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Taxes for independent contractor vs. corporation

Dear Tax Talk,
I started working as an independent contractor in February of 2005. I am not sure what taxes I have to pay.

Should I register as a corporation, and do I get any tax benefits by doing so, or should I continue to be an independent contractor? Thanks for your help. -- Ravi

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Dear Ravi,
As an employee, you have your taxes withheld by your employer and that is pretty much all you need to do for the year. As a self-employed person, you are responsible for your own taxes, which means you have to pay them to the Internal Revenue Service directly.

In addition to owing income tax, self-employed individuals pay self-employment tax on their net earnings. Self-employment tax is 15.3 percent of the net earnings and is computed on Schedule SE. Your earnings less expenses are reported on Schedule C. Certain additional expenses allowed to a self-employed individual are considered adjustments to gross income on page one of Form 1040 and therefore do not reduce your self-employment tax. These adjustments include health insurance, pension contributions and one-half of your self-employment tax.

You need to estimate your taxes for 2005. You can do this based on 100 percent of the tax you paid for 2004 (if you had high income in 2004, you might have to estimate higher), or based on 90 percent of the tax you expect to owe for 2005.

Traditionally, you would remit one quarter of your total tax as estimates to the IRS on a somewhat quarterly basis: the 15th day of April, June, September and January of the following year. You would use Form 1040ES to remit the payments. Depending on your cash flow, you may want to make more frequent payments to the IRS to avoid owing a large amount quarterly. You can either send in additional Form 1040ES coupons or, if you prefer, you can register to pay your taxes online at www.eftps.com. The Electronic Federal Tax Payment System Web site is free to register and use. It's also beneficial as it keeps a history of all your payments within a certain period of time.

The incorporation decision depends on several cost factors. You can probably set up a corporation for less than $500. You also have to measure the annual cost of maintaining the corporation, such as licenses, separate bank accounts, additional tax filings, your volume of sales and the likelihood of its continued existence. You also have to look at your state's tax situation. I wrote more about incorporating in a previous column on Bankrate.

Bankrate.com's corrections policy-- Posted: May 6, 2005
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