The main reason any individual receives a 1099 is because they performed contracted work or are currently self-employed. Since you’re tracking your income individually and not through an employer’s payroll software, a lot of errors can take place.
One of the main issues for making a mistake with 1099 income is a lack of organization, which can lead to back taxes and penalty fees.
In order to keep more of your hard-earned money, here are six common mistakes that many individuals make on 1099s and some tax prep tips to help you avoid an audit.
1. Misunderstanding Form 1099
There are a number of different 1099s, and each has specific tax-reporting requirements. For example, consider the Form 1099-K, which is only sent to you if you make over $20,000 and receive over 200 payments. Many contractors think this means they don’t have to pay taxes unless they make over $20,000, which is very incorrect!
If you don’t receive a paper form, you still have to self-report the income on your taxes. Otherwise, you could be subject to an audit, which could result in paying back taxes plus interest and penalties.
The added flexibility of contract work comes with some added responsibility. For contractors who are new to 1099 work, make sure you educate yourself on what a 1099 is and the implications of it.
2. Not Writing Off All Business Expenses
As a contractor, you get much more leniency in what qualifies as a business expense.
For example, as an employee, you don’t get to write off your commuting costs. But if you’re a contractor and primarily work from a home office, any commutes to client offices are considered business mileage.
Writing off all your business expenses is the easiest way to save money as a contractor. Not doing so means you’re overpaying hundreds or even thousands of dollars in taxes each year.
3. Not Keeping Adequate Records
Even if you’ve done a great job writing off your business expenses, it will all be for nothing if you haven’t kept adequate records. The IRS requires you to keep proof of all business receipts, mileage and the like to prove that the transactions actually happened.
If you don’t have proof of your receipts, they might refute the expense, meaning you could be on the hook for back taxes and penalties.
4. Not Paying Quarterly Taxes
In general, if you expect to owe more than $1,000 in taxes for the year, you have to pay quarterly taxes. Why? Think of it like this: The government’s income comes from taxes. What would you do if your clients only paid you once per year in April?
Keep in mind that traditional employees have taxes withheld from their pay every two weeks, so they are actually paying taxes six times as often as contractors. Contractors only make four estimated tax payments throughout the year.
5. Writing Off Personal Expenses
Do you use the same cell phone for personal and business use? Some self-employed individuals try to write off the entire expense as a business expense, which the IRS frowns upon. Another example: If you use your car for both personal and business use, you can’t write off personal mileage; you can only write off the business portion.
So how do you write off this expense? You have to estimate what percentage of the cost is related to personal versus business use, and you can only write off the business portion. The IRS allows you to use some judgment here, so just make sure you can tell a compelling story for why you’re writing off 80% of that cell phone bill.
6. Counting Expenses More Than Once
The most common culprit is car expenses. Most people use the Standard Mileage Rate (54 cents per mile for 2016). This rate includes gas, repairs and maintenance, lease payments, insurance, depreciation and registration.
Many self-employed professionals use the Standard Mileage Rate to write off their mileage, but then also write off individual gas or repair receipts (this is a separate method called the Actual Costs Method). You must choose only one method of deducting car expenses; otherwise you’re double-counting the expense. Accounting software can help automate expense management, which will help avoid errors like this and expedite the tax-filing process.
4 Tips to Avoid an Audit
Committing the aforementioned mistakes could lead to steep fines and possibly an IRS audit. And even if you avoid these mistakes, you could still be an audit target.
The truth is that the IRS uses statistical formulas to select individuals from all groups, which ensures that everyone has a chance of being selected. It’s their way of keeping people honest. Think of it this way: If the IRS only looked at people who made more than $5,000 in profit, then everyone would just change their books to look like they made less than $5,000.
That being said, there are a few steps you can take to decrease your chances of an audit. Here are four tips to keep your taxes on the up-and-up.
1. Ensure Your Reported Income Matches Any Tax Documents
As an employee, you receive a Form W-2 at the end of the year, but as a contractor, you receive a Form 1099-MISC. Both of these summarize income you’ve earned, and copies are sent to the IRS so they also know how much you’ve made. Since it’s tied to your Social Security number, their system will automatically pick up any mismatches, which will increase your risk of an audit.
If the document you receive doesn’t match the amount you were paid out:
- Make sure you haven’t made a mistake. For example, a 1099-K might include commissions and fees in your gross payout. You can deduct these as a business expense, so your taxable income and tax brackets aren’t affected by the fees.
- Contact the company to request a reissue. If there is actually a mistake, then contact the company as soon as possible to sort out the issue.
2. Carefully Document Any Commonly Audited Expenses
There are some income and expenses that the IRS audits more than others, either because people commonly abuse them or make mistakes on them. For contractors, a few common areas are:
- Car expenses. Make sure all mileage you write off has a business purpose and has been properly logged in a logbook or via a mileage tracker.
- Home office expenses. The home office must be your primary place of business and used regularly and exclusively for work.
- Meal expenses. Make sure the meals were either with a client and had a business purpose, or were incurred while traveling overnight on a business trip.
3. If You Have a Business Loss, Make Sure It’s Not a Hobby
If you sustain a business loss for three out of five consecutive years, the IRS might come in and claim you’re pursuing a hobby and not actually running a business. You’ll need to prove that you actually have the intent to make profit and clarify reasons why you haven’t yet.
If the IRS decides your business is actually a hobby, they might disallow any business expenses you have previously written off, meaning you could be on the hook for a large amount of back taxes.
4. Make Sure You’re Living Within Your Means
The IRS commonly compares your income to others in similar situations. If you only claim $5,000 in income but live in a wealthy zip code or work in an industry that typically makes a lot of money, they’ll become suspicious and increase your likelihood of an audit.
They will also look at your prior tax information. If you made a lot of money last year and no money this year, that will also increase your likelihood of an audit.
Use these tips to keep your expenses and receipts organized so you can claim the maximum amount of deductions you’re eligible for. In addition to paying less taxes, you’ll be able to steer clear of common tax mistakes and avoid being audited unnecessarily. And in the event you are audited, you’ll be prepared and organized to help make it a smooth process for everyone.
For more tax-season tips, see our guides to taxes for the self-employed and filing taxes when you have both 1099 and W-2 income.