Being an independent contractor isn’t simply a matter of choice or agreement between the worker and the employer. The facts and circumstances of the relationship, and who has control over the work, and other factors dictate the nature of the relationship.
When you are an employee, you get a paycheck that has income taxes withheld from each pay. When you file your tax return, any extra tax paid in can be refunded, or if there wasn’t enough tax withheld during the year, you pay in a balance due with your tax return.
If you start working as an independent contractor, however, things are quite different. The immediate difference is that you will be paid based upon your agreement with the person who hired you, and no taxes of any kind will be withheld from the pay.
A self-employed person is still responsible for paying income taxes. He also must pay social security and Medicare tax. In fact, he now has to pay double the social security and Medicare tax because there is no longer an employer picking up half of the obligation. This tax is known as self-employment tax.
A self-employed person might pay more tax than an employee. One of the most difficult things for a newly self-employed person to get used to is that they need to make quarterly estimated tax payments during the year. This means they have to make their best guess as to how much tax they will owe for the year, and then pay in 25% of it each quarter as a deposit towards that tax. This takes the place of the tax the employer used to withhold from each paycheck all year long. The estimates need to be paid in for federal tax, which includes both income tax and self-employment tax, and any state income taxes.
If you don’t pay in any estimates, then all the taxes for the year will be due with the tax return, and there will be underpayment penalties and interest on top of the tax due. This can create a very large, unexpected bill for taxpayers who were not aware. It is even worse for those who spend all their money during the year and then have nothing left when the big tax bill comes due.
Be sure you understand the rules before you venture out and work for yourself. Being your own boss can be a great thing, so don’t let the tax obligations trip you up.
Related Resources:
Associate Partner
Julie has over 20 years of experience in public and private accounting, representing varied clientele including the medical, legal, and real estate industries and trusts.
View Julie's Bio →
