Your employment status determines which year-end tax form your employer uses to report your annual income. Employers use Form W-2 to report earnings and tax withheld from an employee's paycheck. Clients use Form 1099 to report income of independent contractors. Although being an employee is generally more favorable, the Internal Revenue Service offers several tax-saving benefits to independent contractors.
1099 and Independent Contractors
A 1099-MISC is a form used by clients to report miscellaneous income paid to independent contractors. The form generally reports miscellaneous income, such as rents, royalties, medical payments and other non-employee compensation. According to the IRS, an independent contractor is defined as someone who has “the right to control or direct only the result of the work and not what will be done and how it will be done.” The IRS requires that clients complete a 1099-MISC for each contractor paid at least $600 during the tax year.
Operating a business is expensive, and the IRS offers several deductions to small-business owners. When you operate a business, you must claim the income on your income tax return. Generally, income for independent contractors is reported on Form 1099-MISC, but some self-employed taxpayers also receive cash payments. Independent contractors must report all income on Form 1040 and Schedule C, which is a supporting form that allows you to make adjustments to your business income. On Schedule C, you can claim business expenses, which can include office supplies, mileage and depreciation. Generally, the IRS allows you to deduct any expense required to operate your business. These expenses can reduce the net profit from your business and reduce the tax that you owe the IRS.
Home Office Deduction
If you operate an office in your home, the IRS allows you to deduct a portion of your home expenses on your tax return. To operate a home office, you must incur certain expenses, such as rent, real estate tax, insurance, utilities, telephone and Internet. Although you can't deduct all of your home expenses, you can deduct a portion, which is equivalent to the size of your home office. To determine which portion of your home expenses is deductible on your income taxes, you must determine your home's total square footage and the square footage of your office. If your home is 1,000 square feet and your home office is 100 square feet, 10 percent of your home expenses are deductible on your income tax return. To claim this deduction, you must complete Form 8829 and report the expenses on Schedule C. For more information on claiming the home office deduction, refer to the IRS publication “Business Use of Your Home.”
Employees who receive a W-2 have the benefit of paying only a portion of Social Security and Medicare taxes on their income. Employees usually pay 6.2 percent of their income to Social Security and 1.45 percent to Medicare, and employers must match an employee's contribution. The 2010 Tax Relief Act, however, reduced the employee portion of the Social Security tax by 2 percent for the 2011 and 2012 tax years.
Because independent contractors are not employees, a self-employed taxpayer must pay 13.3 percent in self-employment tax; this also reflects a 2 percent reduction authorized by the Tax Relief Act. Employees must pay taxes on gross income, but independent contractors pay tax only on adjusted gross income, which is net income minus business and office deductions. The IRS also allows independent contractors to deduct one-half of the self-employment tax. For more information or to calculate your self-employment tax, refer to Schedule SE.