Your Guide to Taxes for Contractors, Freelancers, and Digital Nomads
Few things unite us together as Americans more than a shared distaste for preparing our tax returns. Income tax can be complicated for a lot of people, but for freelancers, independent contractors, and other self-employed individuals, the tax code can be especially convoluted. Taxes for contractors can feel overwhelming, but it’s absolutely worth it for the lifestyle made possible by self-employment.
It’s always best to confer with a tax professional. This article is meant to be an introduction to the issues involved in taxes for independent contractors.
Independent contractor vs. self-employed vs. freelancer
First, let’s be clear about who we’re talking about here. What’s the difference between an independent contractor, a self-employed person, and a freelancer? The short answer is that a freelancer is a type of independent contractor, who is a type of self-employed individual.
If you have an agreement to perform a particular type of work for a company, you are a contractor for that company but are still considered self-employed because they do not control your time, and you are generally free to work for other clients.
The definition of a freelancer is a little more subjective. It’s generally someone who is brought in from outside a company to perform a task not usually done within that company, like if a salon has someone create a website for them. Freelancers, then, fit the definition of independent contractors.
If you sell goods online (like a Shopify seller, for example), you are similarly self-employed but not in contract to another company. You’re not doing anything for someone else’s business—you’re running your own small business.
For tax purposes, these categories are mostly treated the same. You may need to provide some different paperwork (we’ll touch on this in a moment), but your tax rate will be roughly the same.
The least fun type of surprise
For those who are new to being outside the tax system of traditional employment, there may be some surprises that will pop up. One of the hardest ideas for new independent contractors to wrap their heads around is the concept of filing quarterly estimated taxes. If you’re coming out of a corporate job, it’s a completely foreign concept.
The idea is that the IRS wants to make sure that you don’t come to the end of the tax year with a surprising and completely unmanageable tax bill, so they want you to pay estimated taxes each quarter. Then, at the end of the tax year, you pay the IRS the difference between the estimated tax you’ve been paying through the year and what your actual tax payment will be.
If this isn’t your first rodeo, you can look back at last year to figure out your estimated tax burden and spread it out over the four quarters. If you’re a newbie, independent contractor taxes can be extremely difficult to estimate. The key is to stay up-to-date, keep an eye on your earnings constantly, and reassess as often as you can.
The self-employment tax surprise
The next big unpleasant surprise for new freelancers is the self-employment tax. No, that’s not just another word for income tax. That’s an extra special self-employment tax just for people like you (lucky!).
In a traditional job, your employer withholds your Social Security tax and Medicare tax payments from your check and pays the portion that they’re responsible for as well. Since you’re self-employed, the IRS considers you both employer and employee and makes you pay both portions. After all, if you’re going to be drawing from Medicare and/or Social Security someday, you should be paying into Social Security and Medicare tax now. That comes out to a 15.3% self-employment tax off the top before we even get to regular income tax.
The silver lining: You can deduct the amount of your self-employment tax from your income when calculating the rest of your bill.
The rest of your tax payment will depend on your self-employment income and your state (or states—more on that below). Of course, we haven’t even touched upon local taxes and sales tax, but let’s not depress ourselves too much right now, shall we?
So, how does a person plan for all of this tax uncertainty? A good rule of thumb is to set aside about 30% of your income in a separate account to stay prepared. If you are a high earner or live in a place with an infamously high tax rate, you may want to set aside even more.
As an independent contractor, the first step in preparing your tax return is assembling all of the 1099-NEC (formerly Form 1099-MISC) forms you should be receiving from any company that paid you more than $600 in a year. For a lot of independent contractors, this could be quite a pile of tax forms.
Don’t think you’re off the hook if you received less than $600 from clients, though. You’re still responsible for reporting that income. It’s just that the client isn’t expected to give you a Form 1099-NEC to show it.
Next, if you receive payments through digital payment services like PayPal or Venmo, you’ll need to get a 1099-K form from each of them that paid you more than $600. The amount used to be $20,000, but the IRS apparently decided that made life too simple, and they couldn’t stand for that.
If your self-employment consists of selling things on platforms like Etsy and eBay, you would similarly be looking for a 1099-K form from them. All of this will be included on your Form 1040, along with the Schedule SE tax form.
Tax deductions for independent contractors
As a self-employed person, many of your daily expenses are directly a result of your small business. This can work strongly in your favor come tax time by giving you a wide variety of potential deductions.
However, you should beware. Sometimes small business owners and independent contractors go a little crazy with what they claim as tax deductions. The fact is that if you would have purchased something even if you didn’t have a business, it’s probably not tax-deductible. That means that things like your cell phone might not qualify since you would have one anyway.
The tax deductions that are permissible are expenses that are typical of conducting business in your field. So, if you’re a graphic designer, you could deduct that expensive software you have to use, as well as your expensive computer—as long as it’s separate from your casual web-browsy desktop or laptop.
You can also deduct the classic business expenses like work travel and client meals if those are applicable for you and your business type.
Your home office is another potentially useful but perilous deduction. If your home office qualifies, it could be used to write off part of your living costs and even utilities. However, to qualify for a home office deduction, the space within your house must be meant solely for a home office. You can’t just use your dinner table and clear it off every night and claim that as a home office. This is one that seems especially out of touch with the way people live and work today—hopefully our friends at the Internal Revenue Service will catch up!
Freelancers on the move
Independent contractors and other self-employed people are more likely than most to live in multiple places over the course of a year. Though often a fun and fulfilling way to live, this lifestyle can further complicate your taxes. But don’t worry, it’s all doable.
For example, say you’re a Landing member who lives in Arizona for four months and Georgia for eight months out of a particular year, but your driver’s license is from when you lived in California, and you have a permanent mailing address there that gets forwarded to you wherever you are. It’s likely that for tax purposes your residence will still be California.
It’s tempting to just file wherever you are currently located or just where your legal residence is, but that’s not technically the right way to do it and could potentially lead to problems down the road.
According to Jonathan Medows, a CPA who specializes in taxes for freelancers, the IRS is wising up to the ways in which people’s work and living situations are changing due to COVID-19. As digital nomadism becomes more common, the IRS will be looking more closely at those who are trying to cut corners.
To avoid problems, it’s best to file in each state you’ve lived in and the state that is your legal residence. That doesn’t necessarily mean you’ll be paying additional taxes for each state. It means that each state will get its share of what you have to pay. In most situations, that means you’ll be paying the states you were physically in and getting tax credits for those payments toward the state that is your legal residence.
So in the example above, you’d pay taxes in Arizona and Georgia for the portions of the year you were there. When you file in California, you’ll be given tax credits for what you paid in those states and only pay the difference between the amount you paid in those states and the amount California wants to charge you, if there is a difference.
Wrapping it up
There’s no question that taxes for independent contractors and other self-employed individuals can be especially complicated. The freedom is worth a little math, though for the most part, it’s likely that a tax accountant is a worthwhile investment.
If you’re an independent contractor, a freelancer, or are otherwise self-employed and love the idea of freedom of movement, you may want to check out Landing, a community of people who are making location independence a way of life. Landing offers fully furnished apartments in over 375 cities throughout the U.S., all with flexible lease terms that make it easy to move from place to place on your terms. Learn more about becoming a Landing member today!