How Does Contract Work Affect Taxes?

Contract work, often called freelancing, offers flexibility and autonomy but introduces distinct tax obligations compared to traditional employment. As a contractor, tax responsibility shifts entirely to the individual, unlike employees whose taxes are typically withheld from each paycheck. Understanding these unique tax implications helps manage finances effectively and ensures compliance with tax laws. Navigating contract work taxes involves recognizing your tax status, properly reporting income, calculating self-employment tax, making timely payments, and tracking deductible business expenses. This guide provides an overview of these key areas to help contractors fulfill their tax responsibilities.

Understanding Your Tax Status and Income Reporting

The Internal Revenue Service (IRS) distinguishes between an independent contractor and an employee based on the level of control and independence in the working relationship. This distinction is primarily determined by three categories: behavioral control, financial control, and the type of relationship. Behavioral control assesses whether the business controls or has the right to control what a worker does and how they do their job. Financial control looks at whether the business directs the financial and business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies. The type of relationship considers factors like written contracts, whether employee benefits are provided, and the permanency of the relationship.

An independent contractor generally controls their own work hours, methods, and often provides their own tools and facilities, making their services available to the general public. In contrast, an employee typically follows instructions on when, where, and how to work, uses employer-provided equipment, and does not incur a risk of profit or loss from their work. Misclassifying a worker can lead to penalties for the business, though for the worker, understanding their status is primarily about their tax obligations. If you are an independent contractor, you are considered self-employed for tax purposes.

As an independent contractor, your income is typically reported on Form 1099-NEC, Nonemployee Compensation. You generally receive a Form 1099-NEC from any client who pays you $600 or more for services during the calendar year. This form details the total amount paid to you. Even if you do not receive a Form 1099-NEC from a client, you are still required to report all income earned from contract work on your tax return.

Calculating Self-Employment Taxes

Independent contractors are responsible for paying self-employment tax, which covers their contributions to Social Security and Medicare. This is distinct from income tax and represents the employer and employee portions of these taxes that would typically be split and withheld by an employer for a traditional employee. The self-employment tax rate is 15.3% on net earnings from self-employment. This rate comprises 12.4% for Social Security and 2.9% for Medicare.

The Social Security portion of the tax applies only up to an annually adjusted earnings limit, which for 2024 is $168,600, and for 2025 is $176,100. However, the 2.9% Medicare tax component applies to all net earnings from self-employment, with no earnings limit. To calculate your net earnings from self-employment, you subtract your allowable business expenses from your gross income. Generally, only 92.35% of your net earnings from self-employment are subject to self-employment tax.

For example, if you have $50,000 in net earnings, you would multiply $50,000 by 92.35% to get $46,175, which is the amount subject to self-employment tax. Then, you apply the 15.3% rate to this amount, resulting in a self-employment tax of $7,064.78. A benefit for self-employed individuals is the deduction for one-half of their self-employment tax. This deduction is taken on your income tax return, which effectively reduces your adjusted gross income.

Making Estimated Tax Payments

Since taxes are not withheld from payments made to independent contractors, the U.S. tax system requires these individuals to pay estimated taxes throughout the year. This ensures that tax liabilities are met as income is earned, rather than in a single lump sum at year-end. You are generally required to make estimated tax payments if you expect to owe at least $1,000 in tax for the current year after subtracting any withholding and refundable credits. This estimated tax liability includes both your income tax and your self-employment tax.

To estimate your tax liability, you need to project your gross income, subtract any anticipated deductions, and then calculate both your income tax and self-employment tax. The IRS provides Form 1040-ES, Estimated Tax for Individuals, which includes a worksheet to help with this calculation. If your income fluctuates, you can refigure your estimated tax for subsequent quarters to adjust your payments.

Estimated tax payments are due quarterly, though the periods do not align perfectly with calendar quarters. The four payment due dates are:
April 15 for income earned January 1 to March 31
June 15 for income earned April 1 to May 31
September 15 for income earned June 1 to August 31
January 15 of the following year for income earned September 1 to December 31

If a due date falls on a weekend or holiday, the deadline shifts to the next business day.

There are several convenient methods to make estimated tax payments. You can pay online using IRS Direct Pay, which allows payments directly from your bank account, or through the Electronic Federal Tax Payment System (EFTPS), which offers options to schedule payments in advance. Payments can also be made by mail using Form 1040-ES payment vouchers with a check or money order, or through the IRS2Go mobile app. Failing to pay enough tax throughout the year through estimated payments or withholding can result in penalties for underpayment. Generally, you can avoid this penalty if you pay at least 90% of the tax for the current year or 100% of the tax shown on your prior year’s return, whichever is smaller.

Identifying Deductible Business Expenses and Keeping Records

An advantage for independent contractors is the ability to deduct legitimate business expenses, which reduces both their income tax and self-employment tax liabilities. To be deductible, an expense must be both “ordinary and necessary” for your trade or business. An ordinary expense is one that is common and accepted in your industry, while a necessary expense is helpful and appropriate for your business, though it does not have to be indispensable.

Common deductible expenses for contractors include home office expenses if a portion of your home is used exclusively and regularly for business. This can cover a percentage of rent or mortgage interest, utilities, and repairs. Other frequent deductions are office supplies, software, and equipment necessary for your work. Vehicle expenses related to business travel, such as mileage, gas, maintenance, and insurance, are also deductible.

Professional development costs, including fees for courses, seminars, and industry publications that enhance your skills, can be deducted. Health insurance premiums paid by self-employed individuals may be deductible if certain criteria are met. Fees for professional services like accounting, legal advice, and business-related bank fees are typically deductible. Startup costs for a new business, up to a certain limit, can also be deducted.

Record-keeping is important for substantiating these deductions and for overall tax compliance. You should keep detailed records of all income and expenses, including receipts, invoices, bank statements, and mileage logs. These records should clearly show the amount, date, and business purpose of each transaction.

The general recommendation is to keep tax returns and supporting documentation for at least three years from the date you filed your original return or the due date, whichever is later. For situations involving substantial understatements of income (more than 25% of gross income), the IRS has six years to assess additional tax, making it prudent to keep records for at least six years. In cases of fraudulent returns or if no return was filed, records should be kept indefinitely.