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Independent Contractor Taxes Depend on Business Type

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Independent contractor taxes depend on whether the business is a sole proprietorship, limited liability company, S corporation or C corporation.

The government has the same basic rate tiers for all businesses. But the actual tax rate as a percentage of profits — also known as the effective tax rate — depends in part on the business type.

Each type has different rules for deductions and exemptions that will increase or decrease the taxes for the business owner.

Financial success in small business is more than growing revenue and profit. It’s also about growing net worth and tax-deferred or tax-free assets that will produce more income at a later date.

Even an independent contractor with limited income will see a big difference in lower taxes and higher net worth by making a wise choice among the major tax structures available. The four options are:

  1. Schedule C sole proprietorship
  2. Limited liability company (LLC)
  3. S corporation
  4. C corporation

I have successfully used the first three options and deeply explored the fourth one as a way of reducing my taxes, increasing my net worth and building legal protection for my family’s assets.

Sole Proprietorship: Simple Beginnings


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The simplest tax structure for a small business is a sole proprietorship. I started my one-person business more than 10 years ago with this option.

The owner usually files a Schedule C tax form with the annual form 1040 that every individual must file. It is a “pass-through entity”, which means all income passes through the business into the owner’s individual tax return.

Because of its simplicity, a sole proprietorship is a good starting point for an independent contractor who has limited experience in business. Just as importantly, it’s a good starting point for someone with limited experience in tax laws and filings.

Unlike other tax structures, Schedule C is the only tax form the IRS requires each year for this type of solo business. It also has the fewest fields of information to fill out.

Employment Tax is Key

On Schedule C, there is no difference between wages and profit for an independent contractor. They are one and the same. This is an important piece of information for what comes next — employment tax.

The employment tax, which is a 2.2 percent Medicare tax and 5.45 Social Security tax, has a major impact on company profits. Employees at a company normally pay this total tax of 7.65 percent while the company pays another 7.65 percent. But a solo business owner must pay both for a total tax rate of 15.3 percent.

This is a critical expense for a solo or small business owner who must pay both the business half and the employee half. The 15.3 percent tax rate on all wages and profit for a sole proprietorship is a painful bite into the owner’s income and contribution to his or her net worth.

Tax laws allow the owner to deduct half of that total bite as a business expense.

The pain mostly stops there. On schedule C, the solo business owner can deduct 100 percent of health insurance and up to 100 percent of retirement contributions.

Contractors who want to reduce the hefty employment tax rate have other options. It starts with filing the tax return as a limited liability company or LLC.

Limited Liability Company: Vital Legal Protection

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An LLC or limited liability company is a simple legal structure whose main purpose is the separation of the company from the individual.

For many states, an LLC requires filing a form with the state corporation commission along with an initial fee such as $100 and some related documents. I found the process easy to do and well worth the money for the legal protection it gives.

By separating the company from the individual, the individual receives protection from legal action against the company. For example, someone can sue the company, win $100,000 in court and get the money (if that much is available) from the company. But the owner as an individual is not liable. In other words, the company could file for bankruptcy if it doesn’t have enough cash, but not the owner.

By itself, an LLC tax structure mainly protects the individual’s net worth, but it doesn’t reduce the 15.3 percent employment tax or give any other tax benefits. It does pave the way for reducing them because of the next step. It’s an important tactic in cutting the effective tax rate for an independent contractor.

Even the smallest independent contractor businesses should use the LLC as a protection against any legal actions.

S Corporations: Tax Savings Take a Big Leap

The small business or solo business owner who sets up a limited liability company can file annual tax returns with the IRS as an LLC using an S Corporation structure (IRS form 2553).

Like the sole proprietorship, an S corporation is a pass-through entity. It means the individual and not the company is responsible for paying the taxes.

Here is the critical part: An S corporation can use “income splitting” which separates wages from profits.

The owner of an S corporation now has to pay a 15.3 percent employment tax only on wages and not on profit. The savings are substantial.

For example, a Schedule C company has $50,000 in what the IRS calls “net income”, which includes both wages and profit. The total employment tax is $7,650 ($50,000 x 15.3%).

An S corporation might file $40,000 in wages and $10,000 in profit. The profit doesn’t have any employment tax, so the owner saves $1,530 ($10,000 x 15.3%). Total taxes decline by 20 percent.

That extra $1,530 becomes a bonus that goes toward savings, net worth and financial security.

Watch Out for ‘Reasonable Compensation’

Business owners who might be tempted to claim $1 in wages and $49,999 in profit to avoid nearly all of the employment tax can’t go there. The IRS says the wage must be reasonable and consistent with what the market will pay for similar work.

“Wages paid to you as an officer of a corporation should generally be commensurate with your duties,” the IRS says on its website.

The ability to reduce the employment tax is a major advantage of an S corporation. The owner can still deduct up to 100 percent of wages for a solo 401k retirement plan. But more than 2 percent owners can’t deduct health insurance. So whether to use Schedule C or an S corporation depends on the individual’s situation, such as existing health insurance from another member of the family.

An S corporation for a solo business owner starts to make sense when the work becomes full time and income runs into the tens of thousands of dollars. It does not make sense for a small, part-time business producing a few thousands of dollars a year.

S Corporation Filing Requirements

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The S corporation tax structure has one big downside: more filing requirements.

The business owner must file quarterly wage statements for the sake of making quarterly income and employment tax payments to the IRS. The forms are fairly simple, but they need close attention to the numbers and tax rates.

Unlike Schedule C sole proprietorships, S corporations also must file annual W-2 statements with the Social Security Administration. This filing is more complex. Although they are doable online at the SSA website, anyone new to the process should consider using specialized W2 tax software.

Even more complex is the annual IRS profit and loss filing for the company. Newcomers absolutely should use tax software and not try to fill out the forms manually. Larger businesses should hire an accountant for the process.

For smaller businesses, an accountant who does the filing may cost enough money to wipe out a large part of the tax advantages of going with an S corporation. It also will make the effort of filing the other forms less attractive.

Even with the software, I made quite a few mistakes in the first few years that I filed the various forms as an S corporation.

For smaller businesses, an accountant who does the filing may cost enough money to wipe out a large part of the tax advantages of going with an S corporation.

C Corporations: Sophisticated Tax Savings

A C corporation usually belongs to larger companies. But it has advantages for independent contractors and other solo entrepreneurs.

Unlike a sole proprietorship or S corporation, a C corporation is not a pass-through entity. The corporation pays taxes on profits. The solo owner of the C corporation then pays taxes again on profits that he or she receives. There are no extra taxes to pay if the profits stay with the corporation.

So what’s the advantage of a C corporation in cutting the effective tax rate?

Solo business owners of a C corporation can deduct 100 percent of health insurance. They also can have other tax-deductible benefits. They include life insurance and health reimbursement arrangement (HRA) that pays for premiums and out-of-pocket medical expenses.

Other benefits include deductible life insurance, disability insurance and loans from company funds.

A C corporation may make the most sense for someone who wants to maximize deductible benefits and not profits.

Profits are taxed at the company level and then again at the individual level. With a minimum tax rate of 15 percent, that means profit gets double taxed at 30 percent.

But it’s a small concern for owners who maximize wages and benefits while minimizing profits.

Again, these various rules need a business owner to choose the option that works best for his or her situation.

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