Those of you who work independently providing services for others are most likely considered independent contractors (other names include freelancers or sole proprietors.) As always there are tax implications and they differ from what you might be accustomed to if you were ever employed as an employee.
People become independent contractors not always by choice. Quite often, companies decide to employ individuals that way because it makes more sense economically as always at the cost of people providing services. If your employment contract is that of independent contractor, you will be asked to fill out Form W-9 for the company. That form gathers your general information that companies later use to prepare Form 1099-MISC given to you at the end of the year and filed with IRS.
One very important aspect of working independently is record keeping. As an employee you receive a W-2 form at the end of the year that already tallies up most of the necessary information later used in income tax preparation. Employees also have fewer deductions or credits to keep a track of comparing to self-employed individuals. Preparing and estimating tax payments requires detailed information on all your income as well as expenses. In case of an IRS audit, it is crucial to have all that data organized and handy. Think of the best system to keep the receipts and bank statements organized, backed up, and log that information periodically. You can break them down by months, jobs performed, clients, etc. The better you are organized the easier and more accurately it will be to calculate the difference between your income and expenses that becomes your taxable base.
As opposed to salaried employees who make tax payments (or receive a refund) once a year (because taxes are withheld automatically by the employer), independent contractors have to estimate tax amount and make appropriate payments quarterly. Those payments are related to income tax and self-employment tax. Self-employment tax is a combination of Social Security and Medicare contributions. In order to prepare those payments, you will need a prior year tax return (if this is your first year as self-employed, you have to estimate business level) and Form 1040-ES, available on the IRS website. Form 1040-ES is a worksheet to estimate your taxes, contains vouchers if you mail your payment, and include instructions and tax rates schedules. It is clear that estimating income while doing business for the first time is very difficult and you may over- or underestimate your tax payments. In that case complete another 1040-ES form and adjust your payments accordingly with your next payment.
Once you calculate the amount you owe, make sure you send the payments before the following dates: 4/17/2012, 6/15/2012, 9/17/2012, and 1/15/2013. The last payment can be skipped if you file your 2012 taxes by the end of January 2013 and pay the entire balance outstanding. Make sure to consult the IRS website for the correct shipping address. There are 8 different addresses and the proper one is based on your state of residence.
You can also make payments electronically to save time. The U.S. Treasury has created a website dedicated to making tax payments conveniently and with ease. Electronic Federal Tax Payment System or EFTPS lets individuals and businesses make and schedule all types of current and future federal tax payments. Sign-up process is uncomplicated and when you finish the IRS will mail you a pin number needed to complete the registration.
Finally, filing your year-end income taxes requires you to fill out Schedule C also called Profit or Loss from Business. This form will determine the amount to report (net profit) on Form 1040, 1040NR, or 1041. It leads you through the series of questions about income the business generated, expenses related to conducting business, cost of goods sold, information on your vehicle (if applicable), and other expenses. Some businesses may qualify to fill out a simplified version of this form, Schedule C-EZ. In order to be able to do that you have to meet the following conditions:
- Business expenses less than $5,000.
- Cash accounting.
- No inventory held at any point during the year.
- Business must be profitable – no losses reported at the end of the year.
- You own only one business.
- Do not receive credit card payments for services provided.
- Have no employees.
- Do not have to file Form 4562 – Depreciation and Amortization.
- Business use of your home is not expensed.
- No prior year unallowed passive activity losses from business
Once you determine a net income for the year, you will be able to accurately determine the amount of social security and self-employment taxes for the year. Compare that with what you paid in the prior months to be in sync with the IRS.