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….
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.
(FYI, I’ve made this planner downloadable if you want to play around with it. It actually works as a simple 1099 vs w2 calculator. Here is the link)
(Some additional notes on this. Tax planning is always a “good estimate,” and so is this calculation below. I also only accounted for federal taxes here, as state tax varies so widely. But the increase in state tax would be on a percentage in line with the differences below.)
As you can see above, the person getting paid through their entity is paying way 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 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. 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.
Having an entity will allow you to save on taxes 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 1099.
- 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.
Deciding On Your Business Entity
For the most favorable tax status and benefits, this is what you’ll want to do in my opinion (which is also an extension of my CPA’s opinion and recommendations).
An “INC” (aka corporation) with an “S-corp” designation, gives you the most favorable overall benefits and also makes it a little easier for you to maintain the independent contractor status in the more stringent states.
Now, the other potential option would be to set up an “LLC” (aka Limited Liability Company) with an “S-corp” designation. But for a stand alone owner, or perhaps a dual ownership with your spouse, I would go with the INC. Mainly because some versions of the LLC require employers to file a 1099 with the IRS. Even though the S-corp version does not require this, 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 11 Steps to Establish and Maintain Your New Entity
1. CREATE THE ENTITY
-You are going to create an INC entity (aka corporation), with an S-Corp classification. 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 “State Entity Number” (the name of this varies by state).
-Then from there you will register your entity with the IRS, at which point you will elect to be an S-Corp (IRS form 2553).
2. ESTABLISH EMPLOYER ACCOUNTS WITH THE FED (IRS) AND YOUR STATE AGENCY (EMPLOYMENT DEPARTMENT)
-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 FEIN) with the IRS. This will be done with IRS form SS4, and can be done easily on the IRS website.
-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.
3. GET YOUR BUSINESS LICENSE (WHICH YOU DO BY REGISTERING IN YOUR CITY USUALLY)
-Legally you have to do this, but it also makes your business as legitimate as possible, which you want. Where you will find “leniency” in terms of being accepted as a independent contractor is by being a “business-to-business” provider. So having a business license helps your case. You usually get this at the city level.
-You also may have to pay a 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 its $0 under 100K in gross revenue than goes up from there.
4. SET UP A BANK ACCOUNT FOR YOUR NEW BUSINESS
-Once you have your Article of Incorporation and Federal Tax ID, you will be able to set up a bank account for your business. I 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.
5. PAY YOURSELF W2 PAYROLL (from your new business to yourself) 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. You can do this payroll once, at the end of the year. 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, you’ll be paying for your payroll service all year so they will file these returns on your behalf.
–Quarterly Tax Dates are Apr30/Q1, July31/Q2, Oct31/Q3, Jan31/Q4.
6. ESTABLISH CREDIT FOR YOUR BUSINESS
-You should 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, perhaps when you open that 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 game changer.
-Additionally, once your business has been established for 1-2 years, you would be able to access more types of business credit, such as revolving credit lines and equipment leases. These could be extremely helpful if you decide to expand your business beyond just your personal consulting.
-Now, it’s not true that ALL business credit cards don’t report to your personal credit report. Here is a list of credit cards that don’t report to your personal credit, and also have good offers in my opinion. You’ll see my top reco is the Chase Ink Business Unlimited Card.
7. OPEN A SELF-EMPLOYED 401K FOR YOUR BUSINESS (And yourself by extension). OPTIONAL.
-You should open a Self-employed (aka Solo) 401K account. This is a huge 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.
-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.
-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.
8. 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.
9. FILE ANNUAL TAX RETURNS FOR YOUR BUSINESS AND YOURSELF
-You will need to file a tax return for your business and yourself at the end of the year.
-There is no federal minimum tax due for S-corps, but each state varies on what their “minimum state” tax would be. In CA, for example, its $800. In RI it’s $400. In TX it’s $0 (if your income is under a certain amount).
-You can do this with an accountant, or even a service like H&R block or Turbotax depending on your situation. Here is a comparison of how these options could cost you more or less money.
-If you go the CPA route, they are often willing to do some of your annual corporate filings (see below) and file for a city tax as well…for a fee.
10. COMPLETE ADDITIONAL ANNUAL FILINGS FOR YOUR BUSINESS
-In addition to tax returns that you will have to file, your entity and the state it’s in often have a few annual filings that need to be done.
-Usually, this is a “Statement of Information” to keep the state updated on your company info.
-States 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.
-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.
11. 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 a variety of clients throughout the year.
-You can create websites pretty easily these days in in Squarespace or Wix. If you want a site that is more scaleable and will allow for customization, more SEO friendliness and will possibly handle significant traffic, build something on WordPress using a Theme.
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. This amazing article just outright confirmed my suspicions, and 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.
I now present…
Click above to read about this service I offer. It’s very comprehensive, but does require some participation from you (so it won’t appear like I have stolen your identity to various institutions–ha!).
Ok, back to the post…
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. If you’d like any further information on the incorporation service I offer, feel free to email me at firstname.lastname@example.org or check out more details here.