Life On Contract: Hacking Your Taxes

You’re a contractor and people are paying you to work in your pajamas. It’s a life of luxury, but when tax time comes, you are in a world of hurt and you wonder why you even do it. Taxes are tricky, but there are some tools you can use to make it less painful on your pocketbook. With planning and diligence, you can significantly increase the amount of money that stays in your bank account.

We are not certified tax lawyers or accountants, so take what follows with a heap of salt, consult appropriate people before you do anything big, and don’t blame us if you get in trouble for anything you do. Also, this advice applies to the United States. If you know some tricks for your country, we’d love to hear them in the comments.


Contractors can do all their work as a person. The company to whom you contract will get your SSN, then submit a 1099 form to the IRS that says “We paid this person $N in this year.” This is easy, there’s very little paperwork, and lots of people do it. However, there are a lot of good reasons why you would be better off incorporating as an LLC and having all your work done through your own business. The biggest reasons are liability and debt. Essentially, if someone sues the LLC, the worst that can happen is you lose the business. Also, if the business runs up debt and then goes bankrupt, the owner doesn’t lose their personal assets. There are lots of caveats to this; if you have to personally cosign a bank loan, for example. Banks aren’t just going to give an LLC a pile of cash without a way to guarantee that they get repaid.

There is a term called “piercing the corporate veil,” which means that in some cases the courts can determine that the LLC is just a shell and you can be sued personally or have your assets seized. This is why it’s important to set up a separate bank account, business cards, a web site, and every other measure possible to show that the business really is a business.

The bottom line is that if you are doing work for someone, then you want to set up a corporation to protect yourself. Setting one up is easy. It’s done through your state’s office, which is usually the Secretary of State, and involves an online form and up to a couple hundred dollars to file (plus a yearly fee to renew). It can be done in an hour or less. Note that in California LLCs have to pay a yearly fee of $800, so if you’re a casual contractor, this is a steep fee. In other states it’s much less. Next you would go to the IRS web site and file for an EIN. This is an online form that takes approximately 3 minutes, and results in an email with your EIN, the number used to identify your business to the IRS.

Next, go to the bank and open up a business checking account. You’ll need the information about the LLC. Finally, buy your domain name, get business cards, and get in the habit of using your business email for all business.


Expenses are an extremely powerful tool in saving money on taxes. In the course of doing business, you take your income, subtract your expenses, and that’s your profit, which is taxed. If you can increase your expenses, then you have less profit that can be taxed. This includes rent for an office, communications (internet and cell phone), office supplies and equipment, travel for work, and a lot of other things that are important in your daily life as a contractor.

As I mentioned before, you should consider incorporating. If you are not incorporated you can still make deductions by filing your 1099 income, and unreported income on a Schedule C. Being incorporated covers more income than just 1099 and unreported work.

Individuals who are not incorporated and do not file a Schedule C may only deduct expenses on their Schedule A by choosing to “itemize” those deductions. But the IRS offers something called “the standard deduction” and if your itemizations are below that threshold, your expenses won’t be counted individually; those expenses don’t help reduce your tax burden.

If you have an LLC, then you can subtract the expenses from the income directly, so that what flows down to you already has the expenses deducted, reducing your taxable income. You will still be able to take the standard deduction in addition to this; it’s your business deducting expenses and you as an individual taking the standard deduction. In other words, having an LLC means you can lower your tax burden more by taking advantage of expenses.

All of these tools are legitimate business expenses.

You can expense a lot more than you think, and it’s important to keep track of it as you go. Every trip you take in your car can be expensed at 53.5 cents per mile, so keep a record of each trip. If you use a room in an apartment for your home office, then the fraction of your apartment’s square footage that is used for the office counts. Your smartphone’s cost and plan are a business expense, as is your internet and computer, and any other equipment you use for your business (like your oscilloscope). You shouldn’t take this too far, though; fraud is illegal, and the IRS gets very unhappy if you try to expense all your food, vacations, and other things that can’t be justified as a business expense. These are expenses for the business, not for your hobby or personal use, so if you use something for both business and personal, you must only count the fraction that is used for business. The IRS probably isn’t going to audit you, but if they do then you want to be able to defend the numbers you gave them.

For all expenses, make sure that you use your business bank account and keep studious records like receipts and mileage logs.


If you work at a corporate job, you may have benefits like health insurance, a 401k with matching, and other perks. As an LLC you can do the same thing, and many of those are expenses that aren’t taxed. Your LLC can pay for your health insurance, or if not then you can deduct the cost of your health insurance on your 1040 if you are self-employed. It’s also possible to set up a solo 401k plan, which lets you contribute towards your retirement, and it lets your LLC contribute to it as well.


All income should be made out to your LLC and go directly into your business bank account. Invoices that you send to your clients should have your business name on them. Make sure that the invoice includes any appropriate taxes. If you don’t collect taxes from your client, you’re still responsible for them, and it eats into your margins. Every year (assuming they pay you more than $600), your clients will have to give you a 1099 form, which says to the IRS “We paid this company $X.” Make sure that the 1099 uses both your business name and the EIN associated with your business.

Paying Yourself

Normally all the net income would flow through to your personal return. You will pay income taxes plus self-employment taxes on this income. Self-employment taxes are the medicare and social security taxes that would be automatically withheld at a normal job, and you can’t escape them by being self-employed. You should definitely be budgeting for these taxes, and you’re supposed to pay the IRS quarterly estimated tax payments. This is one reason why contractors must charge a lot more per hour than what they would make in a salaried job.

There is a neat thing that you can do if you made a decent amount of money, though: the IRS lets you file a form (2553) that allows you to elect for S-Corp taxation. This allows you to get paid two different ways; as a salary and as a distribution. Distributions are not subject to self-employment tax. So if your LLC brings in $100k, you can pay yourself a decent salary like $60k, and pay self-employment and income tax on that, and then give yourself a distribution at the end of the year of $40k, and pay only income tax on that. You have to pay yourself a salary that’s reasonable for your industry, so you can’t avoid the self-employment tax entirely, but this is a great way to avoid having to pay self-employment tax on ALL your income.

Final Notes

There are lots of ways to set up your contracting business so that you can save some money. They’re not especially difficult, and none require a lawyer. Learn about the terms hastily mentioned above and find out if they are appropriate for you. Talk to an accountant. Have them do your taxes for you for the first year and after that if it’s especially messy. They will save you more than they cost, so it’s to your benefit, and the more diligent you are with record-keeping, the more you save.

Do not push the limits. You don’t get to claim that taxes are unconstitutional or that your weekend getaway to Hawaii was a business expense (you can go to Hawaii for training or a conference, but any additional time or activities must be clearly separated as a personal expense). Most likely you will file your taxes and the IRS will just accept them. But if something goes wrong or you push something too far, then you can lose the corporate veil, or the IRS can put you through a painful ordeal. It may not be a full audit, but if they have a question, it’s nice to be able to answer quickly and with certainty. Keep good documentation on your business vs. personal expenses for at least the past 6 years. The trick is to take advantage of opportunities to save, not to flaunt them.

37 thoughts on “Life On Contract: Hacking Your Taxes

  1. Great article. Another thing to consider is local licenses & taxes.

    If you “do the right thing” and incorporate as an LLC, your company may need a business license in your local jurisdiction (i.e. your county, city, township, etc.), and you may owe taxes in that jurisdiction to boot. It’s another set of things to keep track of, and a bit more money, but it can save a big headache down the road if someone notices that you haven’t done things correctly.

    Oh yeah, get yourself some liability insurance. It’s relatively cheap, and similarly can come in handy if anything should go awry.

    1. Yes, incorporate.
      I recommend that you actually get a lawyer/barrister and don’t just get a boilerplate from the web and fill it out.
      The lawyer might/should find other steps to take to protect yourself.

    2. Another big warning:

      In at least some states this may affect your ability to run a home business which services customers on-premises! Meaning that if you choose to incorporate and claim your house as your place of business you may be violating the local regulations surrounding your business license. I mention this because a family member has a business license in a region like this, and even having direct family members ‘on the payroll’ violates the terms of the business license (along with having more than 1 customer in a 1 hour period, or having signage of any sort identifying it as a business.)

    1. 1) You can’t “incorporate” as an LLC. An LLC is a limited liability company. You can “organize” as an LLC, then choose to be taxed as a corporation, but you can’t incorporate as an LLC. You either incorporate, or you organize as an LLC.

      2) LLC fee in CA is $800, but what about the gross receipts fee. What if you bring in a million dollars in gross receipts (income), but you know you’re going to have $950,000 on expenditures? Now you have a gross receipts fee of $6,000 as well. You’d have been better off being a Schedule C with no LLC.

      3) 2553 – If you are single person filing the LLC, you default to filing a Schedule C. For federal purposes it’s called a disregarded entity. That means they don’t care that you’re an LLC and all the rules of a sole proprietor apply to you.

      4) There are very few items that you can’t deduct on a Schedule C that you can on a corporate tax return. They follow almost exactly the same rules for deductibility. The biggest benefit is choosing to be an S-Corp then paying yourself a wage so that the rest of the profit is not subject to self-employment tax. But the rule is that it has to be commensurate with wages paid to someone doing that same work elsewhere. So now you have to pay yourself the wages, the payroll taxes to the Federal and State. It may now be more than if you would have just paid the SE taxes.

      5) “Piercing the corporate veil” – where do I start. In CA, that piercing can happen if you don’t follow every single rule of being an LLC. Didn’t take your minutes on that required meeting? Pierced. Paid for a personal item out of the corporate account and didn’t add it to your wages? Pierced. Maybe you even did add it to your wages, but if you get an aggressive enough lawyer, he can find that one thing you did not do. If you are single member LLC and didn’t file the 2553 election, you file a schedule C anyway and that is part of an individual tax return. How can you guarantee separation now?

      It really irritates me when I see these articles because I always have to sort out the mess that you create.

      1. Thanks for your feedback. I hope I can address your concerns and explain why I used the words that I did.

        1) Incorporation is a commonly used term for creating an organization structure. Since the C in LLC is short for Corporation, that’s what is happening here. In addition, I’m describing the benefits of creating a corporation as opposed to not, which could include an S or C corporation, so incorporation as a headline is appropriate. I don’t want to split hairs, but I do want to be as accurate as possible, and provide words that are easily googled to get people to find out more on their own.

        2) There are a lot of details that I left out in the interest of giving the most relevant information to the most people. California does not represent all readers, and I thought it worth mentioning that fees can change the balance and should be considered, but going into too many details that are relevant to a specific state would be doing a disservice to all the readers for whom it doesn’t apply.

        3) Yes… What did I say that conflicts with this? An LLC can file the 2553 to elect for taxation as an S-Corp.

        4) Yes… I pointed out that “you have to pay yourself a salary that’s reasonable for your industry, so you can’t avoid the self-employment tax entirely.” You can still take a distribution for anything above that, which isn’t subject to the FICA taxes. Did I miss something?

        5) That’s why I linked to another resource on piercing and why it’s important to do as much as you can to prevent it. I don’t see how what I wrote disagrees with your complaint.

        My intention was not to give the readers everything they need to be able to do this on their own, but to provide some general knowledge and terms and options they can research and discuss with their accountant, which I mentioned at the beginning.

          1. Whoop, you’re right about the expansion of LLC. Good thing I didn’t screw it up in the article, just in my hasty response. But the rest of what I said in the article is still correct.

          2. and the rest of the link … LLC is a corporate structure… The last part is why it’s confusing

            “Limited liability companies are essentially hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship.”

            A limited liability company (LLC) is a corporate structure whereby the members of the company cannot be held personally liable for the company’s debts or liabilities. Limited liability companies are essentially hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship.
            Limited Liability Company (LLC) – Investopedia

        1. 1) Limited Liability COMPANY

          2) You’re right about all readers, but you did specifically specify CA in your post, so I expanded.

          3) I don’t feel you addressed the NECESSITY of the 2553. It seemed more like an after-the-fact. I believe most people reading your article would think “I’m an LLC corporation and can pay myself to be so” where so much more is required.

          4) In CA and in may other states to be on payroll you have to pay FUTA, Employment Training Taxes, Unemployment Insurance, State Disability Insurance and now filing the tax returns for those taxes. It can easily be more than just paying SE taxes.

          5) When people read your article, they think they are listening to an expert, even though you say you’re not. You’re just this side of practicing law without a license. Many states have laws against this.

        2. You do realize that in the very middle of your article IN BIG BOLD LETTERS it says:

          “then you want to set up a corporation to protect yourself.”

          Right in the center. Big Image. Again confusing corporation and LLC. It really does show that you have a fundamental misunderstanding of the concept and should not be giving the advice.

          1. – I’d tend to agree – the article seemed to contradict my general understanding of what it takes to incorporate, and was more LLC based. Since you seem very well versed in this, a question for you if you don’t mind: – My understanding of an LLC is it is more to protect you from OTHER employee’s screw-ups, in that usually the person who made a mistake, and the company, can be sued for damages. If you are the owner of an LLC with no employees (contract work), they can come after the company, but then you personally and your assets also, since you personally are the one going to be causing damages, and not some other employee of your LLC. This is why I haven’t seen benefit to going LLC for a sole proprietor of contract work generally, but maybe I’m mistaken…

    2. Filing a Schedule C and paying the self employment tax is probably the best solution for most, especially if you don’t do a whole lot of business. Chances are you will probably spend more money hiring an accountant etc, paying lawyers, than if you just used the schedule c in the first place.

      The extra laws, accounting rules, and other things that you become subject to as an LLC or corporation are not worth it in my mind, unless you do sufficient business to warrant the extra overhead.

      Also, claiming part of your home for use in doing business is pretty much asking for an audit, as it is a big red flag to tax examiners; where there is smoke, there is usually fire…

      1. To clarify one point: The cost of hiring accountants and lawyers will easily outweigh the money you save by taking advantage of the corporate tax structure. Paying the self employment tax, while a bit more expensive at first glance, can easily cost you a lot less than all the other stuff combined, especially if you don’t do a lot of business. Run the numbers and check it out! For some it is worth the investment to set up a corporation or LLC, but for the weekend warrior who does PCB layout on his spare time and maybe helps with firmware for a couple places, the dollar amount of business isn’t enough to offset the overhead.

      2. The office-in-home deduction is not as big of a problem as it used to be. As long as you have a space, sole and separate for the business AND you do not have another place where you primarily conduct business, you can take the deduction. The IRS even has a more simplified method for taking that deduction, now.

    3. Mileage is another thing that you just made more difficult. LLCs taxed as Corporations and Partnerships are limited to taking “Actual Expenses”. You can have the LLC pay for the gas and take that as a deduction, but that is not all that “mileage” entails. To get the mileage expense from the corporation, you have to get reimbursed for your mileage. You have to get an actual check from the LLC after submitting a mileage log for the LLC records. You don’t have that step when you are Schedule C and then you can take “Actual Expenses” or mileage, whichever is greater if you meet all the criteria. As a Schedule C, you still need to keep a mileage log, though.

    4. Can you please elaborate?. What you are claiming, and to a lesser extent the article, are fairly new to me. My side business has been growing to the point where I might need to worry about some of this stuff. I am genuinely curious, thanks.

      1. While I am in no way qualified to give tax advice, my approach would be to run the numbers and ask myself the following questions; If it will save me some significant money to incorporate or organize, or I did a lot of stuff that has the potential to expose me and my assets to serious liability, it would make sense to take advantage of the protections and additional structure that being incorporated or organized would offer. Also, am I moving large amounts of money around frequently? that will draw attention, and I would want to be sure that i was able to account for where it went etc. This is how I would evaluate the situation… YMMV…

  2. For any Canadians reading, much of this article has a Canadian equivalent in practice if not in name. In other words, broadly speaking things will work similarly and for similar reasons, but be called different things.

    For those of you interested in starting a side business (or being self employed), the terms you want to look into are Sole Proprietorship (you and your business are one entity) and Incorporation. It requires very little to operate as a Sole Proprietor. Incorporation costs money and has added complexity, but brings benefits as well. Consult an accountant to understand whether and how incorporating would help you, but generally speaking: if you reach the point where you’re making more money than you need to operate, that’s a good indication that it’s time to talk to an accountant about incorporating (if you aren’t already).

    1. There’s a few more options available to Ozzies. You can register a company (accountants usually keep a few “on the shelf” which only require a transfer to your ownership and renaming, which is a bit cheaper than registering a new entity), register as a sole trader, or even set up a family partnership. The last one is a good way of combining two unequal incomes and being taxed on the average of the two. I’m a sole trader with a trading name and an ABN (Australian Business Number), which gives my business a legal entity for taxation purposes, without actually establishing a company with all the paperwork and obligations. The ABN is usually needed to establish trade accounts with suppliers, and it’s easy and cheap to set up as a sole trader.

  3. Do they still have that situation in the USA where technical people (computer programmers etc) can be classified as “employees” by the IRS even when they claim to be independent contractors just because the IRS decides you are doing too much work for one entity (and therefore should be classified as an employee of that entity) regardless of the fact that you do all the things an independent contractor does (works from home on your own with no direct supervision using your equipment and other things?

    1. In some states, yeah. From personal experience NY is like that. I wasn’t allowed to be an independent contractor for a previous employer until I moved out of NY due to a previous mishap. Often paying as a self-employed person and sending invoices is not enough for $government

  4. My business attorney gave me very different answer with regard to the protections of a LLC. His advice was that if I screw up, I’m liable, regardless of whether my business is a Sole Proprietorship or LLC. He laughed at me when I asked about the difficulty of ‘piercing the corporate veil’. The case he cited where it makes a practical difference is if I have a partner. With a partnership, if my partner screws up, I could be personally liable. With a LLC, if my partner screws up, my personal assets would have greater protection.

    The SE tax is the employer’s contribution to Social Security, which is 6.2% up to $118.5k, and Medicare, which is1.45%. If you make significantly more than the $118.5k limit, the savings from evading it may not pay for the additional payroll and accounting costs required for an S corp. The IRS is unlikely to consider a $25k salary to be reasonable if your S corp grosses $250k. If you only make about $125k or less, you could save some money. At least that is what my accountant advised. Although, keep in mind it will reduce your Social Security earnings, which may eventually reduce your benefit amount.

    If you make hardware, basic business liability insurance will be several times more expensive than if you are just a programmer. (Never mind that a misplaced indentation can result in an article about your code on the front page of the business section, while your hardware might only injure someone if it were dropped on their head.) A significant fraction of business insurance carriers will not even provide a quote if you sell hardware. And good luck getting product liability insurance. Note that unlike health, homeowners, or auto insurance, what matters for professional liability insurance is whether you have active insurance when the flaw is discovered, not whether you had it when you made a mistake.

    1. Forgot to mention: one hack with the SEP-IRA is that unlike an IRA, your contribution is due by the due date of your return, including extensions. You will pay penalties if you do not pay all the taxes due in April. But you don’t have enough cash to pay your taxes in April, you can plan on a larger SEP-IRA contribution six months later, which reduces the amount you owe.

  5. It was said to me at one time, “If an accountant cannot save you 3x what he charges he isn’t worth it.” It has proevn to be fairly true thus far. It pays to get professional tax services….unless you are an accountant. Learning all the ins and outs for what may be claimed what may not when one already has career-related knowledge to be aware of is just a headache one can do without.

    1. Perhaps.

      I have way too many clients that have come into my office after becoming an LLC once they realize they have caused themselves too much headache and problems. Quite often it’s because they read something like this article. Tax season just finished and the first thing I read is something that is just going to cause problems. Someone is going to get hurt because of this article. Plain and simple.

      I think my biggest problem with this article is that it is clear that the author does not understand incorporation vs LLC and using the terms interchangeably gets people in trouble. Then even though he talks about the problems relating to “piercing”, he says you’ll be ok if you just keep things separate. It’s way too easy to pierce because you did something wrong and therefore LLC’s quite often don’t give you the protection you’re looking for. SBW got the advice that I give to all of my clients.

      1. One valuable lesson that everyone can take from this is that running a business involves more than that just creating a product that someone actually wants, and being able to provide it at a price point that makes money. Lots of paperwork, taxes, insurance, no to mention overhead expenses. When you are an employee, taxes are something someone else pays. When you are self-employed, it becomes painfully obvious that it is you and not Keebler Elves paying those taxes.

      2. Rick, the reasons you’ve mentioned are way I’m not yet a LLC. One major reason, as you mentioned, is that my locality has a gross revenue tax, and I’m just break-even now. Being an independent contractor puts me out of their requirements for having a business license and therefore paying the tax on gross revenue.

        At the end of the day, if an entity with money has an interest in suing you, from what I understand, a LLC isn’t going to protect you much.

        Now the *deductions* part of this article is something that everyone should read through and discuss with an accountant or legal advisor. My first year as a contractor, I got hit with huge taxes due to having no real deductions. Having always been a W-2 employee, I had no idea it was coming.

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