Recent studies indicate that approximately 36% of US workers (57 million individuals) participate in the gig economy as their primary job or as a way to earn additional income. The gig economy refers to people who are engaged in freelance and side-hustle work, such as ride share operators (e.g., Uber or Lyft), delivery services (e.g., Uber Eats or Door Dash), cleaning services, tutoring, babysitting, and pet sitting, versus a traditional job with an employer. As technology and the economy continue to evolve, estimates show that around 50% of US workers will join the gig economy by 2027.
Many individuals begin working in the gig economy without a complete understanding of the related tax issues. This article will attempt to explain the various issues frequently encountered by gig workers related to independent contractor taxes.
Table of contents
- Are independent contractor taxes applicable?
- Forms related to independent contractor taxes
- Deductions often used
- Self-employment taxes
- Underpayment of independent contractor taxes
- Reducing the tax burden of independent contractors
- Independent contractors outside the gig economy
Are independent contractor taxes applicable?
Typically, the first issue is determining whether the individual is an independent contractor or employee. The general rule is that an individual is an independent contractor (i.e., self-employed) if the client or customer receiving the services has the right to control or direct only the results of the work—they do not control the nature of the work and how it will be completed.
An individual is an employee if they perform services that can be controlled by an employer, such as the hours they work or the equipment they use. This applies even if the individual is given freedom of action. What matters is that the employer maintains the legal right to control the details of how the services are performed.
Since jobs in the gig economy generally lack such control, most gig workers are independent contractors. However, it’s important to consider each individual case to ensure they are classified correctly as either an independent contractor or an employee.
Forms related to independent contractor taxes
Independent contractors who work for a business and were paid $600 or more during the tax year should receive a Form 1099-NEC reporting their annual income by January 31st of the subsequent year. If their total income is below $600, the business is not required to furnish a Form 1099-NEC. However, when completing independent contractor taxes, they must include all income received from the business activity on their tax return. There is no underlying requirement that income must be reported on Form 1099-NEC to trigger income tax recognition.
Independent contractors who do not form a separate legal entity (i.e., they are a sole proprietor) or form a single-member Limited Liability Company (LLC) include their business income on Schedule C of Form 1040. A separate Schedule C is required for each type of business activity. For example, if an individual performed delivery services and pet sitting, they would file a separate Schedule C for each activity.
Deductions for independent contractor taxes
In addition to income, independent contractors are allowed to deduct their ordinary, necessary, and reasonable business expenses on Schedule C. Below are some of the most common deductions those working in the gig economy may be eligible for.
Mileage
One of the largest business expenses for individuals working in ridesharing and delivery is mileage. While not required, many of the businesses employing ride share drivers provide an additional report detailing business miles driven to aid in filing independent contractor taxes. Business miles driven include: 1) miles driven to pick up passengers/delivery items, 2) miles driven with passengers/delivery items in the car, 3) miles driven returning from drop-off points to a place to wait for other ride/delivery requests, and 4) any other business-related mileage.
Business miles do not include miles from the independent contractor’s home (unless they have a qualified home office) to the location where they wait for passengers/delivery items. Likewise, the miles related to the commute home are not business miles. While most gig workers use the standard mileage method ($0.67 per business mile for 2024) to deduct automobile expenses, they can also elect to deduct actual expenses of operating the automobile under the actual cost method.
When utilized, actual business-related expenses for the automobile are determined by using the ratio of business miles driven to total miles driven for the year. However, using actual expenses requires maintaining receipts for all expenses, and mileage logs must be maintained for either method. Moreover, all business tolls and business parking may be deducted under either method.
Home office
Independent contractors may also qualify for the home office deduction if a portion of their residence (or a detached structure close to the residence) is used exclusively and regularly as 1) a principal place of business or 2) a place of business used by clients, patients, or customers. The principal place of business requirement is fulfilled if the office is used by the independent contractor to conduct administrative or management activities and there is no other fixed location where the independent contractor can conduct such activities. Exclusive use of the home office is not required for licensed day-care businesses.
When completing independent contractor taxes, you can calculate the home office deduction under either the actual cost method or the simplified method. Under the actual cost method (with some limitations), direct costs that only benefit the home office are deducted in full, and the indirect costs to maintain and operate the home are allocated to the home office using the ratio of the home office square footage to the total home square footage. The home office deduction is calculated under the simplified method by multiplying the square footage of the home office by $5, but it is capped at 300 square feet ($1,500) and generally cannot create a loss from the business.
Self-employment taxes for independent contractors
After deducting business expenses, the net income reported on Schedule C is included in the taxpayer’s gross income on Form 1040. This income is subject to federal income tax as well as the self-employment tax, which covers Social Security and Medicare taxes on independent contractors’ income. When an individual is classified as an employee, the employer pays half the Social Security and Medicare taxes (7.65%) and the taxpayer pays the other 7.65%, up to the annual Social Security wage base. Conversely, independent contractors must pay all Social Security and Medicare taxes (15.30%).
To reduce the self-employment tax burden, independent contractors are afforded two tax benefits. First, Schedule C net income is reduced by 7.65% when calculating the self-employment tax base (no reduction for income tax). Second, independent contractors can deduct half of their self-employment tax liability. Self-employment taxes are collected with income taxes on Form 1040 by filing Schedule SE. Independent contractors must file Form 1040 if their Schedule C income is $400 or more.
Underpaying independent contractor taxes
One problem usually encountered with independent contractors, especially in the first year of operation, is underpayment of taxes. Under the IRC, both income and self-employment taxes are subject to the pay-as-you provisions. Independent contractors must generally make estimated quarterly payments to adhere to the prepayment requirements. Such payments are mandatory when the taxpayer’s estimated tax (total tax liability less tax credits and withholdings) is $1,000 or more and the taxpayer’s withholdings from other sources (including wages) do not equal or exceed the required annual payment.
The required annual payment is the lesser of:
- 90% of the current year’s tax liability
- 100% of the prior year’s tax liability (110% if AGI exceeded $150,000).
For calendar-year taxpayers, one-fourth of the required annual payment must be remitted on April 15, June 15, and September 15 of the current year. The fourth payment is due January of the subsequent year. Failure to make these payments on time will result in penalties and interest.
Reducing the self-employment tax burden
One strategy to reduce the self-employment tax burden is to form an LLC under state law and make an S-corporation election using Form 2553. To qualify as an S-corporation, each individual LLC member must have the same liquidation and distribution rights under the operating agreement.
Once a valid S-corporation election has been made, any member working for the LLC must be paid a reasonable salary. The member-employees will then only pay Social Security and Medicare taxes on their salary—the remaining income of the LLC will escape Social Security and Medicare taxes. The member-employees will only pay half of the Social Security and Medicare taxes with the LLC paying the other half. More importantly, the members will also have limited liability to shield their personal assets from legal liability. However, this strategy has additional compliance costs because the S-corporation must file Form 1120-S annually.
There is one potential pitfall for independent contractors who start their business after marriage in community property states, including Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. These states consider a business started after marriage as owned half by each spouse, irrespective of which spouse starts the business. In this event with no tax elections, an unincorporated business will be treated as a partnership—not a sole proprietorship—because it has two or more owners conducting an activity with a profit motive.
When completing independent contractor taxes where this is the case, a partnership return (Form 1065) is required with each spouse receiving a K-1 to include with their Form 1040. To eliminate the Form 1065 filing requirement, the taxpayers can elect to treat the business activity as a qualified joint venture if:
- The only members of the joint venture are a married couple who file a joint tax return
- Both spouses materially participate in the business activity
- Both spouses elect not to be treated as a partnership
To make the qualified joint venture election on a jointly filed Form 1040, each spouse must prepare a Schedule C that divides all items of income, gain, loss, deduction, and credits between them in accordance with each spouse’s respective interest in the joint venture (usually 50%), and, if required, file separate Schedules SE to calculate self-employment taxes for each spouse. While income taxes should be the same with or without the election, Social Security and Medicare credits must be allocated between each spouse. Moreover, Social Security and Medicare taxes could differ depending on the income of each spouse because of the annual Social Security wage base limitation.
Get a FREE CPE course from Becker
With Becker, you can meet your CPE requirements, gain new skills, and stay aware of the latest updates and news. See why more accountants are choosing Becker with a free CPE course!
Independent contractors outside the gig economy
Please note these issues are not only related to independent contractors in the gig economy. Individuals such as doctors, dentists, veterinarians, lawyers, accountants, subcontractors, contractors, and auctioneers who are in an independent trade, business, or profession where they offer their services to the general public are generally independent contractors. If they do not form a separate business entity or form a single-member LLC, they will be required to file a Schedule C for the business activity. It is also important to note that attorneys will not receive a 1099-NEC. If they are paid annual fees of $600 or more, they will receive a 1099-MISC.
Lastly, businesses have financial incentives to classify workers as independent contractors versus employees. If an individual classified as an independent contractor performs the same type of work as others classified as employees, they are likely misclassified. Individuals can also review the IRS’s 20-factor test to help determine if they are misclassified1. Moreover, if the individual feels they are misclassified and the employer will not correct the issue, they can file Form SS8 and ask the IRS to decide the proper classification. If the individual is waiting on a response to a filed Form SS8 from the IRS, they may file Form 8919 with Form 1040 and only pay half of the self-employment tax.
Take the next step with CPE from Becker
If you want to learn more about independent contractor taxes and other relevant topics, Becker has CPE courses to build your skills and knowledge, including the following:
- S Corporations from A to Z: Getting Ready to Prepare the S Corp Return
- Partnerships and Multiple-Member LLCs: Taxation and Other Considerations
- Choice of Business Entity
With a Prime CPE subscription, you'll have access to the above courses along with over 700 other on-demand CPE courses, weekly CPE podcasts, and 1,000 annual live webcasts. You can earn unlimited CPE credits in the topics that are most relevant to you while easily meeting your state's CPE requirements.
Related Articles
Share
