How Do Independent Contractors Calculate Net Pay From Gross Fees?

People generally become independent contractors because they want to be able to control their schedules, time, and projects. But how do you handle it if they come to you and ask how they calculate their net pay because no taxes have been taken from their contracted fees? If an independent contractor comes to you questioning their correct tax responsibilities:

• Suggest they contact a professional tax advisor
• Tell them they must pay both the employee and employer Social Security and Medicare taxes
• Encourage them to check into their state and local tax requirements

When you think about this challenge, recognize that this conversation can put you and your company in a challenging position. Unless you are in the business of providing tax advice, you don’t want to give the perception that you are qualified to provide it. Even so, let’s look at some basics that independent contractors need to know.

Medicare and Social Security taxes

When someone decides to become an independent contractor, they often are focused on the upsides of the prospect. Few understand that they are responsible for paying not only the employee portion of Medicare and Social Security tax, but also for the employer’s. According to the IRS, the 2022 combined deductions are 15.3%, and the deduction rates cap out at $147,000 and are calculated at:

• Medicare: 2.9% (1.45% for each the employee and employer portion)
• Social Security: 12.4% (6.2%*2 to pay the employee and employer’s contributions)

There is a caveat. When the contractor’s annual income exceeds $200,000 or more ($250,000 if married and filing jointly, or if filing separately, but married, $125,000), the Medicare tax incurs an additional .9% on everything earned about that amount.

Deductions matter

Before an independent contractor can determine what income number to use for their Medicare and Social Security tax calculation, they first need to figure out their business’s net profit or net loss. The IRS site says, “Before you can determine if you are subject to self-employment tax and income tax, you must figure your net profit or net loss from your business. You do this by subtracting your business expenses from your business income.” Let’s take a scenario of someone in today’s “gig” economy who functions as an independent contractor by using their car as their office. They offer ride-share, deliveries, or messengering services. Their deductions could include items such as:

• IRS mileage deduction: 58.5¢ per mile for 2022
• Office supplies
• Health deductions
• Fees for operating payment collection services
• Increased insurance rates
• Work-related training classes

There’s much more, but a tax advisor could get to the bottom of a comprehensive list.

Before an independent contractor can determine what income number to use for their Medicare and Social Security tax calculation, they first need to figure out their business’s net profit or net loss.

Even so, say this driver started off with a first-quarter (January 1 – March 31) income of $7,200. But then, when the legitimate deductions were applied, found that the actual taxable income was $6,480. What would that mean aside from the fact that they found $720 in deductions? Remember … there’s also the Federal personal deduction! The site says that:

• “For heads of households, the standard deduction will be $19,400 for tax year 2022.”

So, $19,400 ÷ 4 = another $4,850 in quarterly deductions. Now the first quarter’s projected taxable income is $1,630. Now, let’s look at the numbers.

An example

Continuing on with our driver example, if this contractor made $1,630, after deductions, in the first quarter of the year, they would be responsible for:

• $1,630 * 2.9%=$47.27 in Medicare tax
• $1,630 * 12.4%=$202.12 in Social Security tax
• So minimal quarterly tax filing is $249.39 (15.3%)

This is not the same as the contractor’s income tax, though. Income tax is calculated based on the projected annualized income at the Federal level and various rates at local and state levels. In keeping with the same example, this contractor’s projected annualized taxable income would be approximately $6,520. According to the IRS’s 2022 tax table, the federal rate for an individual is:

• The lowest rate is 10% for incomes of single individuals with incomes of $10,275 or less ($20,550 for married couples filing jointly)
• $6,520*10% = $652 ÷ 4 (quarters) =$163

So that would be an additional $163 for the first quarter’s projected Federal income tax. This is where it starts to become clear that having a plan to save for quarterly tax payments is critical. So far, without considering state or local income taxes, the contractor’s estimated quarterly tax bill is:

• $47.27+$202.12+$163 = $412.39

If this particular contractor decides to set aside $68.75 on the 15^th and the last day of each month, they will have their tax savings ready. They won’t have any headaches on filing day.

What does the business do when the contractor has questions?

In today’s environment, your company will likely work with professionals who are new to being independent contractors. Be proactive. We have provided you a high-level understanding of what the contractor needs to be prepared to pay. Still, we also suggest that you create a resource sheet that has:

• A disclaimer included in the contractor hire paperwork that clearly states that the contractor is responsible for their own tax deductions and payments
• The IRS links we’ve provided in this article
• A list of local, reputable tax professionals who can provide guidance

This will let you be helpful and seen as a great partner without placing you or your company at risk of giving tax advice.