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When you first start working on the side, it’s fine to just get paid as a contractor. You get the checks, deposit them into your personal bank account, and you make your quarterly estimated taxes.

Eventually, however, you may need to set up something more substantial to make sure you are making the most of your deductions and not paying more taxes than you need to.

Below, I’ll explain what you can do to reduce your taxes as a side hustler and when you may want to do things differently, such as incorporate and take business income deductions.

How to Minimize Your Taxes as a Contractor

But First:  Why Are You Called A Contractor ?

In it’s simplest terms, a contractor, or Independent Contractor, is someone who is not an employee yet provides some sort of service in exchange for payment.

A freelancer is a contractor.  Most side hustlers are contractors.

And, If you’re a contractor, you are self-employed and therefore your earnings are subject to Self-Employment Tax.

Which brings me to the following ways to minimize your taxes.

Maximize Your Expenses

When you’re a contractor, and you make more than a certain amount from each side gig ($600.00 in 2018), each company you work for will send you a 1099-MISC. It’s a tax form that explains how much you earned in a tax year.

It looks like this:

When you go to fill out your taxes, you’ll put that income down in your tax form Schedule C, Profit or Loss from Business (Sole Proprietorship). This is a vital form to reducing your taxes as a contractor.

The Schedule C form looks like this:

You put in your income, deduct your expenses, do a little math and then the profit (or loss) will flow through to your Form 1040 income tax return.

To reduce your taxes as a side hustler, the key is to maximize your expenses. This means keeping close track of everything you spend related to your business as an Independent Contractor and making sure you have proof so you can deduct them safely.

Common Expenses You Can “Take”

Part 2 of the Schedule C even lists out some common expense categories like Advertising, Office Expense, Pensions, Repairs and Maintenance, etc. Most of these expenses are self-explanatory so I’ll let you Google them for more details.

There are some expenses that you can take that are not listed on a Schedule C, not often realized by people who work from home. The main one has to do with retirement plans like an IRA, Solo 401(k), SEP IRA, SIMPLE IRA, etc. If you have a day job, you may be familiar with a 401(k) and how your contributions reduce your taxable income. The same applies to Solo 401(k) programs too. In fact, they share the same contribution limits.

Always Section 179 Deduct Your Eligible Expenses

When you buy equipment for your business, say a new computer for your online transcription job, you have the option of deducting the equipment this year or spreading it out over many years.

Section 179 allows you to deduct tangible personal property in the single year as long as it satisfies certain conditions. The rules become complicated for larger businesses buying bigger pieces of equipment, but for most of us the rule applies to practically anything we buy. Just as an example, the annual limit for the total you can write off under this is a million dollars. 🙂

Where it gets a little trickier is if you use this to purchase a car for your business, since cars are considered equipment. The biggest rule is that a piece of equipment has to be used for business purposes more than 50% of the time. You’ll have to keep track of all the miles of the car and make sure you’re using it for business at least half the time. It also has separate limits, which are $10,000 for vehicles up to 6,000 pounds and $25,000 for vehicles over that size.

Don’t Be Afraid of the Home Office Deduction

The home office deduction is often held up as a red flag for an IRS audit.

If you have a home office that is solely used for business purposes, don’t be afraid to deduct it! I’ve been taking the home office deduction for years and it has never caused problems for me.

And now there’s an even safer way to claim this deduction with their simplified option. With the simplified option, you can claim $5 per square foot of home office up to 300 square feet. The regular method involves calculating the percentage of your home being used as a home office and then claiming actual expenses, such as heating, cooling, etc.

One advantage of the simplified option is that there is no depreciation deduction and no depreciation recapture on the sale of the home.

When Should I Incorporate?

You can always incorporate into a limited liability company to help separate your business finances from your personal finances. If your side hustle involves being a delivery driver on the side to earn some extra spending money, you may not care to go through the trouble or cost of incorporating your business.

If, however, you plan on building a business that you may wish to do full-time in the future, like becoming a Virtual Assistant – incorporation may make sense.

The steps to starting a business are very simple:

• Get an Employer Identification Number
• File Articles of Incorporation with your state
• Open a business bank account
• Profit!

As you can see, the steps are easy and straightforward.

In most states, if you incorporate your business then you’ll have to file an annual tax return. In Maryland, it’s called a Personal Property Return and has a minimum $300 annual fee! As you can see, it may not be worth incorporating if you’re just making a little extra cash on the side. No one wants to pay $300 for no reason!

If your business becomes more substantial, incorporating gives you the option to have your LLC be treated as an S Corporation. An S Corporation is a separate entity, whereas the LLC with a single member is a disregarded/pass-through entity. As a separate entity, your business can now start paying you a salary.

When you are an LLC and the income passes through, you’re subject to self-employment (SE) taxes. This can be a real killer if you aren’t prepared for it.

What are self-employment taxes? Well, if you have a day job, check your pay stub. It’ll have your pay, a few deductions, and then what’s known as FICA. FICA covers Medicaid and Social Security. When you work for a company, they cover half of FICA and you cover half. When you work for yourself, you are the company so you pay for both and it’s called self-employment taxes.

Ask for S Corporation Tax Treatment

You can ask the IRS to treat your LLC as an S Corporation and then pay yourself a “reasonable” salary. Whatever the company earns that isn’t paid to you as salary can be disbursed to you as a distribution as an owner withdrawal. That owner withdrawal is not subject to FICA and that can represent significant tax savings.

Another advantage of incorporating your business is that if one day in the future you decide you want to invest your business profits into some passive income streams, you could do so with this entity and it offers you some liability protections.

The IRS tells us this:

To qualify for S corporation status, the corporation must meet the following requirements:

1. Be a domestic corporation
2. Have only allowable shareholders
May be individuals, certain trusts, and estates and
May not be partnerships, corporations or non-resident alien shareholders
3. Have no more than 100 shareholders
4. Have only one class of stock
5. Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

20% Qualified Business Income Deduction

Finally, make sure you are aware of a recent change to the tax code as a result of the Tax Cuts and Jobs Act. It offers up a juicy 20% “qualified business income” deduction. This is available for all businesses from sole proprietors to partnerships to S Corporations.

If you’re a domestic business that doesn’t exceed the income thresholds and not considered a specified service trade or business (SSTB), you’re generally qualified.

An SSTB is a business: “involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The principal asset of a trade or business is the reputation or skill of its employees or owners if the trade or business consists of the receipt of income from endorsing products or services, the use of an individual’s image, likeness, voice, or other symbols associated with the individual’s identity, or appearances at events or on radio, television, or other media formats.”

This doesn’t apply to most side hustle types of work so you can usually reduce your income by a significant amount with this deduction.

Conclusion

Taxes can often be very complicated but once you understand the various steps at a very macro level, it’s actually not as scary as it first appears.

I hope this guide can act as a starting point for more research and if you ever have questions, please don’t hesitate to ask!

Jim Wang has been writing about personal finance for over 15 years and currently resides at Wallet Hacks, a blog where he shares his strategies and tactics for getting ahead financially and in life. The Wary Worker is a great blog for finding your next side hustles, and help separate the good from the bad, and Wallet hacks can help you set up your financial world to best take advantage of those opportunities and make better money decisions. We have a free newsletter and you can sign up for it here!