Key Concepts and Terminology Explained
Navigating the gig economy requires learning a new vocabulary. The terms used by the IRS and in business contracts can be confusing, but understanding them is the first step toward managing your new venture with confidence. Let’s define some of the most important concepts.
W-2 Employee vs. 1099 Independent Contractor
This is the most fundamental distinction you need to grasp. In the eyes of the law, and especially the IRS, you are generally one or the other.
- A W-2 Employee works for an employer. The employer has the right to control what work will be done and how it will be done. They set your hours, provide the tools and equipment, and typically offer benefits like health insurance or a retirement plan. At tax time, your employer sends you a Form W-2 showing your total wages and how much tax was withheld on your behalf.
- A 1099 Independent Contractor (also called a freelancer, consultant, or gig worker) is self-employed. You are in business for yourself. A client pays you to complete a specific project or task, but they generally do not control how you do your work. You set your own hours, use your own tools, and are responsible for your own business expenses. You do not receive employee benefits. Instead of a W-2, companies that pay you $600 or more in a year will send you a Form 1099-NEC (Nonemployee Compensation).
The vast majority of gig economy work falls into the independent contractor category. This simple classification has significant legal and financial implications.
Are 1099 workers considered self-employed?
Yes, absolutely. This is a critical point. If you receive income reported on a Form 1099-NEC, the IRS considers you to be self-employed. You are operating a business, even if it feels more like a side hustle or a hobby that makes money. This “self-employed” status is what triggers a different set of tax rules.
Understanding Tax Forms: 1099-NEC and 1099-K
While W-2 employees get one primary form, gig workers may receive several different ones. The two most common are:
- Form 1099-NEC: As mentioned, this form reports payments made directly to you for services you provided. If a client paid you $1,000 to design a website, you would likely receive a 1099-NEC from them showing that income.
- Form 1099-K: This form reports payments you received through a third-party payment network or online marketplace. If you sell items on Etsy, drive for Uber, or accept credit card payments through a service like PayPal or Stripe, you might receive a 1099-K. This form shows the gross amount of payments processed on your behalf. It’s important to note that tax law around the reporting threshold for this form has been in flux, so it’s always best to track your income yourself rather than relying solely on receiving this form.
Remember, even if you don’t receive a 1099 form because your earnings from a single source were below the reporting threshold, you are still legally required to report all of your income to the IRS.
Self-Employment Tax: The Big Surprise
When you are a W-2 employee, you pay Social Security and Medicare taxes through something called FICA tax, which is automatically deducted from your paycheck. Your employer pays a matching amount on your behalf. The total FICA tax is 15.3% of your earnings (12.4% for Social Security up to an annual limit and 2.9% for Medicare with no limit). As an employee, you only see your half, 7.65%, come out of your check.
When you are self-employed, you are responsible for paying both halves. This is known as the self-employment tax. It amounts to the full 15.3% on your net business income. This is often the biggest financial shock for new gig workers. It is a separate tax calculated on top of your regular federal and state income tax. The good news is that you get to deduct one-half of your self-employment tax when calculating your income tax, which helps to offset the cost slightly.
Estimated Taxes: Paying as You Go
Because no employer is withholding taxes from your gig work payments, you are responsible for paying them to the IRS yourself. The U.S. has a “pay-as-you-go” tax system. This means you can’t wait until April 15 of next year to pay all the taxes on the income you earned this year. Instead, you are generally required to pay estimated taxes in four quarterly installments throughout the year. These payments should cover both your anticipated income tax and your self-employment tax. Failure to pay enough tax throughout the year can result in underpayment penalties.
Business Deductions: Lowering Your Taxable Income
One of the key advantages of being self-employed is the ability to deduct the ordinary and necessary expenses of running your business. A business deduction is a cost that you can subtract from your business income to calculate your “net profit.” You only pay taxes on your profit, not your total revenue. For example, if you earned $5,000 from a consulting gig but spent $500 on software and supplies to do the job, your taxable profit would be $4,500. Keeping meticulous records of these expenses is essential for keeping your tax bill as low as legally possible.
