Those who hire independent contractors reduce a company’s overhead because they pay their own payroll taxes and their own benefits. These contractors are often a part of the trusted support network that grows companies. And yet, many independent contractors are heavily in debt with the IRS.
Surprised? These are the same people who have a good lifestyle but find themselves owing tens-of thousands of dollars in federal (and possibly state) taxes. To add even more stress to their situation, every contractor knows at any moment, unlike an employee with more job security, the checks can stop coming and they can be out of work overnight.
A few business lessons in corporate structure from those who employ 1099 contractors will go a long way in keeping those trusted associates part of the organization.
The Vicious Cycle Begins
In many industries, 1099 contractors are paid a lot of money and for the most part, that income goes unnoticed at the IRS until a 1099 is issued.
Come tax time, the visit to the CPA can sound like this: “You’ve done really well for yourself. I see you were paid under your Social Security number, so you’re going to be paying more taxes when you file your 1040 this year.”
For the 1099 contractor, the inevitable question follows: “How much do I owe this year?” Now, reality sets in because many have made and spent $150,000 over the year and there’s a $48,000 federal tax bill due. Most have a few thousand in the bank, if that much.
The second reality? That’s just the beginning because most 1099 contractors are still working for the same money in the new year and should be paying quarterly estimated taxes to the IRS. If the estimated tax liability is $12,000 per quarter (calculated from the previous year’s tax return) and is due by April 30 – on top of the $48,000 due on April 15 – a vicious cycle has begun.
Educate Your Contractors
To maintain a strong and healthy independent contractor workforce, companies should help educate their contractors on the tax consequences and benefits of incorporating. Yes, incorporating. Those who hire 1099 contractors know the tax benefits of structuring an entity in the most tax efficient way possible. Most contractors have no idea about keeping track of expenses throughout the year to lower the tax liability, much less have the knowledge that becoming an LLC and electing that LLC to be taxed as an S-Corp would save (on average) between 16-20 percent in federal taxes each year.
Talking with a CPA should begin with a review of entity structure. For those contractors who use a Social Security number instead of creating an Employer Identification Number (EIN# and are taxed as an S-Corp), they will see more of the contractor’s hard-earned income being given to the IRS. The most easy-to-maintain and effective way to save on taxes is with an LLC S-Corp structure.
Two Tax Scenarios
Here are two scenarios to show how much a 1099 contractor can save by changing how their money is taxed. In both examples, the contractor is single, has no dependents and no itemized deductions:
Example 1: Contractor makes $150,000 and uses their SSN for filing their Form 1040. For the 2013 tax year, the Adjusted Gross Income (AGI) would be $140,942. Using the $6,100 standard deduction and the $3,900 exemption deduction, the taxable income is $130,942. Federal tax is $29,957 PLUS another $18,116 for Self-Employment tax, equaling a total federal tax liability of $48,073 for the year.
Example 2: Contractor makes $150,000 and is paid as a Limited Liability Corporation (LLC) taxed as an S-Corp under an Employer Identification Number. The only downside to an S-Corp is the contractor is required to pay themselves a “reasonable salary” and file an additional tax return which costs a little extra – generally about an extra $1,000 per year. Here are the numbers for the S-Corp: A $150,000 income, less an $80,000 “reasonable W-2 salary,” less $6,120 employer FICA taxes paid, less the $1,000 for payroll & tax return processing. That gives the contractor/owner of the LLC a Form K-1 profit of $62,880.
Now back to the contractors Form 1040. There is now a W-2 of $80,000 from the LLC plus the $62,880 K-1 from the profits of the S-Corp. Those two combine for an AGI of $142,880. Subtracting the standard deduction and exemption amounts, there’s a taxable income of $132,880, bringing the total federal tax due to $30,500 for 2013.
The Tail of the Tape
Reporting income directly on a Form 1040 resulted in a tax liability of $48,073. Reporting the same income under an LLC, being taxed as an S-Corp, and paying a “reasonable salary,” even with the additional operating expense of $1,000; only incurred a federal tax due of $30,500 . . . a savings of nearly $18,000.
Fewer taxes paid to the IRS and more hard-earned money in the contractors’ pocket equals a happy contractor with less stress, providing a high level of productivity, knowing their hard work is increasing their net worth.
Point out the tax benefits to 1099 contractors and it’s a win-win for the company and the contractors.
Chase Insogna, CPA, CGMA is Managing Partner of Insogna & Stewart, CPAs based in Austin, specializing in paperless QuickBooks and income tax preparation. www.iscpapc.com