A number of proposed and pending reforms are shaping the way the IRS views workers in the gig economy.
- Tax benefits for the self-employed
- Pass-through deductions for independent contractors
- Self-employment tax
Tax benefits for the self-employed
In the past decade, a surge of workers flowing into the gig economy has created a realistic avenue for earning a living outside of just collecting a paycheck from an employer. Many who earn income from self-employment do so in a part-time capacity on top of another job, though plenty also engage in this type of work full-time. Gig work can offer attractive benefits, such as flexible work schedules, increased earning potential, or the ability to make money with your unique experience and skills from multiple businesses simultaneously.
As a result of tax reform and changes in healthcare policy from the Affordable Care Act, people have more financial flexibility to pursue work of their own making. Whether through side projects or ongoing freelance work, many of those who operate in this type of work have access to a substantial number of tax advantages that are well worth understanding.
Pass-through deductions for independent contractors
Prior to tax reform, gig workers could deduct several self-employment expenses. Now, the reform changes often provide the ability to reduce tax liability to businesses with a pass-through deduction on qualified business income (QBI) for eligible businesses.
Formally known as the Section 199A deduction, this tax code provision allows most self-employed taxpayers and small business owners to exclude up to 20% of their QBI from federal income tax (but not self-employment tax), whether they itemize or not.
The deduction amount depends on the taxpayer's total taxable income—including wages, interest, capital gains, etc. — in addition to income generated by the business. In 2023, once the taxable income reaches or exceeds $182,100 ($364,200 if filing jointly), the type of business also comes into play.
Below that level, the deduction amounts to 20% of either taxable income (minus dividends and capital gains) or of the QBI, whichever is less. Above that level, the deduction phases out or eliminates, depending on the nature of the business.
In short, this valuable deduction typically allows businesses to deduct up to 20% of their business income before considering other, smaller deductions such as the cost of equipment or the depreciation of property. This 20% deduction, designed specifically to benefit pass-through entities — such as sole proprietorships, partnerships, S-corporations, and limited liability companies (LLCs) — also applies to gig workers. While limitations exist on certain types of service businesses, this deduction can greatly benefit self-employed individuals and small businesses alike.
One drawback to working as an independent contractor comes from self-employment taxes: paying both the employee and employer portions of Social Security and Medicare. In effect, this comes to 15.3% of your covered earnings, though the IRS allows self-employed gig workers to deduct half of that from their income when calculating their taxable income.
Effectively, self-employed people can claim up to 50% of what they pay in self-employment tax as an income tax deduction. For example, a $1,000 self-employment tax payment reduces taxable income by $500.
Worker classification reform
Prior to tax reform, labeling yourself as an independent contractor often resulted in a higher tax bill than if you made the same money as an employee. Tax reform changed that for many thanks to pass-through deductions and other new items in the tax code.
Before you can qualify as an independent contractor, you will need to assess the nature of your work. You should focus on the three items the IRS uses for determining your worker classification of whether you are an employee vs. independent contractor.
The IRS publishes annual updates to its Publication 15A, Employer’s Supplemental Tax Guide, but it relies mostly on the degree of control in three categories:
- Behavioral Control: Does the business have the right to direct and control how you perform tasks?
- Financial Control: Does the business have the right to control the business aspects of your work?
- Type of Relationship: What type of relationship do the parties maintain? Independent contractors should be free to work wherever and for whomever. Employees work under the control of the business.
Independent contractors should estimate effective and marginal income tax rates accurately
As an independent contractor, you need to accurately track your income to estimate your effective income tax rate, or the average rate by which your income will be taxed.
- Understanding your effective income tax rate allows you to estimate the tax you will owe.
- Understanding your marginal income tax rate will help you determine when your tax rate might increase if you earn enough income to bump you up to the next tax bracket.
- Adding your effective income tax rate to your self-employment tax rate gives you the overall tax rate you pay on income from your contracting work.
Tracking your earnings can be especially tricky if you don’t engage in gig work as a primary means of earning a living, and you have several tax documents to keep track of from multiple sources of income. Once you identify how much you likely owe, you can make quarterly estimated tax payments to the IRS.
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