Contractor v. Employee ~ How Does It Affect Your Taxes?

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Published by Eva Rosenberg, MBA, EA

What they're saying about TaxMama:

Thanks for your site on how to properly dertemine how many exemptions to claim on your W-4 without getting a headache.

These should be the directions on the actual form as opposed to what the IRS has on them.

Doug Davis

2/15/01

(The 20 common law factors the IRS looks at)

Working for your boss, you realized that you did all the work, but got paid only a fraction of what you are worth. So, you quit and ranged out on your own. Now, you have your own business, you get to keep all the money and you're much better off. Sure, but you have to do it all by yourself!

For some, the business details are so overwhelming, they can't get past them to let their genius shine. Others simply breeze through all the administrative nonsense. Either way, dealing with the IRS can be challenging for people working on their own.

It makes a big difference whether you're legally an independent contractor (self-employed) or really an employee without benefits in the eyes of the IRS. If you're self-employed, you may deduct all your business expenses without having to itemize deductions. You claim the expenses on Schedule C and only pay taxes on the business profits.

If you're an employee, you'll have to itemize everything on Schedule A. That means, for a single person with $40,000 in billings, you won't get any benefit for the first $5,800 of your business expenses -- $5,000 for the standard deduction you would have gotten anyway, plus $800 for the 2% of adjusted gross income you cannot deduct. In the 28% tax bracket, that costs you $1,624 plus penalties and interest. (Yes, there is a consequence for self-employment taxes, but if you did it right, you would have had about $20,000 worth of business expenses, so it would balance out the FICA/Medicare on $40K.

The moral of the story: know thyself (and make sure the IRS agrees with your identity).

But how can you tell? There are twenty common law factors that determine your status. A tax professional who specializes in small business and freelance work can tell you more about the relative importance of each factor to your own business or industry.

What makes an independent contractor independent? The 20 common law factors the IRS looks at:

   1. Instructions are generally not given by the company that hires you.
   2. Training is not essential and is not given by the company.
   3. Your personal services are not required; you can assign the work to anyone.
   4. The work you are performing is not essential to the company.
   5. You set your own hours.
   6. You have no continuing relationship with the company.
   7. You control and hire your own assistants.
   8. You are free to pursue other work.
   9. Where you work is your choice.
  10. You set your own work priorities.
  11. No interim reports are required of you.
  12. You work for more than one firm.
  13. You pay your own business expenses.
  14. You use your own tools and equipment.
  15. You bear a risk of loss.
  16. Your services are available to the general public (or industry).
  17. You have a significant capital investment.
  18. Right of discharge is limited by contract.
  19. You are not compensated for incomplete work.
  20. Timing of payment coincides with completion of job, rather than in regular intervals.

If you're still confused, consider that to be in business for yourself, you must look and act like a business. You have to have all the licenses and certifications standard for your profession and for your city, county, state, province or other government division. You don't necessarily have to have a business name though. (But if you are Susan Johnson Consulting, instead of plain old Susan Johnson, you may be required to file a fictitious name or your bank may not accept your deposits.)

To lend legitimacy to your claim that you are an independent contractor, open a separate business account. Obtain a Federal Identification Number for your business to give to clients for tax purposes instead of your Social Security number. It's also wise to have business cards and a brochure that identifies your products or services. This helps demonstrate that your goods or services are indeed available to the public, not just one client.

Finally, look for a tax advisor who specializes in this area of the tax code and wants to help independent people succeed. Being self-employed doesn't mean working alone!

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