(Art credit: Kathryn Sheldon)
Given the focus in May on National Small Business Week, (May 1 to 7) and the end of the tax filing season, if you find yourself transitioning from regular wage-earning employment income (reported on a W-2) to self-employment (tracked by those who pay you on a 1099), or a combination of both income streams, you need to understand how to handle your income tax and other taxes to avoid problems later.
If you are not a full-time freelancer, and you have a side job such as consulting, writing, or selling ecommerce or other products, you will have to handle your taxes differently and separately for both your W-2 and your 1099 income.
How do you do this if you have been an employee of a company at some point this year? First, you should do a quick check to make sure your tax withholding is correct. The same goes for freelancers who pay quarterly taxes. Now is the perfect time, right after tax season, to look at making any changes to your tax payments to make sure they are in line with your actual obligations.
The basics of tax obligations for self-employed vs. employed workers.
As a self-employed individual you are responsible for paying income tax on all revenue that you generate from your freelance business. If you have at some point during the tax year derived W-2 income, then you must report that as well. Your employer will provide a W-2 ahead of tax time and they will (by law) have withheld taxes on your behalf based on the withholding amounts you selected during the employment process.
If you made accurate withholding elections through your employer, you should be relatively even when it comes to the need to pay tax on those wages. However, if you have also received freelance income, regardless of whether you receive a 1099 form from your clients or not, you must set aside money to pay income tax on that revenue.
Keep up on expenses, estimated tax payments and withholding thresholds.
It is likely that your W-2 withholdings are not enough to cover the income tax on your Form 1099 income, which means you will need to make estimated tax payments each quarter to the IRS using a Form 1040-ES, Estimated Tax for Individuals to make sure you are paying enough tax. Before you cut that estimated tax check, you will want to make sure that you have taken all possible self-employment deductions including:
- Home office deduction
- Phone and internet bills
- Health insurance premiums
- Business insurance premiums
- Business travel and meals eaten at a restaurant, during business.
- Mileage driven and actual vehicle expenses
- Interest on business loans
- Business-related educational expenses
- Commercial rent
- Startup costs
- Qualified business income
The list above is a guide to the deductions you may be able to take on your 1099 income. Remember that the business expenses deducted must be “ordinary and necessary” in the eyes of the IRS. Your income tax is paid on your profit so the more qualified expenses you have, the lower your tax bill will be. It is vitally important to keep track of these expenses and make sure you have a receipt, (either digital or in hard copy) in case you become the focus of an audit. You should keep these records for at least three years.
Payment on self-employment income is made to the IRS and your state taxation department (and, potentially, your municipal tax department) on a quarterly basis. These are commonly known as “estimated taxes” and it is imperative that you make these payments each quarter (usually January 15, April 15, June 15, and September 15) to avoid fines and penalties.
As noted above, for your freelance earnings, you do not receive a W-2 form at tax time like an employed person would. Instead, you will receive a 1099-MISC or 1099-NEC from your clients and a 1099-K from any online platforms (such as Etsy, Shopify, etc.) on which you made more than $600.
Regardless of the proportion of income that you derive from self-employment versus your W-2 job, you will need to report both streams of revenue on your next tax return via Schedule C on Form 1040 if you have a limited liability company or on Form 1065 if your business entity is a partnership and Form 1120 or 11-20S if your entity type for taxation is a C-corporation or S-corporation.
Freelance FICA rules are critical to understand for W-2 vs. 1099 income.
In addition to income tax, as a freelancer, you also need to pay the employee and employer portions of the self-employment tax, under the Federal Insurance Contributions Act, or FICA.
For freelancers, here are the FICA rules in a nutshell. When you earn any form of taxable income, the IRS is owed 15.3% of it under the Federal Insurance Contributions Act, or FICA. This represents the 12.4% Social Security tax and the 2.9% Medicare tax. For any self-employment income, you are responsible for paying all this tax (as both the employee and the employer). On W-2 wages, your employer pays half, and the remainder is deducted from your paycheck.
There are also some key FICA thresholds to take note of:
- As an employee if you earn $147,000 prior to the end of the year, you no longer pay into FICA because this is the cap instituted by the IRS.
- However, if as an employee, you earn more than $200,000 you are subject to an additional 0.9% Medicare surtax applied to your gross earnings.
- If you earn both W-2 and 1099 income, you are responsible for the self-employment tax only on the money you earn through self-employment.
Remember to check your local tax obligations, too. It is important to remember that you may have to pay income tax and business or other taxes on a local level to the county and/or city where you live. For example, New York City has an unincorporated business tax, while New York State has the Metropolitan commuter transportation mobility tax which applies to New York City and the surrounding counties. Both taxes apply to self-employed individuals.
Use proper tracking and regular payments to help you maintain control.
While being in transition between full-time or part-time W-2 work and full-time freelance (or a new side hustle) can be stressful, it is not insurmountable from a tax perspective. The most important thing is to be clear on how you are classified as a worker (independent contractor versus employee) and keep close tabs on all your income, tax obligations, and related expenses while also making regular tax payments.
Doing so should make balancing your employment income and cash flow much easier and help you keep a sense of control as you navigate your new normal.