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Originally Posted On: https://playlouder.com/independent-contractor-taxes-and-how-to-incorporate/
If you are self-employed as an independent contractor (aka freelancer), then you’re in one of the best possible work scenarios, in my opinion. You get much of the flexibility of business ownership, without having to jump into the deep end of a stand alone operation! Furthermore, you can save big on taxes! That said, very often folks aren’t quite sure how to deal with independent contractor taxes. Nor do they know how to incorporate, or even if they should.
Independent contractor taxes, or freelance taxes, are a little confusing for sure…but with a little help, you can be using your independent status to save yourself quite a bit of money come tax time…”just like the big kids do it”…Booooooyah! (I know. whatever.)
Nonetheless, how you set yourself up to operate as an independent contractor, will make a big difference in your bottom line….
A quick Disclaimer break..
I have to point out that I am not a licensed CPA or licensed attorney.
I am a do-it-yourself entrepreneur who, has started multiple business, and owned a lot of real estate, and consequently has gone through all these processes many times.
I say this so you understand that, while I have a lot of practical knowledge about all of this stuff, I don’t make official claims about tax savings or give advice on which kind of entity you should go with. I do share what I have done for myself however.
Sooooo….any points below. related to this disclaimer, are noted with a double asterisk (**). Ok…back to the post….
Are Taxes for Independent Contractors Better or Worse than the Average Employee?
One of the most significant benefits of being a freelancer is that you get much of the preferential tax status of being a business owner! (Notice I said much.)
Business owners are offered significantly greater tax benefits than a standard W-2 employee. And while freelance taxes offer similar benefits, they are still not quite as good as an actual business entity.
The steps I’m going to outline in this article have helped me personally both save money in taxes, and also earn more money, as I shifted my thinking and opened up more opportunities for business.
Independent Contractor Taxes Are Largely Determined by How You Collect Your Money
Ok, I’m going to get to the good stuff early on this post, so that you’re hopefully intrigued enough to keep reading!
Here is a basic tax planning spreadsheet I created that shows the potential difference in taxes owed between a person getting W2 income, 1099 income and Business Entity (corporation) income**.
As you can see above, the person getting paid through their entity could potentially pay much less in tax!** Granted the entity comes with some cost, but it’s still worth it. And the more money you make, the better you will usually do on a percentage basis.
What Determines the Way I Get Paid?
There are a two ways an “independent contractor” or “freelancer” can be in business. They can get paid as an unincorporated 1099 contractor, or can incorporate themselves and get paid to their corporation. There is potentially a big tax difference between the two!
Freelance Definition (a quick sidebar)
Freelancers are often referred to as independent contractors or 1099 contractors, but people often wonder if those terms are interchangeable. These terms get used interchangeably in my experience, but there IS a distinction. And, naturally, folks want to know exactly what category they fall into for tax reporting purposes.
Well..according to the IRS, an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. Meaning no set hours, they work on their own equipment and at their own office or home, and they just need to deliver a finished product by the deadline..
In practice many “freelancers” don’t fit this definition. Very often freelancers are actually technically “temporary employees,” because they show up and leave an employers workplace on specified hours and work on the employers equipment. They just do this for a temporary time period.
That said, it seems the degree to which this distinction is enforced varies mostly by the states. Many employers just pay all “non full-time” workers as freelance/independent/1099 contractors because it’s easier and they then don’t have to cover the employer payroll taxes. Just because they do that doesn’t make it correct, but they and the contractor are in fact saving on taxes. Just something to ponder and discuss with your CPA.
1099 Income: This means you are contracted by a customer on a project by project basis. They don’t have you on “W2 payroll” and do not deduct freelance taxes on your behalf.
At the end of the year the company that hires you reports the amount of money they paid you to the IRS via a “1099.” You would get a 1099 from every customer you have contracted with.
Working this way means you personally “are the business.” Your 1099 income is accounted for on the “Schedule C,” on your personal federal tax return (and whatever the similar schedule is on your state return).
Here’s the problem(s): having a “1099” or “Schedule C” business does not give you as favorable a tax benefit as this next option below. This set up may fall into the category of Independent Contractor Taxes.
You pay more in self-employed payroll tax and are offered a few less potential business deductions than if you were incorporated. Plus, you can’t build business credit as a “1099” service provider. That’s just not sweet.
Business Entity Income: This option is where you create a separate business entity for your freelance business activities. In layman’s terms, this would be an entity that has a separate business name and has the “INC” or “LLC” designation at the end of it. You likely would also want to get the “S Corp” designation for tax purposes.
Having an entity will allow you to save on taxes, and improve you business standing, in the following ways (this is both in my experience and according to my CPA, Wheeler & Bi, Los Angeles).
- Self-Employment Tax
You will pay less self-employed payroll tax than if you are just a 1099 contractor.
- Business Deductions
You will get the most allowable business deductions available.
- Business Credit
You will be able to build business credit that won’t show up on your personal credit report and affect your credit score.
- Legitimacy for Customers
You will have the most desireable set-up to help employers feel comfortable paying you as an independent consultant rather than via W2 Payroll.
- Liability Protection
By creating an entity, you create a wall of protection between your business activities and your personal financial life. So if someone sues your business, your personal assets can likely be shielded from the suit**.
Deciding On Your Business Entity
For a single or spousal owner busiuness, this is what you’ll want to do in my opinion (which is also an extension of my CPA’s opinion and recommendations).
You will want to create an “INC” (aka corporation) with an “S Corp” designation, or “LLC” (aka Limited Liability Company) with an “S Corp” designation.
I personally would go with the INC, mainly because Even though the LLC/S Corp does not require a 1099, the employer may just assume your LLC requires a 1099, and be less inclined to pay your corp.
It’s important to note that each state has their own rules as to what constitutes an independent contractor. Some are far more lax about it than others. California, for example, is becoming increasingly aggressive about classifying more independent contractors as “W2 employees,” so they can gain more payroll tax revenue for the state.
How Do I Set Up My Entity?
OK, so now we’re finally getting to the action! There are 11 critical steps to follow in order to set up and maintain your new entity, and its legitimacy as an independent business.
I’ve tried to be as detailed as possible, and offer as many tips as I can, so you can understand exactly what you need to accomplish and how to do it the easiest way.
The 10 Steps to Establish and Maintain Your New Entity
1. CREATE THE ENTITY
-You are potentially going to create an INC or LLC entity, possibly with an S Corp classification (but again, you may want to also get advice form your CPA or attorney on what’s best for your situation). I recommend using the web service Incfile for this. It’s easy and inexpensive.
-If you decide to incorporate in a state other than your own, you will have to pay to have a “Registered Agent” address in that state. You can purchase this through IncFile as well.
-Initially the entity will be established in your state of choice, and you will be issued Articles of Incorporation and a “State Entity Number” (the name of this varies by state).
-Then from there you will register your entity with the IRS, obtain an EIN, then you will elect to be an S Corp (IRS form 2553). Incfile will provide the 2553 file for “free,” but in order for them to do that, they need your EIN. So the cheapest (and almost as quick) approach is to do both yourself. It’s easy…more below.
-You will want to to purchase Corporate By-Laws and an Annual Meeting template from IncFile. These are boiler plate documents. The By-Laws you will sign and keep handy. The meeting and minutes template you do once per year.
Related Content: The 4 Best LLC Formation and Incorporation Services 2020
2. OBTAIN A TAX ID# FROM THE IRS (ALSO KNOWN AS AN EMPLOYER TAX IDENTIFICATION NUMBER OR EIN)
-Once your entity is established, you have to set up “employer accounts” with the fed and state so you can run some payroll for yourself.
-You’ll need to obtain an Employer Identification Number (AKA a Tax ID or EIN) with the IRS. This will be done with IRS form SS4, and can be done easily on the IRS website. (If you elected for IncFile to do it, then you can skip this step! They would have provided you with a SS4 letter which shows your number.)
3. FILING YOUR S CORP ELECTION (IRS FORM 2553)
-After you obtain your Federal EIN, you will need to fill out and send in your S Corp (small business corporation) election. Again, this is IRS form 2553. It’s pretty simple, and takes about 5 minutes to fill out. The only hassle is that you have to fax this one in (I know, I know).
-I use an app called Scanbot to send the fax. It will take pictures of documents and then turn them into low file size PDFs for you. Then you can pay a dollar, inside the app, to fax it anywhere. It’s pretty handy actually!
-You are also supposed to get this in within 2.5 months of your entity being established. Now that said, if you blow it and don’t get it in, you can apply for a “late acceptance.” I have always had my CPA do late requests (to give them the best chance of being accepted), and I have never been declined so far.
4. UNDERSTAND AND OBTAIN YOUR STATE & CITY BUSINESS LICENSES AND TAX IDs
I have combined all of these items under one heading because, often, the state systems will combine the application process for some of these items together. But then again, some don’t, so you have to further research you states requirements.
-You will also need to establish employer accounts with your state. Most states have a departmental website where you can do this. Each state has a different name for this department. For example, in CA it’s called the Employment Development Department. In FL it’s called the Department of Economic Opportunity. You will need these account numbers to provide to your payroll service.
-Your state will also require additional TAX IDs depending on what you do. For example, if you sell retail goods, you will need a Sales Tax ID number. If you sell alcohol, you may need another number. It’s definitely a bit of a maze, but you want to get it right, so you don’t get an unexpected tax bill for sales tax or aluminum can redemptions, three years down the road. Of course, for many individual service providers and consultants, these won’t apply. You’ll likely just need your employer tax ID.
-At the state level, you may have to apply for a business license, depending on your profession. For example, lawyers, CPAs, general contractors, architects, and real estate agents (among many other professions) all need a state license to operate. Some may require just a form to be filled out, while some require testing and have more significant oversight (aka “regulated”). But again, many individual service providers and consultants don’t need anything.
-You also will usually have to register for a city business license and pay city business tax, depending what city you live in. It’s usually a % of gross income over a certain amount…or it could be a small minimum fee. My city of Dunedin, FL is $60. In LA it’s $0 under 100K in gross revenue, then goes up from there.
5. SET UP A BANK ACCOUNT FOR YOUR NEW BUSINESS & ESTABLISH SOME CREDIT.
-Once you have your Articles of Incorporation and Federal Tax ID, you will be able to set up a bank account for your business. I personally use BofA, and I can link it with my personal account under the same login, so it’s very easy to manage my biz and personal accounts and transfer funds. I’m sure most big banks allow for this.
-You should also start establishing credit for your business, which can be used for a variety of purposes in the future. Start by applying for a business credit card, which you likely can do at the same time you open a bank account!
-One of the main benefits of this credit, is that you can (mostly) utilize business credit without it showing up on your personal credit profile. Therefore, the credit usage doesn’t lower your credit score! (That’s a big deal actually.)
Related Content: Here is a list of credit cards that don’t report to your personal credit. You’ll see my top reco is the Chase Ink Business Unlimited Card.
6. SIGN UP WITH A PAYROLL SERVICE (so you can pay yourself from your new business) AND FILE QUARTERLY PAYROLL TAX RETURNS
-You will need to give yourself an annual “W2 salary” (from your corp to yourself) for a predetermined amount of money. This is best done using a payroll service. I currently use Gusto (use this link and get a $200 amazon gift card), but a few of my clients use Square).
-Your company will have to file quarterly payroll tax returns to your state and the IRS. That said, your payroll service will file these returns on your behalf.
–Quarterly Tax Dates are Apr30/Q1, July31/Q2, Oct31/Q3, Jan31/Q4.
— Daisy Pettles (@DaisyPettles) January 5, 2020
Related Content: Choosing Payroll Software: Square Payroll vs. Gusto Payroll vs. ADP
7. OPEN A SELF-EMPLOYED 401K FOR YOUR BUSINESS (this is a huge tax savings tool, but is optional)
-You should open a Self-employed (aka Solo) 401K account. This is a major tool in tax planning and in saving for retirement. I currently use Fidelity for my Solo 401K, as well as all my brokerage accounts. I like them and feel the customer service is quite good.
-These accounts are usually free to set up, and don’t require any annual filings until they have 250K in them. After that, you or your CPA have to file IRS form 5500.
Related Content: If you are curious to know more about the value of the SE401k, I wrote an “insanely great” post on the topic entitled Comparing the SEP IRA vs The Solo 401k.
8. UNDERSTANDING AND HANDLING YOUR ANNUAL CORPORATE REQUIREMENTS
This is honestly a big hassle to figure out at first, but once you do, it’s not as bad as it all sounds. Lucky for you I have written a post that explains all this in a bit more detail AND provides a list of requirements for each state! Yes…I’m insane. Check it out…
Related Content: State by State Review of Annual S Corporation Filing Requirements
FILE ANNUAL TAX RETURNS FOR YOUR BUSINESS (AND THEN YOURSELF, OF COURSE).
-There is no federal minimum tax due for S Corps, because the entity is a “pass-through,” which means all profits pass through to your personal tax return. But, even though there is technically no tax due for the entity itself, you will still 100% need to file a FEDERAL tax return for your business. This produces a K1 form, which is what passes the profit (or loss) to your personal return.
-Like with the Fed, in most cases S Corp profit is not taxed, and is just passed onto the personal return. BUT, again, in most states you will still need to file a state tax return for the same reason. The state return generates its own specific K1 for your state personal return.
-THAT SAID, each state varies on whether they charge a “minimum” state tax or not. This is also commonly referred to as a Franchise Tax or Privilege Tax, for having the privilege of doing business in the state. In CA, for example, it’s the nations highest at $800. In RI it’s $400. In TX it’s $0 (if your income is under a certain amount).
-To further complicate matters, depending on the state, you may pay this fee as part of your tax return or as part of your “Annual Corporate Filing” (see below).
Related Content: H&R Block vs TurboTax vs an Accountant
ANNUAL STATE BASED CORPORATE FILING (NAME VARIES BY STATE)
-In addition to tax returns that you will have to file, your state will likely require some form of annual report. By-in-large this form supplies the state with updated records about ownership and management. And in some cases, it’s another opportunity to grab a few $’s in fees.
-Some states call this an “annual report,” while some call it a “Statement of Information.” Some require it every year, and some every other. Sometimes you pay a fee specifically when filing this report and sometime it’s free. As you can see, each state is different.
-And as mentioned above, if a state requires a franchise tax, it may be paid along with this filing, as opposed to the “tax return.” Or this filing may even be part of the tax return.
-Admittedly, it’s confusing at first. But luckily, most of this is done online and it’s actually pretty simple to do, once you get your bearings.
ANNUAL CORPORATE MEETINGS AND MINUTES
-States and the Fed also require you to keep annual records for your business. This comes in the form of an “annual meeting” where you take “minutes” and a few other things. This is where you might take a vote on issues or just proclaim “all is well” with the business.
-That said, the reality is that these documents just sit in your desk drawer. You don’t have to file them with the state, so they don’t actually know if they are in your desk drawer or not. I’m not saying don’t do them…you should “definitely” do this…I’m just saying there is no Entity Police coming and looking in your desk drawer every year. That’s all I’m saying.
-Of course, if you undergo and audit, the state or IRS may ask for them. So it’s probably good to keep up on them semi-regularly. All of the incorporation services will provide you with a template to use, which makes it easy.
SOME WAYS TO DO ALL THIS STUFF
-If you go the CPA route, they are often willing to do some or all of your annual corporate filings at the Federal, State and City Level. You have to pay them to do this of course…but it’s easier.
-The truth is that while this all sounds complicated, once your figure out what you state requires, it’s not that hard to do yourself. And if your business is just consulting, and doesn’t make huge sums every year, states often offer “easy” forms that are super simple and you can do online. Even for the tax returns.
9. DO YOUR BOOKKEEPING (Just do it already!)
-You will want to keep a set of financial books for your business. Furthermore, you really need to keep books for your personal world as well. This is a major key to success in business and in life.
-I personally use Quicken Home & Business, because it’s very comprehensive. It allows me to manage my personal accounts, business accounts, market investments and real estate investments all in one application. It also includes built-in invoicing.
-Alternatively, a lot of people tend to like Personal Capital for tracking their financial life.
Related Content: If you would like learn about more options, I have compared the difference between QuickBooks vs Freshbooks vs Xero vs Quicken Home Business .
10. CREATE A WEBSITE FOR YOUR BUSINESS
-As I mentioned above, you want your business to be as legitimate and professional as possible…and this means having a website.
-It doesn’t have to be extensive, but you at least want it to list your services, show examples of your work and also show that you are working for a variety of clients throughout the year.
-You can create websites pretty easily these days in Squarespace or Wix. If you want a site that is more scaleable and will allow for customization, has more SEO friendliness and will possibly handle significant traffic, then build something on WordPress using a Theme. I use SiteGround* for my WordPress site hosting.
Wow! That Sounds Like a Lot of Work….
NOW, I’m sure after reading all that you’re saying to yourself…
“Well, I always assumed setting up something like that would be a huge pain in the ass, which is why I’ve never done it. and this amazing article here Independent Contractor Taxes & How to Incorporate just outright confirmed my suspicions. Now I KNOW I definitely don’t want to deal with any of that crap.”
OK, #1) you would be correct in saying that. But #2) in this very competitive world of ours, it’s the pure, simple and crushing truth that the human “disdain for paperwork” is the reason for many-a-great-persons not reaching their full potential.
SO, I have devised the perfect solution for all you hard-working-but-detesting-of-paperwork types: you can pay ME to do all of this work for you! Genius!
This stuff is old hat for me and, to be honest, I strangely enjoy these tedious tasks. If you know you’ll never get around to doing it yourself, just bite the bullet and let me get it done for you.
Additionally, beyond just paying me to do it ALL for you, I also provide some less expensive options for you to contemplate as well. You can ready about all these options here if you like….
I now present…
Ok, back to the post on Independent Contractor Taxes & How to Incorporate…
What are the Costs to Set This Up and Maintain it…and is it Worth it?
Now, whether you hire me to do the leg work or not, there are still costs involved in all of this. You will incur one-time fees when setting up some of the above, as well as ongoing monthly and annual fees to run your business correctly.
Because of the costs involved, there is a minimum “income threshold” that makes this more official business set up worth it. So you want to make sure that those costs are less than the potential tax savings, so you end up with a “net positive” benefit from having your entity.
HERE IS THE LIST OF COSTS (WHEN SWITCHING FROM INDEPENDENT CONTRACTOR TAXES TO BUSINESS ENTITY TAXES)
(And you can mostly choose the cheapest of everything, as all the options basically provide the same service, except for the CPA).
Creating the Entity: $150-250 one-time fee, depending on the options you choose.
Registered Agent Fee: $0-195 annually depending on the state.
Establishing Employer Accounts: $0
Business Bank Account: $0-$180 annually depending on what bank you choose. IncFile offers a few cash back options for setting up an account with BofA. So you can make up to $450 back in incentives.
Payroll & Quarterly Payroll Tax Filings: $360-$600 annually depending on which payroll company you use, or $0 if you do it yourself.
Credit Card for You Business: You can actually make $500 with the Chase card and it has no annual fee.
Self-Employed (Solo) 401K: The account with Fidelity is free to set up, and does not require any annual filings until it has over 250K. After that you can file this or have your CPA do it for a fee.
Bookkeeping Software: If you go with my reco of Quicken, you’ll be paying about $100 annually. There is no need to use Quickbooks for a single owner entity.
Tax Returns: The cost of doing the tax return for your business will be $150-1500 annually depending on how you do it.
Minimum State Taxes: $0-800 depending on the state.
Minimum City Taxes: $0-100 depending on the city.
Other Annual Filings: These filings include statements of information and the like. $0-100 annually.
Creating a website: If you are not going to be selling products, blogging or trying to drive significant traffic to your site, go with a simple Squarespace or Wix site. Hosting would be up to $50-100/year roughly.
I hope I’ve made clear to you why it’s so important for independent contractors making over 60k per year to incorporate themselves in order to receive the most favorable tax status and benefits.
While the steps to establish and maintain your entity may seem lengthy, the result is a game changer and well worth the hassle. It’s the best way to attack your independent contractor taxes.