If you’ve recently decided to be your own boss as a sole-proprietor, you might be wondering about your tax situation and how it’s going to change. This is particularly important if you’ve always held a job where your taxes were removed from your income prior to your receiving your check or direct deposit.
W-2 Employee Versus 1099-MISC Employee or No Tax Reporting
It’s important to understand that this article will cover the basics of W-2, 1099-MISC and No Tax Reporting as far as income sources. There are other ways that your income can be reported to the IRS. This article is not meant to be professional tax advice. If you have tax questions, it is best to call your accountant, CPA or the IRS or other licensed tax professional.
As a regular employee for someone else, your employer was responsible for paying a portion of your taxes, and you were responsible for paying a portion of your taxes. This is the most common way to get paid. Although, with the invention of the GIG economy, it’s becoming less common as more people choose to perform gigs or per job work for various companies, including content mills, Uber, Lyft, Doordash and Shipt, than work a traditional job with a regular full-time or part-time schedule.
W-2 and I-9s
Traditional employees fill out I-9s and W-4s as part of their introductory paperwork. The W-4 is the Employee’s Withholding Certificate. This tells your employer the amount of taxes that should be withheld from your paycheck. New employees are also given an I-9, which is an Employment Eligibility Verification form as well as other forms for state withholding, employee address and direct deposit, etc. As a result of these forms (They are legally required.) a certain amount of taxes will be automatically withheld from your paycheck. This includes Federal income tax, state income tax, social security and Medicare. Some employers also automatically withhold insurance premiums and retirement money as well as other fees. I once worked a job where they charged a car fee because every employee had a company car. The end result is that you don’t receive your entire salary for the weeks in which you are paid. Instead, you receive your salary minus all of these deductions.
My last traditional job paid $42,000 a year. If we divide that by 52, each weekly paycheck should say: $807.69. However, that doesn’t take into consideration all the taxes. After all the taxes and fees were removed from my check, it amounted to about 23 percent of my income. This meant that I could expect a deposit amount of $621.92, not $807.69.
Since most employees only look at the deposit amount, they never miss the subtracted income, which in my case, amounted to $186 every week. In addition to the taxes that the employee pays directly from their paychecks, the employer also pays taxes on the employee in the form of payroll taxes. Payroll taxes include Social Security tax, Medicare Tax, Federal Unimployment Tax and State Unemployment Tax. This amounts to an additional 19.2 percent. For an employee that makes $40,000 a year, the employer is paying $7,680 on top of the employee’s annual salary. This means that for the employer, that employee costs $47,680.
The W-2 is the document that a traditional employee receives in January that states the amount of money they earned during the previous year and the amount of federal, state and social security taxes withheld from that employee’s paycheck. If everything worked correctly, the amount withheld is greater than the amount owed after all tax credits and deductions are applied. This means the W-2 employee typically gets a refund from their state and the federal government.
A 1099-MISC is used to report miscellaneous income for non-employees. Typically, this form is used by businesses who hire individuals on a contract basis. For a freelance writer, the contract may begin when they pick up an article to write and end the moment the client accepts the work. For someone who delivers food or groceries via Shipt or Doordash, the contract may begin as soon as the contract employee accepts the delivery order and ends when the customer accepts the order. Once the individual has completed the requested service, they are paid a certain amount of money. It’s important to understand that most 1099 contractors do not have any taxes withheld from their “checks”. Instead, they get 100 percent of the amount they are owed. The employer is also not required to pay payroll taxes on the 1099 contracted employees.
When Are 1099-MISCs Required to be Filed
The company or business must file a 1099-MISC with the IRS if the contracted employee is paid:
- $10+ in royalties or broker payments that are not paid via dividends or tax-exempt interest.
- $600+ for rent, services, prizes, awards, health care payments (Aflac?), fishing or boat proceeds, crop insurance proceeds and other types of payments. A complete list can be found on the IRS website.
Since there are very rarely any taxes withheld from a 1099-MISC, the contractor is responsible for paying the entirety of his or her tax bill. This includes social security and applicable business taxes. To mitigate the bill that may be owed at the end of the year, many 1099-MISC contractors opt to pay quarterly estimated taxes directly to the IRS. These are estimated tax payments based on the individual’s actual income that they received for the previous three months or an estimate of their taxes owed.
If the contracted employee expects to receive $20,000 in contracted labor from a business and they assume their tax liability is 15 percent, their estimated end-of-year tax bill would be $3,000. In order to not owe $3,000 to the IRS, this individual would divide $3,000 by 4 and pay $750 to the IRS every quarter.
Some states also allow independent contractors to pay estimated taxes. I recommend looking up your particular state in order to determine how they accept estimated tax payments.
No Tax Reporting
In some instances, the sole-proprietor may not receive any documents at the end of the year. This typically happens when the individual receives cash payments for services or payments via their website. In this scenario, no external business is going to process a W-2 or a 1099-MISC. Instead, the individual is solely responsible for reporting all of their income at the end of the year and paying any applicable taxes to the IRS and their home state. Like the 1099-MISC contractors, individuals who do not receive any tax documents at the end of the year must pay their tax bill in full by the time they file their taxes or at the time they file their taxes. If the individual does not pay estimated quarterly taxes, they could be in for a massive end-of-year tax bill.
Estimated Quarterly Taxes and When They Should Be Paid
The IRS stipulates that sole-proprietors, S corporations and shareholders must pay estimated quarterly taxes if they expect to owe more than $1,000 for the tax year. Failure to pay estimated quarterly taxes can result in additional fines by the IRS.
- April – for the tax period between Jan 1 and March 31st
- June – for the tax period between April 1 and May 31st
- September – for the tax period between June 1 and August 31
- January – for the tax period between Sept 1 and December 31
It’s important to note that the tax deadline for estimated quarterly taxes is the 15th for the month in which they are due. If the 15th of the month falls on a weekend, taxes are due by the Monday after the weekend.
What Happens if You Can’t Pay
For beginning freelancers, it is possible that their income isn’t enough to allow them to pay all their bills and pay taxes. The bad news is that if you owe more than $1,000 at the time you file your taxes, the IRS will add additional fees and interest to the tax bill, which will increase your tax liability. The good news is that the IRS also allows for repayment via an Installment plan or other method, including offer in compromise and temporary delays in collection. It is up to you, your tax professional and the IRS to figure out how best for you to pay your tax liabilities.
Disclaimer: This article is meant to provide general tax information on tax liability as an independent contractor (sole-proprietor, S-corporation etc). While this article has been researched, it is not professional, legal tax advice, and it is not meant to be professional tax advice. I am not a tax professional, accountant or CPA. If you have questions about your specific tax liabilities and what you may or may not owe and specific tax situations that apply to you, please seek the services of a tax accountant, CPA or tax firm and/or call the IRS.