1099 Independent Contractor Taxes

Let’s dispel a common myth right away. An S corporation does not exist as an entity. You will not see it listed by any Secretary of State. It is a tax election. You need an underlying entity such as a limited liability company (LLC) or corporation (C Corp). When your LLC or corporation is taxed as an S Corp you are considered both an employee and a shareholder (think investor). As an employee being paid a salary, your income is subject to all the usual taxes that you would see on a paystub- federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment and state disability premiums.

However, as a shareholder or investor, you are simply getting a return on your investment. That income, or basically the remaining contractor profits after salary and expenses, is a form of investment income and therefore is not subject to self-employment taxes.

As you recall, when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a 1099 contractor perspective, they are self-employment taxes. From an employee perspective, they are Social Security and Medicare taxes. Same thing.

Let’s look at another visual in terms of how the 1099 money travels. The four boxes on the left are the money trail of your common contractor being paid via a Form 1099-NEC. The series of boxes on the right is the money trail of your entity being taxed as an S corporation, or as some might say, the 1099 S Corp. Note the $60,000 chunk of income on the far-right hand side that is not being taxed at the self-employment tax level. This is the source of your savings. Yay!

What is your net-net savings on all this gibberish? On $100,000 in 1099 contractor profits, you could save $8,000 to $10,000 in cash. On $250,000, you could save $15,000 to $18,000. The relationship is not purely linear, and it depends on your shareholder salary and how health insurance including health-savings accounts are being leveraged. We have a complete analysis of the tax savings of a 1099 S Corp in other webpages and from our book.

Also note that all your $100,000 is being subject to income taxes. This is a common misconception- a lot of contractors and business owners believe there is a magical income tax reduction with an S Corp election. Not true. The only reduction is in self-employment taxes. All other tax deductions such as operating expenses, home office expense, mileage, meals, self-employed health insurance, 401k plans, etc. are equally deductible with or without an S corporation election.

There are a handful of downsides to S Corps as well. Certain states are not attractive, additional accounting fees for tax preparation and payroll processing, among other things. Please review the 185 reasons S Corps stink from our book.

Naturally, you would want to pay a tiny salary to reduce the amount of income subject to Social Security and Medicare taxes, right? However, the IRS through Fact Sheet 2008-25 and a zillion tax court cases has enforced a reasonable shareholder salary standard. What does this mean? We have a webpage and an entire chapter from our book dedicated to this very question- what salary to pay yourself as a self-employed independent contractor.

Let’s say you are giving all this some thought, but would like to know how much to set aside for the looming tax bill. Without regards to your 1099 tax deductions and without knowing your overall household income, WCG CPAs & Advisors recommends setting aside about 20% to 25% of your gross 1099 earnings. Having said this, we are shooting in the dark and proper tax planning is a must.