How to Reduce Your Taxes on 1099-MISC

Earned income is generally recorded in two ways for federal tax purposes. There is W-2 income and 1099-MISC income. The former is for employees, either full- or part-time. The latter is for contract workers, sometimes known as a freelancers. If that describes you, you may be wondering how to reduce taxes on a 1099-MISC.

If you’re unsure about filing taxes, you could consider engaging the services of a financial advisor.

What Is a 1099-MISC

Contract work is by far the most common form of self-employment. It allows workers to strike out on their own without necessarily having to launch a formal business. However, taxes for freelancers aren’t fun.

For a W-2 employee, the employer and the employee each pays half of the individual’s payroll taxes. This comes to about 7.65% for the employer and the employee each. However, a 1099-MISC employee must pay both halves of this tax, amounting to a flat-tax increase of 7.65% across the board for the self-employed. ¹ This is known, appropriately enough, as the self-employment tax.

Since taxes tend to start out pretty high for contractors, they try hard to cut that bill. If this is how you earn a living or just some money on the side, we’ll cover some tips to do so.

Deduct Your Business Costs

As a contractor you are, for tax purposes, running a one-person business. This means that you can deduct any and all legitimate business expenses from your taxable earnings. Like any other tax deduction, you calculate your expenses and reduce your total taxable income by that amount. For example, if you earned $75,000 in freelance income during the year and spent $20,000 on relevant expenses, you’ll only owe taxes on $55,000.

Don’t forget to track your startup costs, which the IRS deems intangible assets. This means you must amortize them over several years. Be sure to note the exact date that the process began and then divide expenses between the costs to get an office up and running (utilities, creating a website, advertising and renting an office space) and the cost of incorporation or otherwise being legally organized in your state and locality. This includes attorney’s fees. ²

Business costs allow you to itemize tax deductions even if you take the standard deduction. (You file these on a separate form.) ³ As a contractor, they can also apply to a wide scope of expenses and activities. For example, you can often deduct office supplies, computer equipment or even travel and dining expenses depending on the nature of your work.

When you split costs between work and personal use you must divide your deduction appropriately. For example, if you buy a new laptop, you need to estimate how much time you spend on it for work and how much for personal use, then deduct the cost of the device accordingly.

Other Expenses

You’ll probably find yourself going over your budget for the year with a fine-tooth comb. Expenses to consider include:

• Website
• Business cards or advertising materials
• Office equipment, such as a computer or a phone
• Office supplies, such as pens, paper and other essentials
• Home office deduction
• Productivity software and apps
• Books or relevant periodicals
• Any subscriptions relevant to your industry
• Networking costs such as dinners
• Travel expenses
• Membership in professional associations or licensing costs
• Professional training and certifications
• Facilities and equipment
• Utilities and other recurring bills

In general, did you do anything that relates to how you earn a living? Given how often independent contractors and freelancers pursue their passions, there’s often a lot more overlap than you might think between how you’ve lived your life and what relates to your work.

Keep your receipts, because expenses listed on them are deductible.

The General Services Administration and State Department have set per diems for federal workers traveling both within the United States and abroad. This is known as the M&IE rate, and it covers the costs of meals and incidentals. If you travel for work, you may use these per diems as the basis for your deductions rather than attempting to calculate your own expenses. This can be particularly useful for contractors whose work takes them to places that don’t tend to give receipts, and it helps ensure that the IRS won’t push back on your deductions.

Failed Business Costs

One thing that many freelancers and contractors don’t realize is that you don’t need a project to succeed in order to deduct its costs. You can deduct any business expenses that have to do with your field of work. It doesn’t matter whether that particular venture succeeded.

Take a trip that didn’t lead to any successful work? Buy a bunch of supplies for a project that went nowhere? It’s okay. As long as the expenses were legitimate, you can deduct them.

Incorporation

Most contract workers are what’s called a “sole proprietorship.” This means that they don’t work under any formal tax structure. All of their earnings become personal income, which they report and then pay taxes on.

The common alternative is to incorporate into an S Corporation. These are private corporations generally intended for a single individual or a small number of people (no more than 100 individuals). Your earnings would be reported as earnings for the S Corporation, which would then pay you a salary (generally all earnings, less business expenses). This changes your tax status, particularly as relates to the self-employment tax. Read more at the IRS website to see if this might be a good move for you.

Self-Employment Tax Deduction

Your tax forms will guide you to this, but it’s still important not to miss.

If you file taxes with a 1099, you must pay that additional 7.65% in taxes. This comes to a total of 15.3% in payroll taxes. Of that total payroll tax, the IRS allows you to deduct between 50% and 57% from your taxable income. ⁴

This is a significant deduction. Definitely don’t miss out on it.

Insurance Premiums and Retirement Accounts

If you have forms of professional or liability insurance that are relevant to your job, you may be able to claim those as business expenses.

Meanwhile, contractors who pay for their own health and dental insurance can claim these costs directly as a deduction. This also applies to any insurance costs you pay for your immediate family.

Finally, don’t forget to deduct your contributions to any qualifying retirement accounts, like a SEP-IRA. Since you don’t have someone managing a 401(k) for you there’s no one to do this for you, and it’s certainly important to take care of.

The Real Tax Cost of Being Self-Employed

A W-2 employee earning $75,000 pays roughly $5,738 in combined Social Security and Medicare taxes, plus approximately $9,263 in federal income tax. Total: $15,001 in federal taxes, leaving $59,999 take-home.

A 1099 contractor earning the same $75,000 pays $10,605 in self-employment tax (both halves), plus approximately $9,455 in federal income tax after the self-employment tax deduction. Total: $17,560 in federal taxes, leaving $57,440 take-home. The contractor loses $2,559 on identical income.

With $20,000 in legitimate business deductions, the contractor’s taxable income drops to $55,000. Self-employment tax still applies to the full $75,000 (deductions don’t reduce it), but federal income tax falls to approximately $7,255. Total federal obligation: $15,760. The deduction brings the contractor within $241 of the W-2 employee’s tax burden. This is why expense tracking directly impacts your bottom line.

Quarterly estimated tax payments are mandatory for self-employed workers. Missing or underpaying triggers penalties and interest. The IRS audits 1099 contractors at roughly double the rate of W-2 employees. Aggressive deductions invite scrutiny. Conservative choices with solid documentation prevent problems.

S-Corporation incorporation becomes cost-effective around $60,000 to $80,000 in annual net income. You split earnings into salary (subject to self-employment tax) and distribution (exempt from it). On $75,000 net income, paying yourself $50,000 salary and taking $25,000 as distribution saves approximately $2,300 in self-employment taxes. Accounting costs run $1,200 to $2,500 annually, netting roughly $500 to $1,100 in actual savings.

Bottom Line

All contractors want to cut taxes. The best way to do this is to pay careful attention to your business expenses, but there are plenty of other places where you can save some money, too. These include failed business costs, incorporation expenses, self-employment deductions, insurance premiums and contributions to retirement accounts.

Tax Tips

• Consider working with a financial advisor as you work on your taxes. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• The federal income tax system is progressive, so the rate of taxation increases as income increases. Use this free income tax calculator to get quickly get a good estimate of what you owe Uncle Sam.
• Make sure you pay your quarterly taxes. Four times per year, anyone who earns a significant amount of 1099-based income is required to file taxes based on what they would owe from that quarter’s earnings. Failure to do so comes with a modest penalty. Much more importantly, not filing your quarterly taxes is a good way to get a massive tax bill come April.

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