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No one looks forward to tax season, even (especially!?) accountants. But tax requirements and reporting burdens may be increasing if you’re one of the 16 million independent contractors working today. Tracking of your business expenses, income and tax payments are all key challenges, and proper accounting is a critical factor in protecting the independent contractor status (for you and the clients you serve) since the government has increased scrutiny of worker misclassification.
Check out these 6 tax tips to help you maximize deductions and increase cash flow while maintaining compliance. Because while the law requires we pay taxes, there is no reason to leave a tip.
Proactively Estimate to Save
The number one mistake independent contractors make is failing to plan for their full yearly tax burden. Independent contractors must ensure that they account for self-employment tax in addition to income tax. Also, depending on where your services are delivered, you may find that additional local business taxes apply (like some Virginia counties having a gross receipts and tangible business property tax) so be sure to know your local tax rules for each city you work in and where you reside. Proactively estimating year end taxes is not only required to avoid underpayment penalties, it can also reduce your year-end tax burden since your are strategizing for the coming year versus reacting to past expenses. Since revenue can be dynamic and your annual tax liability can change based on new projects and expenses, we recommend mid-year tax planning to adjust for revenue changes and business development. If you don’t tax plan, at least consider opening a separate bank account for taxes and each time you receive a client payment, deposit a percentage based on the tax bracket. A stitch in time can save more than nine in this instance.
Properly Manage Business Expenses
Many self employed professionals miss important tax deductions because they don’t have a system or process to properly track expenses. To be deductible by IRS standards, the expense must be “ordinary and necessary.” As ordinary expenses vary by occupation, it’s important to get educated about allowable deductions and put an organized system in place that allows you to properly track and maintain the appropriate documentation throughout the year. Number one: open a business bank account or use a separate credit card to segregate your expenses from business and personal. Second, track your expenses with a solid accounting system. If you’re a very small business, you can use this customizable Business Expense/Revenue Spreadsheet, and growing businesses should use a formidable accounting system like QuickBooks. Wendroff & Associates can get you a 25 percent discount on QuickBooks purchases, and we offer customized one-on-one training to help you manage the accounting system properly and effectively. You pay taxes on your revenue minus expense, and though the law requires us to pay taxes, you don’t have to leave a tip.
Evaluate Your Corporate Structure
Independent contractors often choose to be sole proprietor LLCs, the simplest form of business ownership that also offers legal protection of your personal assets from creditors of your business. However while that is an excellent option for a beginning business, as your revenue grows you may be paying considerable Self Employment Taxes (15.3%), which could be significantly reduced by changing your corporate structure to an S Corporation.
An S Corporation allows the business owner to hire themselves as the “manager” of the business, paying themselves a reasonable salary (portion of total revenue) through payroll. The remaining revenue can be distributed to the sole shareholder of the S Corporation (the business owner) through a distribution.
Here is an example:
Maria is a contractor making $90,000 annually. After she pays her costs & expenses, her profit is $60,000. As a sole proprietor, she is required to pay self- employment tax of 15.3% on this entire $60K of profit, which equates to $9,180.
Let’s assume Maria formed an S Corporation for her business, and chooses to pay herself $35K for the year in salary, and take the remaining $25K of profit through a distribution. She still earns the same $60K in profit. Because corporations only pay Social Security & Medicare taxes on salaries, she’s only liable for $5,355, saving more than $3,800 in taxes.
S Corporations do have additional organizational requirements including bookkeeping and payroll, and the tax preparation is more complex and slightly more costly. Though payroll can generally simplify the payment process for the business owner. We typically recommend the S Corporation strategy if a contractor generates more than $80K in annual net revenue. Regardless of the additional requirements, the strategy can significantly reduce your tax liability if you’re in the right situation.
Per Diem Rates Still Apply
If you have yourself set up as an employee of your company, you may be entitled to a per diem allowance when you travel a certain distance from home to conduct business. Provided you comply with the IRS rules (ask your accountant!) this can help reduce your tax burden when working on projects that require long-distance travel.
Leverage Your Health Benefits
Properly managing your health benefits can effectively reduce your tax liability. For example, opening up a Health Savings Account (HSA) along with opting for a high-deductible (annual deductible starting at approximately $1,200 for single and $2,400 for family coverage) medical insurance plan reduces your taxable income dollar for dollar by the funds you contribute into the HSA. For 2012 you can contribute up to $3,100 for an individual, or $6,250 for a family. As you pay for medical expenses to meet your deductible, they are taken from your HSA. If you do not use the funds they will roll over, earning pre-tax interest, which then can be applied to future healthcare costs.
Take Advantage of Special Retirement Options
Self employed professionals have a number of options for retirement planning including the Simplified Employee Pension Individual Retirement Account (SEP IRA), Simple IRA and Solo – 401(k)s. If you are saving for retirement, create a plan that allows you to save the maximum. Owning a company allows you to leverage your retirement plan to contribute well up to $50,000 (and in some cases more) tax free dollars depending on the type of plan you choose. This is one of the best ways to build up your nest egg for your future. Talk with your CPA or Financial Planner for more info.
Taxes are a critical part of running your independent business. A little guidance, time and planning can ensure that you are not only in compliance, but also help you generate more cash flow and develop your business. While all expenses affect the bottom line, there is good reason to turn to a specialist if you are losing sleep, billable time and income by trying to do it all yourself. Working with the right CPA firm is an investment, and eventually can help you grow your business.
For more information on planning a retirement options, S Corporation strategies or the other tips mentioned in this article, please contact an associate at Wendroff & Associates at 703-553-1099.