Mid-Year Tax Check-Up:
Employee or Self-Employed?

This Friday, June 30, is the close of the 2nd Quarter of the tax year, and I remembered that there was a topic which I wanted to revisit. The second quarter is an appropriate time to revisit such a topic since estimated tax payments are due, once again. For those that might not realize they are in a bind, I imagine that it is better to find out you are in a bind in the 2nd Quarter, rather than the 4th Quarter. Unfortunately, all too many people find out in the 4th Quarter and find themselves in what seems to be a never ending tax crunch.

So, what is the issue that I am alluding to? That of the Independent Contractor, who may even believe that he/she is an employee and naturally was having taxes withheld, only to find out, at the end of the year not less, that he is actually self-employed, has not had a penny of taxes withheld, and now owes the unavoidable self-employment taxes (15.3% in addition to any marginal taxes owed), yet has never set aside money to pay the taxes.

If you don't think this topic is Orthonomic, I beg to differ. If I had the power to institute any changes in the general side of the Yeshiva or day school education, conveying basic financial information, including basic literacy about taxes, would be one of those changes.

If I had to venture a guess, I would imagine that more people in the Orthodox world than in general society are self-employed/independent contractors. It seems if a family member is not fully self-employed, they run a small business on the side of their full time employment either selling a consumable or selling a service. Robes, hats, sheitals, tzniut clothing, buying/selling airline miles, catering, brit milahs, tutoring, counseling, life coach, flipping enough real estate that you exit the world of capital gains and enter the world of self-employment, etc, etc, etc. . . . . you name it, your neighbor is probably selling it!

I even substituted at a day school for a few days recently, only to be handed a W-9 to fill out, rather than a W-4. So, even though I expected to be paid as an employee (and believe strongly that I should have been paid as an employee), I found I was self-employed. (Note to self: find out which administrator or board member came up with this brilliant and nearly indefensible way of paying subs).

Time for Some Definitions

Social Security Tax: This tax, instituted during the Roosevelt Administration is the 1930's, funds the pension and other benefits known as "Social Security." Social security is paid on every dollar earned. For employees, half of the social security tax (7.65%) is paid by you and comes out of your paycheck and half is paid by your employer (another 7.65%). Those who self-employed must shoulder the entire burden of the social security tax and must pay a 15.3% self-employment tax on their profits.

Federal and State Income Taxes: By contrast, federal and state income taxes are NOT paid on every dollar of tax earned, as these taxes are subject to numerous deductions and credits.

Myth: Unfortunately, there are many (self-employed) people that mistakenly believe they owe no taxes because they are eligible for certain welfare benefits including the Earned Income Credit (EIC) that funnels through the IRS. They are sorely mistaken. Even those who are eligible for the EIC can owe taxes. As I said before, the self-employment tax (or social security tax) is completely unavoidable, no matter what government programs you are on!

Self-Employed or Employee?: There are 20 tests to determine if a worker is a worker is self-employed or an employee. A self-employed/independent contractor generally sets their own schedule and provides their own equipment and office. In short, an independent contractor is running his/her own business and is calling the shots. Once the client starts calling the shots (e.g. come into the office on these days between these hours), chances are the client is an employer.

Unfortunately, many employees are paid as contractors, which means that not only are they responsible for their own social security tax, but they are not eligible for whatever benefits a company might offer (paid vacation and sick leave, 401k matching, health insurance, etc). Above I mentioned a case where I was clearly an employee, but was paid as a contractor. I was told the days and hours I needed to come in. I was provided with the equipment to do my job. I was subject to the rules of the employer. Basically I got the short end of the stick. Fortunately, I only was needed for a handful of hours, or I have probably brought this issue beyond my discussion with the secretary in the front office.

Schedule C: The form one needs to file with the 1040 tax form. The Schedule C allows the self-employed to record all income, inventory, and expenses to come to the actual profit figure, according to the IRS Code.

W-2: The form an employee receives at year end from the employer showing how much was earned for tax purposes, social security/Medicare purposes, and how much was withheld in federal and state taxes.

1099: The form an independent contractor receives at year end from the client or employer showing how much was paid. The amount paid is not the actual profits, assuming the contractor incurred expenses, which he most likely did as a contractor. A schedule C is used to show the profits.

Conclusion:

If you find out that you are being paid as a contractor, when you assumed (maybe rightfully so) that you are an employee, speak to an accountant immediately. You don't want to fall behind in your tax obligation. The 2nd Quarter estimated payment is due on July 15, 2006.

You also will want to start figuring out what expenses can lower your profit legally, and you will need to start collecting any receipts to compile a spreadsheet of expenses.

Lastly, if you are being paid incorrectly (by an employer), you need to find out the appropriate way to approach your employer and your situation to have it rectified (I can't advise you here). If you are being underpaid for your work, now that you have discovered that you are responsible for another 7.65% in social security tax (the employer's half of the social security tax), you may want to negotiate for a higher wage.