Tax Deduction Guide: Contractors vs. Employees
Tax season can either be a blessing or a curse. Some will see their money go, while others will get a well-deserved windfall back from the government. In the case of independent contractors, who are different than employees, there are several built-in setbacks that come with the territory, including:
- No sick days
- No vacation hours
- No health insurance
- No worker's compensation
- No retirement, pension, and unemployment benefits
- No eligibility for overtime pay
However, there are deductions that contractors can write off, decreasing their taxable income and by extension, how much they will be taxed. The following are deductions independent contractors can write off, employees can write off, and a few that overlap.
Independent contractors are defined by the IRS as self-employed individuals providing services to businesses, who have the right to "control or direct only the result of the work and not what will be done and how will it be done."
Contractors are subject to different tax rules than regular employees in a number of ways. For instance, employees split the cost of payroll taxes for Social Security and Medicare with their employer, each paying 7.65 percent of the employee's eligible wages. However, a contractor is technically considered both the employer and employee, and must pay both halves, 15.3 percent in total.
The silver lining is that there are several tax deductions they can claim to minimize how big a chunk the government takes back in taxes.
Home office: As a contractor, you most likely use a portion of your home or a separate structure to conduct your business or meet with clients. This space must solely be used for business purposes, as the IRS has become very strict with what counts as an office. You are entitled to claim deductions for this space and expenses that may include real estate taxes, mortgage interest, utilities, insurance, painting, rent, repairs and depreciation, and this write-off can be claimed on Form 8829 and deducted on Schedule C.
Moving expenses: You can deduct a portion of your moving expenses from your taxable income if you move your work space at least 50 miles farther away than your old space. As a contractor, you must be employed full-time for at least 78 weeks for the next 24 months after the move to deduct these expenses.
Moving expenses include packing and shipping costs, travel to your new space, hotel rooms, disconnecting and reconnecting utilities, and up to 30 days of storage.
Meals and Entertaining expenses: This is another categorization of costs the IRS is stringent about. Uncle Sam stipulates that the setting must be conducive to conducting business, and it has to show. For instance, an individual who tried to write off tickets to a baseball game was rejected because the IRS states that the volume levels of a baseball stadium don't allow for "comprehensive business discussion."
Interestingly, if you throw a business party with a mix of employees and spouses, you can deduct 100 percent of the cost. However, if it is only for clients, potential clients, and other contractors, you can only deduct 50 percent of the cost.
Commuting expenses: Self-employed individuals working from home can deduct the cost of driving to see a client or go to a work location. Keep a record of this driving or else the IRS can deny you the deduction.
Medical insurance expenses: Contractors can deduct 100 percent of the health insurance premiums paid for themselves, their spouse, and dependents, which will reduce their income tax.
Retirement plans: Contractors are able to establish IRAs such as an SEP (Simplified Employee Pension Plan) or a Keogh plan, through which you can deposit 20 percent of your net earnings, your net profit minus the deduction for one of the halves of your self-employment tax.
Travel expenses: If you're scheduled to take a business trip to another U.S. city, by spending a few more days there as vacation, you can deduct 100 percent of your airfare expenses! Just make sure the days for business take up more of your trip than your vacation. Also, lodging, hotel tips and 50 percent of meals are eligible to deducted only for the business days.
Hobby/business: For employees that aren't really independent contractors but have a hobby such as growing vegetables that you sell to others, you can report your business income and expenses on your normal 1040 tax return (Schedule C) and deduct the expenses related to your business. However, if your business is not profitable, the IRS will investigate your losses as a tax shelter. If your business is profitable for three out of five years however, consider yourself in the clear.
Education expenses: The IRS college tax credit comes in two ways: the American Opportunity Tax Credit and the Lifetime Learning tax credit. The IRS will credit your tax bill and fund up to 40 percent of your college tax credit in the first, with the latter being more flexible for any professional taking college courses to better their employment opportunities.
Health insurance premiums: Starting in 2014, those who get their health insurance coverage through the Health Insurance Marketplace are eligible for the premium tax credit, which you can have some or all of the estimated credit paid in advance to your insurance company to lower your out-of-pocket expenses during 2020, or get it later and wait to get all of the credit when you file your 2022 tax return in 2023.
Business-related goods: Clothing and equipment like scrubs, lap coats, and tools can be deducted, as well as laundering and cleaning these items. Additionally, professional journals, subscriptions, and reference books are deductible as well as the business-use percentage of Internet expenses and the cost of online research.
Commuting expenses: A loophole has made it possible to deduct the cost of commuting to your place of employment. Some employers in America have begun participating in commute benefit programs, such as TransitChek. Due to this, employees can make pre-tax deductions from monthly paychecks to cover your expenses, which functions as a deduction from your overall taxable income (since the money is deducted from your paycheck before taxes). However, only 6 percent of American employees participate in these commuter benefit programs.
Work expenses not covered by employers: You can deduct items such as uniforms you are required to buy and wear, dues if you belong to a union and other professional organizations, and business-related vehicle expenses like gas and repairs.
Travel and auto expenses: Travel expenses are deductible as long as you incurred the costs for traveling between workplaces (not a home office like the ones contractors work out of) and you can even deduct the cost of laundry, baggage, telephone bills, tips, and meals when traveling. You can deduct parking to attend a business meeting, and if your car is used for business purposes, you can deduct either your car expenses for the year or the standard mileage rate, which was 58.5 cents per mile from January 1 - June 30 while it was 62.5 cents per mile, from July 1 - December 30, up 4 cents from the rate effective at the start of the year.
Job search expenses: During your current occupation, you can deduct anything from the cost of producing and printing your resumes to travel expenses you accumulate while interviewing for a job.
Passport: This is only if you need to buy one for a business trip.
All in all, though contract workers are known to get slammed during tax season, there are plenty of ways for these individuals to minimize their taxable income and get quite a few breaks, and, employees who have the fortune of having their tax burden shared with their employers, also have a few significant ways to save.