Box 1 of the 1099-NEC covers workers, fish, and attorneys. I’ll open: An Uber driver, a tilapia, and a lawyer walk into a bar...
It is March, and you’re doing your taxes. You enter the income from your W-2 and see that you are getting a refund. Next on your tax-paper pile is another form. Oh, yeah – it’s the $6,000 you earned in April of the previous year from your side job during Masters Golf Week working at Augusta National. You enter the $6K in from Box 7 of the 1099-MISC form and see a chilling change. That tax refund is now a bill due. What happened?
First, Realize That “Income” Is Taxed
It’s great to receive money. Your paycheck, holiday cash, rebates, dividends from stock your grandma bought a decade ago, a quarter at your feet. However, the money you earn today becomes part of your earnings this year and starts a “tax-owed” tab. Some money, like gifts or life insurance proceeds, aren’t taxed. But money you earn by working (or by having your money work for you by earning dividends) is taxed.
Second, Understand the Process When You Are a Regular Employee at a Job
When you earn income at a job where you are a regular employee, your employer takes care of many of the tax issues surrounding your income. There are two main types of tax burdens are:
Income taxes as a regular employee
Our Federal government taxes workers on the money they earn. Most state governments do, too. These taxes go on the Form 1040 (and the comparable state tax form) and with that form comes different deductions and credits that can help you reduce your taxable income. With each paycheck, your employer withholds (puts away for you) and sends to the IRS an estimated amount that goes to your annual tax bill. If your employer didn’t pull out these taxes for you, you’d have to do it yourself and send “Estimated Tax Payments” to the IRS because that revered entity is not going to wait until the next year to get its financial pound of flesh. As an employee, it’s no sweat because as much as you hate seeing your smaller paycheck, you are spared the hassle of sending income tax money to the IRS and your state government throughout the year.
FICA taxes as a regular employee
In addition to paying income taxes, our tax system requires that people who earn money pay into the Social Security (income when you’re old) and Medicare (health insurance for the over-65 crowd) systems, as mandated by the Federal Insurance Contributions Act. These taxes, commonly known as FICA taxes, are in addition to income taxes. The total tax rate for FICA taxes in 2020 is 15.3%. As a W-2 employee, you only owe half of that or 7.65% (6.2% goes to the Social Security fund; 1.45% is for Medicare) because your employer pays the other half (the other 7.65%, broken down the same way). Have you ever looked at your W-2 and felt depressed at how much comes out for FICA taxes? You have income tax coming out plus FICA tax. For example, if you earned $50K, your annual paycheck was reduced by $3,100 for Soc Sec and $725 for Medicare or almost $4,000, as well as being reduced by another $6,000 or more for Federal and state income tax. Unlike the income tax discussed above, there is no way to possibly reduce or have a lower rate of what is due on these FICA taxes. (Note: Another term for FICA tax is “Payroll Tax,” a term you heard during Covid-19 relief discussion.)
Third, See the Difference When You Are a Contract Employee, Freelancer, or Gig Worker
Income taxes for contract workers
In contrast to your regular paycheck, when you earn money as a non-employee, the “paycheck” you see has none of the FICA or income tax reductions you’ve grown accustomed to in a W-2 paycheck. You get all that money upfront, which is great! Until tax time. At that point, you have to pay the taxes. As a freelancer or contract worker, you still use the Form 1040 to do it, and it gets added in the same area as the W-2 information.
Do you have to pay those income taxes ahead of time the way you do with W-2 income? If you don’t earn a lot at your non-employee, 1099 job, you will probably be ok in not sending in tax payments ahead of tax filing day; however, since your employer isn’t withholding income tax and sending it to the IRS for you, if you earn a lot from your contract job, you’ll need to make those estimated payments yourself, either by check or electronically through the IRS’ EFTPS system. Think about it: our Federal government, through the IRS, wants to collect money all the year workers are making it, not just a lump sum of it the next April 15 almost a year later. That is why W-2 earners have taxes come out each paycheck and why 1099 earners maybe need to pay in taxes over the year. Another thing to be aware of is that from an income tax standpoint, you’re not going to have to pay a higher income tax rate on 1099-MISC income than you would on W-2 income, but if you earned mostly W-2 income and had a side job with 1099-MISC income, it will pop your tax bill up into an unpleasant surprise if you had not sent in tax payments ahead of time.
FICA taxes for contract workers
FICA taxes as a non-employee can be even more financially devastating than income taxes. As a 1099-MISC employee, you have to pay both halves of the 15.3% FICA tax because in essence you are your “own employer.” You will owe 15.3% of what you earned on that 1099-MISC in FICA taxes which are in addition to income taxes. On that $6,000 example we’ve been using, that’s $918 of FICA tax you have to pay in addition to the income tax, which will vary based on your total amount of earnings that year. One good thing is that you get to subtract half of that FICA amount later in the tax return (after you’ve calculated your AGI), which helps to reduce your tax burden but doesn’t completely eliminate the surprise that most 1099-MISC earners get when they see what they owe in taxes.
To figure out your self-employed FICA tax, you do a special tax form within the Form 1040 for this. It is called Form SE. If you earned $50K as a contract employee with no W-2, your 1099-MISC “paycheck” will effectively be reduced by $6,200 for Soc Sec and $1,450 for Medicare or almost $8,000. Although you can use half of those taxes as “business expenses,” you are still going to have a bigger tax bill than you may have realized you were going to have. As a tax preparer, I’ve run into this situation with clients, and it’s a hard conversation to have when I explain what they owe in taxes. One bright spot (well, not really “bright” but less dark than no options) is that taxpayers can set up payment plans with the IRS if they can’t pay a surprise high tax bill.
Conjuring Trick and More Confusion: Flourish of the Handkerchief and 1099-MISC Magically Becomes 1099-NEC!
Remember when you had to read selections from Dante’s Inferno in high school? That poem where Dante and sidekick Virgil head to Hell for Spring Break? They trek down through nine subsequently more sinful rungs: Limbo, Lust, Gluttony, Greed, Wrath, Heresy, Violence, Fraud, and Treachery. I’m not sure if I place the TCJA (Tax Cuts & Jobs Act of 2017 aka Trump admin tax reform) in the eighth or ninth circle, but changing the already-fraught-with-confusion Box 7 of the 1099-MISC to Box 1 of the brought-back-from-the-dead 1099-NEC fits some (infernal) where. What’s the deal?
Direct from the IRS website: “File Form 1099-NEC, Nonemployee Compensation (NEC), for each person in the course of your business to whom you have paid the following during the year: At least $600 in: 1) Services performed by someone who is not your employee (including parts and materials) (box 1); 2) Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the trade or business of catching fish (box 1); or 3) Payments to an attorney (box 1).”
There has got to be a joke that Box 1 of the NEC is for workers, fish, and lawyers. I’ll start: An Uber driver, a tilapia, and a lawyer walk into a bar...
The takeaway: in 2020 after, you will get a 1099-NEC if you normally would have gotten a 1099-MISC, and you’ll use the amount in Box 1 of the 1099-NEC the way you used to use the info in Box 7 of the 1099-MISC.
Example of Income and Expenses for 1099-MISC/NEC Income
What happens to your tax bill when you earn 1099-MISC income (now 1099-NEC)? The simple answer is that it usually increases it unless you have substantial expenses that reduce the income. You can read more about Schedule C, the business tax form that is part of your 1040, here.
Let’s compare a contract worker at the Master’s golf tournament who earns $6,000 (Susan) with a person who earns $6,000 from raising chickens and selling eggs (Lavern). Susan has no expenses for her week of work: she lives 2 miles from the National, didn’t need any special clothes, and couldn’t even take her cell phone in. Lavern has all the expenses from the chicken coop, animal care, and food plus the miles she drove to deliver the eggs and the cost of the cell phone she uses just for the business (she tried using her personal cell and expensing just a portion, but the calls came at wacky times!)
When Susan adds that $6,000 in and tells the software to hook it to Schedule C, she has no expenses to reduce it. Lavern has $4,000 in expenses that she enters on Schedule C, and that reduces her income to $2,000, which means that Lavern’s $6,000 will have less of an impact on her tax bill than will Susan’s $6,000.
The Earned Income Credit
I feel like a short discussion of the Earned Income Credit (EIC or EITC) is important here because in the case where a non-employee earns under a certain amount and is within a certain age range (if you have no dependent kids, you need to be at least 25 years of age or under 65), the EIC helps ease the tax burden by providing a bit of a credit (Read more about the EIC here).
Without going into too much technical detail about where things get subtracted on a tax form and what is “refundable” and “nonrefundable” credit, the EIC is money you get even if your taxable income is zero. It’s a way the government tries to give low earners a little financial boost, and it can be used by W-2 earners as well as 1000-MISC/NEC earners.
What about expenses? If you are a W-2 employee, TCJA pretty much takes away the ability to deduct job-related expenses. As a contract employee who is engaged in business, you can deduct business expenses. You use Schedule C to report reasonable and actual expenses that will reduce taxable income. I am working on an article to explain Schedule C and will post the link here when I’m done. Meanwhile, you can read more here.
If you work and earn money, you’ll have to add it to your income tax Form 1040. If you work for an employer and get a W-2, your income and FICA taxes will probably already have been reduced and the money sent to the correct tax authority. If you are not an employee and are paid in ways other than the W-2, you owe income and FICA taxes that can add up to a surprising amount. If you can pay ahead as you through the IRS EFTPS system, it can be less of a burden. If you wait and have a big tax bill you can’t pay, check out the IRS’ payment plans, which can help you stretch out payments to a more affordable amount over time.
Remember, even if you have to pay taxes, it’s on money you earned, which is money is your pocket. Having $6,000 minus taxes is better than having $0.
Kathryn Hauer, a Certified Financial Planner™, adjunct professor, and financial literacy educator has written numerous articles and several books including the “11-Step, DIY, Comprehensive Financial Plan Workbook” and “Financial Advice for Blue Collar America.” She works to help clients and readers understand and act on complex financial information to keep them and their money safe. She functions as a strong advocate and guiding light for her clients as they move through a murky and unfamiliar financial world. Learn more at her website.