How to avoid paying taxes as an independent contractor (legally)

If it was possible to call up the Internal Revenue Service (IRS) office for a discount on tax payments, their phones would probably ring all day.

But it’s not, so smart independent contractors have to explore more feasible ways to reduce income tax and keep more of their business profit. This is where tax avoidance comes in.

Tax evasion is different from tax avoidance because the first is illegal while the second is not. Tax evasion means dodging or underpaying taxes by knowingly reporting less income than you made or exaggerating deductions. Tax avoidance is any legal means of lowering your tax bill—including allowable deductions, tax-advantaged investments, and business structure choices.

1. Find all of your deductions

As a small business owner, the higher your income, the more are your taxes. Deductions reduce your tax liability because they let you report less income. 

Use a Schedule C IRS form to claim any of these 12 deductions that apply to you.

Home office

The home office deduction is $5 per square foot. Every self-employed individual—homeowner or tenant—who works from home is eligible for this deduction. 

Say your home office space is 200 square feet. This deduction lets you subtract $1,000 from your net profit, so you’ll have less taxable income. 

If you’re a remote employee (and not a freelancer), you can’t deduct home office expenses.

Internet and utilities

If you use personal utilities like your internet or phone for business as well, claim them as deductions. Calculate the percentage of the utility bill you used for work and deduct that amount from your net income.

Imagine your phone bill was $0.50 an hour, and you spent 1,200 hours making calls. The total cost adds up to $600. If 400 of those hours were for business calls, you’d be able to claim $200 as a deduction.

Health insurance

Claim your premium amount as a tax deduction if you pay for health insurance by yourself. 100 percent of your health insurance cost—plus long-term care, dental and vision coverage—is tax-deductible for yourself and your dependent family members.

If you’re on a group/company health insurance package, you’re not eligible for this deduction. Also, the health insurance deduction only applies to you if you’re not part of your spouse’s plan from their employer.

Meals

Meals are tax-deductible when you’re meeting with clients, during business travel, or at work conferences. Some conditions to note for this deduction:

• Typically, you can only deduct 50% of meal costs that aren’t extravagant—unreasonable “based on the facts and circumstances.”
• Temporarily—between December 31, 2020, and January 1, 2023—you can deduct the total meal receipt. But you must have bought the food at a restaurant and collected the bill separately from entertainment expenses like seminars or other social events.

Travel

The travel deduction covers your transport fare, accommodation, and meals during a business trip. 

This deduction often draws scrutiny from the IRS because some entrepreneurs try to deduct personal expenses under the guise of business. For example, your trip expenses are not tax-deductible just because you handed out flyers at a friend’s out-of-town wedding party.

Business travel only counts as a tax deduction if your trip:

• Lasts longer than one workday
• Involves sleeping or resting
• Happens outside your tax home—the city where your regular place of business is located
• Has a pre-planned business purpose like getting new customers or learning work-related skills

Vehicle

This deduction is known as mileage rate, and you can claim it if you use your car for business, as long as you’re able to document and prove that you drove your vehicle for work.

If your car is solely for business use, determine how much it costs to operate—including registration fees, gas, licenses, tires, repairs, insurance, and more—and deduct it.

But if the car is also for personal use, calculate the total cost of operating it. Then track the miles you drove—personally and for business—and claim mileage on only the portion of the total distance used for work.

Interest

Interest on a bank loan or credit card for your business is a tax-deductible amount. 

Personal loans or credit cards don’t count for this deduction unless you can prove that you used them for business purposes as well. In that case, you’ll have to track how you spent the funds and confirm all your business expenses.

Subscriptions

There are a few subscriptions you can claim as tax deductions, including:

• Journals, books, or magazines in line with your business
• Professional supplies subscriptions like software or paper
• Home office utilities like internet or electricity
• Company web hosting costs

Education

If you take training sessions or classes to learn how to attract new customers and grow your business, deduct the cost from your net income to lower your tax bill.

Advertising

The IRS lets you deduct advertising expenses from your taxable income. Any amount you use to generate and keep customers qualifies as a basic tax deduction.

Subcontracting

If you engage another freelancer to help you with a client project, the IRS lets you deduct the cost of paying them. You just need to prove that you hired a ‘contractor’ not an ‘employee’ by keeping invoices and a record of each payment.

Self-employment tax

You can deduct 50% of your self-employment tax.?

The current self-employment tax rate is 15.3%—12.4% for Social Security and 2.9% for Medicare. At the same time, 92.35% of net self-employment income is subject to tax. But the government lets you deduct 50% of your self-employment tax from gross income.

?If your net income is $15,000, the taxable amount is $13,852.50. This means that $2,119.40 (15.3% of $13,852.50) is your self-employment tax. You can deduct half of that ($1,059.70) from your gross income when filing your income taxes.

2. Look into tax-advantaged investments

A tax-advantaged investment is any asset whose capital and income are tax-free or that allows you to defer taxes until many years later.

The interest on investments in municipal bonds or municipal bond funds are exempt from Federal taxes may be exempt from state taxes if the bonds were issued within your state. 

You don’t need to be an employee to take advantage of tax-advantaged investments like a retirement savings account. The options available to you as a self-employed person are just different.?

Lower your tax burden and save for the future by contributing to a:

• Solo 401k retirement account: You make 401k contributions before paying tax. The more money you save in this account, the less your taxable income. You as the employer can also make matching contributions, further reducing our tax liability.
• Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE IRA): Similar to the solo 401k account, contributing to the SIMPLE IRA reduces your taxable income. SIMPLE IRA contributions are basically tax-free, and the account balance is tax-deferred. You’ll pay taxes when you retire and begin to withdraw funds. Since you’re not retiring just yet, using this account is a win-win.
• SEP IRA Account: You can contribute, and take a tax deduction, for up to 25% of your net self-employment earnings which is your net profit less half of your self-employment taxes. 

3. Consider your business structure

The way you register your business makes a difference in your tax payments. Consult a lawyer or CPA (Certified Public Accountant) for professional advice on which business structure is best for your company—especially in terms of affording you a lower tax burden. Consider these popular small business structure options.

• S Corporation (S Corp): As an S Corp, you may be able to avoid some self-employment taxes if you pay yourself a salary because this differentiates your personal income from business earnings.
• Limited Liability Company (LLC): Limited liability companies can be either single or multi-member. If you register as a single-member LLC, you can’t separate personal income from business earnings, so you’ll need to file tax returns for the amount you make.
• Sole proprietorship (Sole prop): Similar to a single-member LLC, you have to file tax returns for all your business earnings as a sole proprietor.

Pay less independent contractor taxes with good record keeping

To avoid taxes legally and prevent costly mistakes like underreporting or overstating earnings at the end of the year, consult a tax professional.

Beyond getting professional help, keeping accurate financial records for tax purposes is vital. With your books and receipts in order, you’ll be able to back up every profit, loss, and deduction claim.

 

Our bookkeeping tool Neat helps you handle your small business accounting, so your finances are in order for tax time. Sign up for a free trial today.