From W2 to 1099: Free Agents and Taxes
by Alyson Preston

Making the transition from full-time employment to work as a freelancer, free agent or consultant involves dealing with Uncle Sam. You need to be prepared to take over several tasks previously handled by your employer, and you’ll want to make sure you have all the facts on tricky business-related deductions.

Your employer will no longer be withholding taxes for you, which means you have to calculate and pay them yourself. And even though you still have to fill out the requisite Form 1040 before April 15, the similarities between an employee’s and an independent contractor’s taxes end there.

Each tax year, employees receive Form W2, detailing their income and the amounts the employer paid out for federal, state, Social Security and Medicare taxes. Independent contractors, on the other hand, receive a Form 1099-MISC from every organization that paid them $600 or more during the tax year. No taxes are withheld, and independent contractors are responsible for paying estimated quarterly tax payments.

You can calculate these payments by entering up-to-date payment information into a tax software program such as TurboTax or TaxCut. The IRS also offers guidelines for estimating tax payments. Staying current with these payments is essential, since there are penalties if you underpay.

Self-employed individuals also have to pay their own Social Security and Medicare taxes, another obligation traditional employees don’t have to worry about. Use Schedule SE to figure out what you owe. Half your payments are deductible from your adjusted gross income.

You can also take a deduction for using your home for business. But consider these important factors before deciding. First, you must use your home office "regularly and exclusively" for work. Your home office doesn’t have to be a room -- a dedicated space will do -- but it can’t double as a homework station, bill pay area or anything else. You must also do the bulk of your work in your home office. You cannot take the home-office deduction if your business takes a loss in the same tax year.

To calculate the home-office deduction, divide your home office’s square footage by the square footage of your whole house. You will then be able to deduct that percentage of your home’s expenses from your business income. You can deduct a percentage of your mortgage or rent payment, real estate taxes, any utilities, repairs and maintenance. The deduction is taken on Schedule C, Profit or Loss From Business (Sole Proprietorship).

You may be able to claim an allowance for the wear and tear on the business-use portion of your home, known as depreciation. For this you will need to know your home’s purchase price, the amount of money you’ve put into it for improvement and the fair market price. Another thing to bear in mind is that if you end up selling your home, you cannot exclude the gain or loss on the home-office percentage of the sale. Under current law, you can exclude up to $250,000 of the gain from your taxes or $500,000 for certain married couples filing jointly.

Save receipts for any business-related expenses you incur, including equipment, furniture, dedicated business telephone line, Internet access charges, travel, office space and insurance. These expenses are deductible on your Schedule C and will reduce your tax liability.

If you use your car in your work as an independent contractor, you can deduct tolls and parking (excluding any fees incurred while parking at your place of work). You can also deduct $0.325 per mile (for tax year 2000), or alternatively, any actual expenses you incur, such as oil changes, repairs and others.

Independent contractors can deduct a percentage of the interest paid on a car loan based on how much they use the car for business purposes. Automobiles depreciate over time, and there are stringent rules about how depreciation affects allowed deductions and additional forms to use in certain situations. Independent contractors take the business portion of their deductions on Schedule C and the remaining portion on Schedule A.

You may be able to deduct up to 60 percent of your health insurance premiums if you are self-employed. The deduction only applies if you are not eligible for benefits through an employer plan or a spouse’s plan. You can also deduct a portion of your dependents’ premiums. Calculate whether you are eligible on your Schedule C.

Read the Schedule C instructions and consult with a tax professional if you have any questions or concerns about making estimated quarterly tax payments or taking any of these deductions. Many situations require additional forms.