Independent Contractor Taxes: A Comprehensive Guide

All companies wish to expand globally at some point. The most common way to do this is to hire independent contractors. This increases their business reach, helps them save costs, and increases flexibility. 

Freelancers/independent contractors have several financial advantages over employees. The most obvious is that these workers are experts in their respective fields. 

As an employer, you do not have to spend any extra resources on training or onboarding them, as you would with a full-time employee. 

However, hiring international contractors can still be quite demanding at times similar to business challenges. Wondering why? 

The answer is the difficulties of managing independent contractor and taxes. 

Here are some of the most common questions asked by businesses that follow this path. 

• How does an independent contractor pay taxes? 
• How do I report independent contractor income? 
• When to, as per the IRS, pay estimated taxes for independent contractors? 
• What are the tax rates for independent contractors?

Here, we will provide you with a detailed explanation of contractor taxes. This will include the entire tax filing independent contractor process, how to pay independent contractor taxes, and more. 

So, let’s begin.

Understanding Independent Contractor Status

The IRS (Internal Revenue System) describes an independent contractor as a self-employed individual. If a person performs services for a client and can control or direct only the result of the work and not what and how it will be done, then that person is an independent contractor.

An independent contractor (1099 worker) and a W2 employee are not the same. You need to understand this distinction, especially for tax purposes. 

It will directly affect how your workers pay their federal income tax, social security, and Medicare taxes and how they file their tax returns.

The ‘Right to Control’ test is used by the IRS and various other agencies to classify workers accurately. 

It is also known as the ‘Common Law’ test. It considers the following factors to establish whether an individual is an independent contractor or an employee. 

• Behavioral Control: If the business has the right to control and direct the worker, that person is considered an employee. Examples include instructions or training.
• Financial Control: If a person invests a significant amount of money in their work and is not reimbursed for some or all of the business expenses, or if the person can realize a profit or incur a loss, they are independent contractors.
• Relationship of the parties: If the worker receives benefits, like paid leave, insurance, or pension, that individual may be an independent contractor. 

In addition, a few similar tests are used to avoid worker misclassification. These include the Economic Realities Test and the Hybrid Test.

Benefits of Being an Independent Contractor 

Before we move further into the details of independent contractors and taxes, let’s first clear the basics. 

Did you know that almost 38% of the US workforce (64 million Americans) worked as freelancers in 2023? Why are so many individuals nowadays inclined to freelancing or being independent contractors? Let us explain. 

Being an independent contractor carries many benefits, not just for the individual but also for employers. They include,

• Independent contractors are their own bosses. They can decide how much workload they wish to take on, manage their schedule according to their lifestyle, and feel a sense of control. 
• Independent contractors can work from anywhere. They are no longer confined to the four walls of their office. This means no need for a daily commute, which equates to extra time with family and friends.
• Businesses that hire independent contractors enjoy greater flexibility. Once the project has been completed, your freelancers will move on to the next contract. This means you are no longer on the hook for continued employment.
• Outsourcing work to self-employed individuals is much more cost-effective than full-time employees. You do not have to worry about paying the mandatory benefits, such as insurance, premiums, etc.

Tax Obligations for Independent Contractors 

Here are two of the main tax deductions for independent contractors. 

1) Income Tax

Self-employed individuals or independent contractors must file an annual income tax return and fulfill quarterly estimated tax payments. The first step is calculating the business's net profit or loss by subtracting expenses from income. 

If your independent contractor's business expenses are less than their income, the difference will be their net profit. Similarly, if their business expenses exceed their income, the difference will be their net loss. 

As per the IRS rules, if the net earnings from self-employment are more than $400, the freelancer must file an income tax return. 

Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship), is the main document used by self-employed individuals to file their annual income tax return. 

2) Self-Employment Tax

Self-employment tax is different from income tax. It refers to only Social Security and Medicare taxes for independent contractors. It is filed through the Schedule SE (Form 1040 or 1040 SR), Self-Employment Tax.

The SE tax rate for independent contractor is currently 15.3% (12.4% for Social Security and 2.9% for Medicare). 

If the self-employment income (including that of the contractor’s spouse if filing a joint return) exceeds a certain amount, Medicare may levy an additional 0.9%.

When and How to Pay Taxes

By now, we hope you have cleared all your doubts related to tax reporting for independent contractors. Moving on, here is a detailed overview of when and how does an independent contractor pay taxes. 

Quarterly Tax Payments

Taxes paid by independent contractors are generally done through estimated tax payments. Any self-employed individual expecting to owe tax of $1000 or more when their returns are filed must follow this method. 

Form 1040-ES is the primary document used to figure estimated tax. It is calculated by determining the expected gross income, taxes, deductions, taxable income, and credits for the year. 

Additionally, individuals are allowed to adjust if their estimated income is too high or too low compared to what they have earned during the year. 

For example, if your contractor has estimated their earnings too high, they can simply complete another worksheet of Form 1040-ES to refigure their estimated tax for the next year. 

Estimated tax payments must be paid on these dates,

• Income earned during January 1 to March 31 - April 15th
• Income earned during April 1 to May 31 - June 15
• Income earned during June 1 to August 31 -  September 15th
• September 1 to December 31 - January 15th of the following year.

Please note that if any of these dates fall on a weekend or public holiday, the payments are due the next business day.

Payment Methods 

Contractor tax payments can be made through the following methods.

Tax Deductions and Credits for Independent Contractors 

Unlike employees, independent contractors often bear extra costs since they run their own business. 

But what if we told you there are a few ways your contractors can soften this blow when the tax season comes around? 

Sounds too good to be true, right? Well, here are a few examples of legitimate deductions that can be used when filing taxes for an independent contractor.

1) Home Office Deduction

• It refers to the cost of any workspace contractors use exclusively to run their businesses. This workspace can be a specific part of their home or a rented space.
• Contractors can deduct expenses from the home office, including homeowners insurance, deductible mortgage interest, a business percentage of rent, utilities, and any payments for repairs during the year.
• Schedule C, Line 30, or IRS Form 8829 are generally used to report home office deductions.

2) Health Insurance Premiums Deduction

• Independent contractors who pay for their health insurance premiums can deduct all their health, dental, and qualified long-term care insurance premiums.
• It can be calculated through the Self-Employed Health Insurance Deduction Worksheet, as provided in IRS Publication 535.

3) Internet and Phone Bills Deduction

• Self-employed individuals can deduct only the business portion of their phone and internet expenses. 
• This can include 100% of the additional cost of long-distance business calls or the expense of a second phone line explicitly used for business purposes.

Apart from these, there are quite a few other examples of deductions. They include vehicle use deduction, interest deduction, meals deduction, and travel deduction.

Maximizing Tax Benefits 

Here are a few tips and tricks for helping independent contractors manage their financial affairs and minimize tax liabilities. 

• Keep all relevant tax-related documents safely in one place.
• Assess all the tax liabilities regularly to avoid hiccups during the tax season.
• Invest in robust accounting software or systems. These can streamline record-keeping and enable contractors to stay organized throughout the year.
• Always stay up-to-date with the latest changes in tax laws, regulations, and economic conditions that can directly affect tax liabilities. 
• Consult with experienced tax professionals, such as chartered accountants, to gain valuable insights tailored to individual business needs and circumstances.

Essential Tax Forms for Independent Contractors

The two main types of forms commonly used when independent contractor tax filing are mentioned below.

1) Form W-9

The W-9 is an official form furnished by the IRS to confirm a person’s name, address, and TIN (Tax Identification Number). 

It is a must-have document for every employer who wishes to hire an independent contractor and is often referred to as a Request for Taxpayer Identification Number and Certification. 

Under the IRS's general guidelines, employers must keep this form in their files for at least four years for future reference. 

2) Form 1099-NEC

Form 1099-NEC is an important document businesses and employers use to report payments made to individuals for their services. This mainly includes independent contractors, not employees. 

Previously, all these payments were reported in box 7 of Form 1099-MISC. However, starting from the tax year 2020, Form 1099-NEC is used. 

If you have paid more than $600, or more, to your independent contractor in a given year, you need to furnish the form 1099-NEC. 

A copy of this form needs to be provided by your worker by January 31st of the year following payment. 

Additionally, another copy must be sent to the IRS by January 31st.

In some cases, 1099 NEC estimated tax payments are also required.

Form 1040 and Schedule C

This is one of the primary forms used by self-employed workers to file yearly income tax returns.

International Independent Contractors and US Taxes

The United States has income tax treaties with various countries. Under these conventions, residents (not always citizens) of that particular country get to enjoy taxes at a reduced rate or are exempted from US income tax on certain income within the United States. 

Let’s understand this in more detail. 

Tax Treaties and Exemptions

Withholding Requirements

If hiring foreign independent contractors, you must collect and file Form W-8BEN. This important IRS document verifies that the worker you are hiring is from a different country than the US and helps establish that the individual is performing work outside the US. 

If hiring a foreign independent contractor who operates under a business entity, you must procure Form W-8BEN-E. 

Please note that these forms are valid for three years from being signed. 

Additionally, under IRS guidelines, a foreign person is subject to a 30% US tax on US-source income. If treaties exist between the individual’s country of residence and the US, or if an Internal Revenue Code Section provides a lower rate, then exemption or reduced rates may apply.

Best Practices for Managing Taxes as a Contractor

It can get very confusing with all this paperwork and different requirements for individual contractor tax rates and deductions. To help you in this process, we have shared a few tips to ensure compliance and optimize financial outcomes for your workers, if not more.

Utilizing Expert Services on AOR Platforms

• An AOR (agent of record) like Skuad is a service provider that can help you manage independent contractors' tax payments. 
• Our unified platform features various capabilities. For example, with Skuad, you can always guarantee that your employment contracts adhere fully to all country-specific labor laws and tax regulations. 
• We feature multi-currency payroll, meaning that your independent contractors will be paid accurately and on time. 
• We automate contractor invoicing creation and have a dashboard from which you can quickly approve or reject invoices without manually managing all paperwork.
• Lastly, we help you manage expense reimbursements, benefits administration, and other aspects of hiring independent contractors.

Keeping Organized Records 

• Bookkeeping is extremely important to keep all financial records of independent contractors streamlined. 
• Most independent contractors usually use their bank accounts as professional bank accounts. But this should not be the case. Instead, they should maintain separate checking accounts for work-related money matters and an individual credit card for work experiences.
• Independent contractors must track every financial transaction they make and record proof. This includes filing away every receipt, bill, bank statement, or invoice they receive.
• Independent contractors can use digital tools like accounting software to facilitate their bookkeeping needs further. These applications can enable them to track expenses and payments, automatically send invoices, and compile spreadsheets.

Utilizing Tax Software

• Tax software is a fantastic way to manage taxes paid by independent contractors.
• These digital solutions are built with users in mind. They integrate various features to help decode tax regulations and automate complex calculations.
• Independent contractors usually work with multiple clients at a time, which means they have diverse income streams, each with a different payment structure or billing cycle. The right tax software can help organize all this information, ensuring no income is overlooked. 
• Furthermore, tax software usually integrates the latest tax codes and regulations. This means independent contractors can always stay current with all relevant changes and guarantee compliance.

Common Challenges and Solutions 

Here, we have discussed a few common challenges of contractor tax filing and how you can solve them effectively. 

1) Managing Cash Flow for Tax Payments

The US uses a progressive tax system. This means that the more income you make, the more you pay. It may not seem like much, but once the tax season comes around, and you do not have the necessary amount to fulfill the tax obligations, it can lead to penalties. 

For example, if something unexpected comes up, such as a major repair or a purchase, you can easily fall short on tax money. 

The best way to deal with this is through proper cash flow management. It is always advisable to keep some amount of emergency money aside. It should not be less than three to six months of expenses. In this way, in the face of any shortage, you will have a safety cushion to fall back on.

Additionally, try to keep track of your expenses. These include utility bills, rent or mortgage payments, insurance, etc.

2) Avoiding Tax Penalties

You will be penalized if you do not pay your taxes on time. The IRS sets the penalty at 0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid. 

To avoid such additional expenses, why not be prepared immediately? You can use the IRS 1040-ES worksheet to accurately estimate your quarterly tax payments. 

Additionally, if possible, try to consult an experienced tax advisor. They can guide you through identifying deductible expenses and familiarize you with the contractor filing taxes process.

How Skuad Helps

Summing it all up, working with independent contractors can bring you terrific benefits. These include greater flexibility, lower costs, and higher efficiency. 

But it also means dealing with all the independent contractor taxes obligations we have discussed. Not all businesses can handle this accurately and compliantly by themselves. 

The end result? Huge legal penalties and fines.

This is exactly where Skuad comes into play. Our comprehensive global employment platform allows you to hire and pay individuals from anywhere without setting up a local entity. 

With Skuad’s AOR solution, you can streamline the entire contractor onboarding process. These include maintaining accurate deductions, submitting the essential forms on time, disbursing payments in the right currency, and more. 

The best part? With Skuad as your trusted partner, you also lower the risk of worker misclassification. Our in-house team of legal experts is proficient in country-specific labor laws to help you correctly classify your contractors and employees. 

‍Book a demo with us today and hire anywhere in the world compliantly, only with Skuad.

FAQs

1: What taxes do independent contractors pay?

Under the IRS guidelines, independent contractors must pay income tax and self-employment (SE) taxes. 

2: How much money should I set aside for taxes as an independent contractor?

If you’re thinking how much is independent contractor tax, Independent contractors should set aside 30% - 35% of their income for tax purposes.

3: What is 30% tax for self-employed?

Foreign persons are subject to a 30% US tax on their US source income. 

4: Do you pay more taxes on 1099 or W-2?

1099 workers or self-employed professionals usually pay more taxes than W-2 employees as the taxes on independent contractor income are on the higher side. This is because they are required to pay SE taxes, which cover both the employees' and employers' portions of Social Security and Medicare taxes. W-2 employees, on the other hand, pay only the employees’ portion, while their employers cover the remaining portion.