While it is true 1099 contractors pay self-employment tax, this does not necessarily mean they pay more taxes overall. In fact, with proper planning, as a 1099 contractor you will likely pay less in taxes than you would as a W-2 employee.
This misconception comes from a couple of things:
(1) the knowledge W-2 employees, have their “self-employment” tax taken care of each pay period with the employer paying half, and the W-2 employee paying the other half. (Self-employment tax is often referred to as payroll tax, social security and Medicare tax, FICA and FUTA tax). But this only tells part of the story. The W-2 employee doesn’t see the payroll tax he is paying.
(2) If the W-2 employee converts to 1099 contractor status, he or she may freak out at the idea of having to pay the “self-employment” tax. The truth is it is already being paid.
The beauty is, with the right structure, a 1099 contractor will pay less in taxes on his or her gross amount received than the W-2 employee will pay. The biggest reason for this:“business deductions”. The next most important reason: Subchapter S Corporation (s-corp) status. If you claim 1099 contractor status you can form an s-corp to help minimize the actual self-employment tax that is paid. Yes, initial setting up of an Corporation does complicate the necessary tax filings, but the cost of the extra complexity and additional fees (assuming the contractor is smart enough to realize a professional should handle the tax filings) is minimal compared to the tax savings.
This means he or she can deduct ordinary and necessary business costs from his gross amount received. Some common expenses for a 1099 contractor are cell phone use, home internet, and vehicle mileage.
Burt, W-2 employee
Burt pays income tax (let’s be conservative and say 10%) on $35,000. Burt’s income tax is $3,500.
Burt pays half of the payroll tax (7.65%) on his $35,000 = $2,677.50. Remember, Burt doesn’t even see this. His actual take home is $32,322.50, because the payroll tax is paid up front.
So, Burt’s total tax cost is $6,177.50 on $35,000 wages. That’s basically an effective tax rate of 18%. Ouch.
Ernie, 1099 contractor
Let’s say Ernie’s cell phone costs $600 for the year. His internet is $360 for the year, and he drives 10,000 business miles. (If you track mileage, you will be surprised how fast it adds up. The average lease is setup for 12,500 miles, which means the typical American drives more than 12,500 miles each year!)
Mileage rates are established by the IRS, but for this example let’s assume it is 50 cents per mile. So that is a $5,000 tax deduction for Ernie.
Now, Ernie is smart and has an S Corporation.
On his S Corporation, Ernie reports $35,000 in gross revenue, and he reports the cell phone, internet, and mileage deductions totaling $5,960. He will also have to report an officer wage (it’s an IRS rule that I can go into more detail about in another post). In this case we’ll have Ernie claim $15,000 in officer wages. (The officer wage requirement is the complex part of the S Corporation.)
So, taxable income from Ernie’s S Corporation is $14,040. ($35,000 – $5,960 – $15,000).
Ernie pays income taxes (let’s assume 10% again) on the $14,040 and the $15,000 officer wage. Income tax is $2,904.
Ernie also pays self-employment tax (15.3%) on the $15,000 officer wage. Self-employment tax is $2,295.
Ernie’s total tax is $5,199, making the effective tax rate 15%.
In this very…okay…fairly simple example, Ernie, the 1099 contractor, saves $1,000 in taxes. But in reality, as a 1099 contractor you are going to have far more deductions. The more deductions you have, the more you save. More deductions means less taxable income and a smaller amount to claim as an officer wage. In practice with my clients, I have found that for every $1000 of income, an s corporation saves $100 in taxes.
In summary, a 1099 contractor is allowed to reduce his taxable income by claiming business deductions against his income. A W-2 employee is not. And, a 1099 contractor with an S Corporation structure pays self-employment tax on a lower dollar amount than the W-2 employee. If you haven’t done so already, make an appointment with your tax advisor as soon as possible to work out the best scenario for you.
John D. Briggs, CPA, is a partner and tax specialist with Incite Tax, certified public accountants experienced in all matters of accounting and taxation, IRS problem resolution, estates and trusts, business formation, financial planning and investment, real estate and business sales. John also is responsible for all of 321Go Project’s accounting and taxes.