expenses in figuring income tax and earnings subject to self-employment. But more tax responsibilities include more bookkeeping and complicated tax/estimated tax filings.
Rates Translate Into Self-Employment Tax Savings
There are occasional simplifications in tax rules. You can use the cents-per-mile method for business auto expense or the detailed expense and depreciation method. The 2021 per mile rate is 56 cents, down from 57.5 cents in 2020. See IR-2020-279. Contemporaneous logs with mileage and purpose are important to sustaining auto deductions.
Business auto and other deductions save tax, But at what rate? State rates vary, with a few states with zero tax. Current federal rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%.
Tax savings are the deduction times the tax bracket given your filing status. Deductions reduce self-employment tax Form 1040 and estimated taxes usually due on April 15th, June 15th, September 15th and January 15th. Dates are adjusted for holidays and weekends. An important part of your “tax kit” will be the estimated tax form, 1040-ES, and its rather lengthy instructions.
Payroll Taxes Add Up
Payroll tax is shared by the employer and employee. The contractor pays roughly both halves of the tax. Self-employment tax is 15.3% — 12.4% self-employed Social Security plus 2.9% Medicare tax. The 2021 12.4% applies to a maximum of $142,800, which may need adjusting if you have wages with self-employment income. Self-employment tax is 92.35% of actual business income.
So what is the tax savings on a $1,000 business deduction in a 32% income tax bracket with a 15.3% self-employment tax? Your rate is basically 32% plus 92.35% of 15.3%, a total of about 46%. This translates to $460 savings on $1,000 expenditure, applying a fairly high tax bracket. State income tax varies, which may save federal tax if itemized, so expenses may be greater.
It gets even more complicated. We’ve not figured tax savings on half of the self-employment tax being deductible. There is another 2.9% self-employed Medicare tax at certain income levels, and state and local taxes such as city license tax.
Tax Experts Turn Tax Complications Into Tax Savings
Keep in mind that proving your deductions reduces income tax and self-employment tax. Both are significant. There are exceptions. For example, the 20% of business income deduction, when available, reduces federal income tax but not self-employment tax. See Section 199A.
Self-employment usually means more complicated taxes and professional tax help.