The Internal Revenue Service defines an independent contractor as someone who offers services independently to the general public. People who pay independent contractors don't have a say in how the work is completed, only in the finished product. Because the independent contractor doesn't pay income taxes automatically when his income is received, he is responsible for paying these taxes on his own. If you're an independent contractor, don't despair -- you can take deductions, too.
Because people who earn wages have Medicare and Social Security taxes automatically deducted from their paychecks, the federal government imposes a self-employment tax on independent contractors to help fund these programs. In 2011, this payroll tax rate, normally 15.3 percent, was temporarily reduced to 13.3 percent; Social Security tax is 10.4 percent and Medicare tax is 2.9 percent. The first $106,800 in earnings are subject to Social Security tax. After this amount, you only have to pay Medicare tax.
How your income taxes are calculated depends on what type of business entity you have. If as an independent contractor you are the owner of a sole proprietorship, an LLC or a partnership, then your taxes pass through to your personal income taxes. This means that the business doesn't pay its own taxes; instead, your earnings are taxed at your personal income tax rate. In 2011, the highest tax bracket is 35 percent. What your bracket is depends upon your filing status and how much you earn. In general, the greater your earnings, the greater the income tax you owe. If your business is a corporation, then both you and the corporation pay taxes. The corporation pays you a wage, which is taxed at your ordinary income tax rate. It also pays its own taxes, which vary depending on income.
Reducing Your Income Taxes
As an independent contractor, you can deduct from your earnings any relevant business expenses. These deductions are subject to limits and rules, but they can add up to significant tax savings if accounted for properly. For example, you can deduct car-related expenses, home office-related expenses, and some travel- and entertainment-related expenses. The IRS loves to flag these returns for audit, so be sure you can back up your deductions with evidence such as receipts, dates and business purpose.
Special Breaks for Sole Proprietors
Many independent contractors are also sole proprietors, and this business type gets two tax breaks that other entities don't. The first relates to hiring children. If you hire your child to perform work for you, you can deduct up to $5,000 from your earnings, a big tax-saver. Because of the standard deduction, your child won't have to pay income taxes on it -- another big savings. In addition, as a sole proprietor you can offer your employees -- including family members -- a health care reimbursement account. This savings adds up quickly, especially if you have private health insurance. The catch? You can't take the HRA deduction yourself. Nevertheless, it's an important tax-saving benefit.