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Is it better to be an employee or an independent contractor for tax purposes?

Published in Tax Comparison 5 mins read

It is not definitively "better" to be an employee or an independent contractor for tax purposes, as each role comes with distinct tax advantages and disadvantages. The optimal choice depends heavily on an individual's financial situation, business expenses, desire for flexibility, and comfort with tax responsibilities.

Understanding the Key Tax Differences

The primary distinctions for tax purposes between employees and independent contractors revolve around payroll taxes, expense deductions, and tax responsibilities.

Tax Deductions

Independent contractors generally have significant tax benefits from expense deductions. They can deduct a wider array of business expenses than employees typically can claim. This includes deductions for home office expenses, business-related travel, professional development, supplies, equipment, and even health insurance premiums. These deductions can significantly reduce their taxable income.

Employees, on the other hand, have limited options for deducting unreimbursed work-related expenses. Since the Tax Cuts and Jobs Act (TCJA) of 2017, employees cannot deduct unreimbursed employee business expenses. Their tax benefits often come in the form of pre-tax deductions from their paycheck for things like health insurance premiums or retirement contributions (e.g., 401(k)).

Payroll Taxes (FICA)

One of the most significant differences lies in the payment of FICA taxes (Social Security and Medicare).

  • Employees: As an employee, your employer pays half of your FICA taxes (7.65%), and the other half (7.65%) is withheld from your paycheck. This means you are only directly responsible for your portion.
  • Independent Contractors (Self-Employment Tax): Independent contractors are responsible for paying both the employer and employee portions of FICA taxes, known as self-employment tax. This combined rate is 15.3% on net earnings from self-employment, up to certain income thresholds for Social Security. This higher tax burden is a major consideration for contractors. However, independent contractors can deduct one-half of their self-employment taxes from their gross income, which helps offset some of this cost.

Tax Responsibilities and Withholding

The method and frequency of tax payments also differ substantially.

  • Employees: Taxes (federal income tax, state income tax, FICA) are automatically withheld from each paycheck by the employer. Employees receive a Form W-2 at year-end, which simplifies tax filing.
  • Independent Contractors: Unlike employees, independent contractors are required to withhold their own federal, state, and local taxes. This means they must estimate their income and expenses and typically pay estimated taxes quarterly to the IRS and relevant state tax authorities. Failure to pay sufficient estimated taxes can result in penalties. Independent contractors receive Form 1099-NEC from clients, which reports their income.

Comparison Table: Employee vs. Independent Contractor (Tax Purposes)

Feature Employee Independent Contractor
Tax Withholding Employer withholds taxes from paycheck. Must pay estimated taxes quarterly.
FICA Tax Burden Pays 7.65% (employer pays matching 7.65%). Pays 15.3% (self-employment tax).
Expense Deductions Limited; cannot deduct unreimbursed business expenses since TCJA. Can deduct a wide range of business expenses (e.g., home office, travel, supplies, insurance premiums).
Tax Forms Received W-2 1099-NEC (from clients)
Tax Filing Generally simpler. More complex (Schedule C, Schedule SE required).
Employer Benefits Often includes health insurance, retirement plans, paid time off. None from clients; must secure own benefits.
QBI Deduction Not applicable. May qualify for Qualified Business Income (QBI) deduction (up to 20%).

Practical Insights

  1. Maximize Deductions: If you choose to be an independent contractor, meticulously track all business-related expenses. Common deductible expenses include:

    • Home office expenses (portion of rent/mortgage, utilities, insurance)
    • Professional development, courses, and certifications
    • Business travel and mileage
    • Office supplies and software
    • Business insurance premiums
    • Health insurance premiums (can be deducted as an adjustment to income)
  2. Budget for Self-Employment Tax: Account for the 15.3% self-employment tax rate when setting your rates or estimating your income.

  3. Pay Estimated Taxes: Set aside a portion of your income (usually 25-35%) for taxes and make quarterly payments to avoid penalties. You can find more information on estimated taxes on the IRS website.

  4. Consider Business Structure: Independent contractors may benefit from forming an LLC or even electing S-Corp status. An S-Corp election can potentially allow you to pay yourself a reasonable salary, on which FICA taxes are paid, and take the remaining profits as distributions, which are not subject to FICA taxes. This can lead to significant tax savings but also adds complexity.

  5. Professional Advice: Due to the complexities of self-employment taxes and deductions, it is often beneficial for independent contractors to consult with a qualified tax professional. They can help navigate tax laws, identify all eligible deductions, and ensure compliance. For more details on the differences, you can also refer to resources from the IRS on independent contractor (self-employed) vs. employee.

Ultimately, while employees benefit from simpler tax processes and shared FICA tax burdens, independent contractors gain significant flexibility and the potential for greater tax deductions through business expenses, which can lead to a lower taxable income if managed effectively. The "better" option depends on whether the advantages of higher deductions and business autonomy outweigh the complexities of self-employment taxes and responsibilities.