Forms 1099 and W-2 are issued by employers to report income earned by taxpayers. Income from both forms must be reported on Form 1040 of the individual tax return each year. Independent Contractors will receive a 1099 for income earned as self-employed individuals. Employees will receive a W-2 from their employers for earned income. Although both forms report income to the IRS, certain tax benefits exist for self-employed taxpayers who receive Form 1099.
Independent contractors can deduct business-related expenses to offset a portion of their 1099 income. Costs of running the business are reported on Schedule C, Profit or Loss from Business. Expenses such as auto mileage, office expense, supplies, advertising, professional fees, utilities, travel and entertainment are just a few of the many items that can be deducted from gross income. Documentation in the form of receipts must be maintained in order to validate the expenses. (Reference 1)
Home Office Deduction
A home office deduction may be taken if certain conditions are met. If eligible, a portion of mortgage and rent payments, taxes, insurance, utilities, repairs and maintenance can be deducted on Form 8829. This amount is then deducted from income on the Schedule C. A net profit or loss is then transferred to line 12 on Form 1040. (Reference 2)
Independent contractors do not have withholding tax deducted from their pay. Quarterly tax payments must generally be made if the expected tax liability is $1,000 or more. Tax liability is based on net income from Schedule C, rather than gross wages from the W-2. Employers are required to withhold social security and Medicare taxes totaling 7.65% of the employee’s wage or salary. The employer matches every dollar of these taxes, also totaling 7.65%. (Reference 3, page 19) An independent contractor must pay the entire 15.3%, however, this self-employment (SE) tax is based on net income, after any business-related expenses are deducted. The net effect can result in tax savings. One half of the SE tax can also be deducted on line 27 of the 1040, which is then deducted to arrive at adjusted gross income. (Reference 4)
Independent contractors may be able to use any loss on Schedule C to offset other income and reduce tax liability, with certain restrictions. A loss on Schedule C is reported on line 12 of Form 1040 and is subtracted from other income. Certain small business retirement plans allow for greater deferment of current income than the traditional IRAs available to employees. Independent contractors can use retirement savings to further reduce their current year income, resulting in reduced tax liability. (Reference 5, page 16)