What's a contractor? For the purpose of this guide, I'm considering a contractor as anyone who's paid for work on a 1099MISC vice on a W2, or who works for themselves and is paid cash by their customers. I say work, because I'm not talking about an Engineer getting paid a few bucks for coaching softball. I'm talking about someone who is in the business of doing the work they get paid for. This guide is best used by someone who earns the majority of their income from the work they do that's paid in cash or via a 1099MISC. If you're a painter who gets most of his money on a W2, and gets a minor portion of their income on a 1099MISC, this guide can be helpful, but it's really not the prime focus of the guide. This guide is also intentionally generic, so it can apply to a variety of businesses.
What does this guide not do?
Foremost, it assumes you are either a Sole Proprietor, or a Single Member LLC. In other words, the business is reported on your personal tax return, vice the business filing its own tax return. There are advantages and disadvantages to forming other business entities, but those are best discussed face to face with a professional you trust.
Second, it is mostly for contractors who provide services, vice those who make or buy items to sell. There is some good information for them too, but I won't be covering inventory or cost of goods sold.
Third, it's not a guide on how to do your taxes. It's a bunch of best practices I've found to make running your business easier, your taxes simpler, and your life better. It's not the only way to do things, but it's what I've found works best. I assume you either have a tax professional who does the tax return, or you're pretty smart and capable of using tax software yourself (though I recommend having a professional check it the first couple years.)
Fourth, it's for SMALL businesses. If you're approaching 7 figures of gross income, get a professional CPA involved.
How does a 1099MISC / cash business work for taxes? You’ll be filing a Schedule C and reporting ALL income, and then taking any legitimate deductions to come up with ‘net’ income. This is what you pay taxes on. You have to pay it all as you go, or at the end of the year when you file your tax return. Also, there's nobody to pay for Social Security taxes except, well, you. Most people are barely cognizant of the 7.65% that's taken right off the top for Medicare and Social Security taxes out of their paycheck. What even the most aware don't realize is that their employer matches this deduction! As a 1099 recipient (self employed is the IRS term) you have to pay both the employee and employer portion! This means a 15.3% additional tax! Imagine you're in the 15% tax bracket - that means you actually pay 30.3% taxes! And this doesn't even cover state taxes!
The good news is that, unlike a W2 employee, you only pay these taxes on your 'net' income. This means you get to take all ordinary and necessary expenses off the top, before you pay a dime in taxes. Even employees with business expenses still pay their half of Social Security and Medicare taxes before any deductions. So what is 'ordinary and necessary'? I like to boil it down into two categories: 1 - things you pretty much have to pay - like licensing, commissions and fees. 2 - things you pay because you expect them to increase your income. If they meet either of these requirements, they're pretty much a lock as being deductible.
Knowing the above, it's important to give one of my biggest pieces of advice - you pretty much should NEVER do something just because you expect it to help on your taxes. Spend money only if you have to, or because it's the best idea for your business! This has two benefits: 1 - you don't waste money on stupid s**t. 2 - chances are the deduction is legitimate.
So what can I deduct? Here’s a non-exhaustive list: Supplies, rent, vehicle mileage, travel, bank fees, taxes, licensing, insurance, home office, office supplies, equipment, marketing, advertising, subcontractors, employees, postage, education, legal and professional expense, bank interest and much, much more. I’m going to give details on a few here:
Marketing Expenses: Business cards, website fees, posters, signs, sponsorships, commercials, advertising, pretty much anything you do to get someone to call YOU when they need your type of services.
Training, Education and Licensing: Whatever you pay to maintain your ability to do your business is deductible, as well as things you do to increase your skills, as well as what you are allowed to do in the field. Classes, seminars, books and certificates mostly all qualify. Commercial Drivers License is another example.
Insurance: I'm not talking about homeowners insurance here. I'm talking about ‘oops I screwed up and someone is suing me insurance.’ Sometimes this is called Errors and Omissions Insurance, sometimes it’s a liability bond, or a rider on your homeowner’s insurance. Also, if you pay a rider to your car insurance for business use, the difference between that and regular insurance is deductible. There is also a self employed health insurance deduction that allows you to deduct your health insurance costs if you have no other insurance source (if you can get insurance through your spouse’s work this is a no-go.)
Entertainment Expenses: Eventually you'll be with a client, or potential client, and pick up the tab for lunch, or dinner, or a stripper (don't do that - it's tacky - and questionable as a deduction). Generally, if you expect the expense to result in a sale that makes you money, either immediately, or in the future (whether it ultimately does or not doesn't matter, as long as you expect it to) it's deductible. I recommend writing the name of the client on the receipt, as well as a quick description - "referral source", "potential client" or something like that.
Travel Expenses: These are a toughie. People love conflating personal and business travel. If you travel to Maine to visit family and see the lobster festival, and go to dinner with a client that is moving to your area, the trip is primarily personal. You can deduct expenses DIRECTLY RELATED to the meeting with the client, but little else. I recommend keeping business and personal separate. You can visit a friend for dinner on a three day business trip, but don't do business for an hour on a three day personal trip. Also avoid what I call BS travel. Flying to Vegas to assess potential markets is transparent vacationing disguised as business travel, especially if you spend 23 out of every 24 hours in the casino! Be reasonable! Go on trips that are going to increase your money-making potential. Stay away from any others. For legitimate travel, you get airfare, rental car, tips, taxis, laundry, internet and phone, as well as 50% of meals and any other reasonable and necessary expenses. Travel assumes overnight trips away from your home area.
Cell phones, laptops and tablets: Do yourself a favor, get a business only laptop, cell phone, tablet and/or computer. It is simply too difficult to calculate expenses on a part personal and part business electronic device. Don't share your business number with friends and family (other than wife and kids). If you keep everything separate, the deductions are easy and legitimate. If you don't, you have to establish a business use percentage, and worry about listed property rules - which suck!
Vehicle Expenses: Keep a mileage log. Let me say it again, unless you have a vehicle that is 100%, no s**t, total business and no personal use, keep a mileage log. Don't worry about gas, repairs, oil changes, insurance or any other car expenses (except as discussed above under insurance). There are other ways to track vehicle expenses, but mileage is the best. Do track annual car taxes and finance charges. The easiest mileage log is a notebook where you right the date, the trip purpose and the miles driven. You will also need to know the total miles the vehicle is driven for the year, so write the odometer reading down every January 1st! Mileage will be one of your biggest expenses, so keep track of it religiously! 10,000 miles of properly tracked vehicle mileage can result in $1500 of tax savings!
Home Office: Set aside a space in your home that is 100% business use. Never used for anything else, and regularly used for business. This is where you keep your business records, your business computer or laptop, make your sales calls from and meet clients. The tax term is regular and exclusive business use. If you do this, you deduct a percentage of the household expenses - rent, interest, taxes, utilities, insurance, repairs, etc, based on the square footage of the office ratioed to the home square footage. Expenses directly related to the office, such as a dedicated phone line; do not have to be ratioed. You can also take a small depreciation deduction for the home losing value (let your tax guy handle this - it's a b**ch!)
Depreciation: Some items that you buy for your business, that have a useful life longer than a year will have to be depreciated over time rather than deducted all at once (examples include computers, digital cameras, machinery, big tools or office furniture). There are many options for deducting it up front, but be wary of this, there are tripwires that can cost you if you dispose of something before it has passed its useful life. Talk about these items with your tax advisor.
Employees or Subcontractors: If you pay someone to do work for you in your business that is deductible. Usually you will hire them as a subcontractor, and may even pay them in cash (use a check!) If you pay them more than $600 in a year, you will need to issue them a 1099MISC – see your tax guy about this as soon as you pay a subcontractor. If you want to hire regular employees, you will have to withhold taxes from their check. Get help with this! Make sure you talk with your tax guy about the difference between an employee and a contractor. If you call an employee a contractor, you could be in trouble. But if you just have a few guys that you call when you have excess work and they can decline to do the work, and you only pay them if they do, they are probably a contractor.
What about Record Keeping? This is where the rubber meets the road. Good record keeping will save you when it comes to tax time. Your records don't need to be extensive, but they do need to be accurate and useable. I hate double entry bookkeeping and would never recommend it as a tool for a basic contractor. I also have found that the various bookkeeping software programs are virtually useless when it comes to taxes. They may help when it comes to managing the business, but they suck for doing taxes. The best and easiest record keeping method I've found involves a small notebook, a big notebook and an envelope or box. The small notebook is for mileage, discussed above. The big notebook is for every other expense. You need simple columns set up: date, description, cost and payment received (if you pay something, it goes in the cost column, if you’re paid it goes in the payment received column.). You can add categories, but don't really need to, if you're unsure something's deductible, write it down and let your tax guy tell you if it's deductible. The box/envelope is for receipts - just throw them in. Really? No sorting, categorizing or organizing? No. Simply put, your odds of ever needing them for an audit are slim to none. Save the box, notebooks and tax returns for 7 years, and then throw it all away. If you ever do get audited, there's plenty of time to sort through the box and organize it to match the notebooks - but why do it if it's not necessary. If I'm doing your taxes I'm going to use the notebooks, and remind you that you should have a receipt for everything. You don't have to prove things to me.
Do I need a Separate Bank Account? This one might be a little controversial, but I believe it's the be all end all of successful businesses. Combined with record keeping discussions above, and budgeting discussions below, this will make everything easier. Open a separate bank account for your business. It doesn't have to be in a different name, just separate from your personal business. If you use credit, get a second credit card that is exclusively for business (again, it doesn't have to actually be a business credit card, just one that you use only for business). Put all contractor business income in this account, and pay all business expenses out of it, or with the business credit card. Pay off the business credit card out of this account. The only expenses not paid out of the account are car expenses (especially gas) and home office expenses that will be divided based on square footage as discussed under home office above (utilities would not be paid out of the account, but office supplies and business only cell phone would). The beauty of this method is that it simplifies budgeting as we'll discuss below, and it allows reconciling of expenses to make sure your notebook covers everything. A good tax expert should be able to compare your account statements with your notebooks and know if you missed something (assuming you don't intermingle personal and business expenses).
How do I Budget if my Income goes up and down? Now that you have an account that is separate for business, you can start thinking about budgeting. Your income may fluctuate wildly, so you can use the business account to pay a "salary" to your personal account. I recommend letting some money build up in the business account until you have a feel for your income level. It will probably start small, but build up over time. Once you have a good feel, you can pay yourself this salary. The salary should be no more than 50% of your gross income or 60% of your net income. You need to play around with it. Start small and raise it if income exceeds expectations, but NEVER pay yourself more than 60% of net income. Having a salary allows you to budget like you had a normal job. Keeping a buffer amount in the account allows you to have a "salary" even during lean months. By paying yourself a salary and saving the rest, if you have a really big month, you end up saving more, which in turn allows you to have the money to pay the tax bill that the big month will generate. When you file your taxes, you should have plenty of money to pay the tax bill, and still have money left to maintain a buffer, and, if you're lucky, have the ability to pay yourself a bonus to your personal account for a big purchase or vacation!
Do I need to make Estimated Payments? My advice is that you should use the budgeting advice above to pay your taxes. You'll still need to make estimated tax payments if you're making good money, but you should pay the minimum required to avoid an underpayment penalty. Your tax advisor will calculate them for you, but to explain simply: you need to pay at least as much as your prior year's total tax liability in withholding or estimated taxes to avoid a penalty (oversimplified explanation, but really all you need to know). This is an easy calculation for your tax guy and he will set up quarterly payments and provide vouchers for paying them. (The timing is a little weird. You pay 4/15, 6/15, 9/15 and 1/15.) You can also pay varying payments to try to avoid a tax bill, but it gets complicated, and the government won't pay you interest.
That’s it! Hopefully this makes your life as a contractor easier. As always, I’m available to answer any questions you have at firstname.lastname@example.org. If this saves you a bunch of money, consider a tip using the button above. Also feel free to make this better by emailing me your ideas and best practices!