So, you graduated in May, received your license in late June or early July, and already had your first position lined up. Your state-approved license comes in the mail, and you’re ready to put your education to use, start seeing patients, and (finally!) bring in some income.
Unless you set up your own practice from day one, a component of your relationship with the practice that you started working with was whether the owner would hire you as a W-2 employee or 1099 independent contractor (IC)—a contracted optometrist.
The IRS’s definitions of who constitutes an employee and who is considered a contracted provider are among the most debated and talked-about issues within practice ownership strategies.
This article is not going to discuss the criteria and basis of how to determine if an OD should be a W-2 employee or a 1099 independent contractor provider. Rather, we’re going to discuss the differences between the two and, specifically, how you can proactively plan so that you don’t spend every year “catching up” from the past year’s tax liability.
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If You’re a W-2 Employee
Being a true employee of a practice is the most straight-forward employment relationship that you can have with your employer.
You’re most likely paid a flat salary, a per day wage, or an hourly wage. There’s also the opportunity to build bonus and performance-based/production-based earnings into a W-2 relationship.
As would be expected, your income is going to be subjected to a multitude of taxes.
There are the obvious federal income tax and most likely state income taxes as well (though there are a handful of states that don’t have a state income tax). There may also be local taxes as well. These taxes are withheld from your paycheck on a per-pay-period basis, making your year-end tax planning much more manageable and predictable because it’s all been done on your behalf on a per-pay-period basis.
If You’re a 1099 Independent Contractor
A 1099 independent contractor is paid all earnings without any taxes withheld.
Therefore, it is your responsibility to understand all of the taxes that you will be required to pay come tax time and budget accordingly throughout the year.
While federal and state income taxes apply to both W-2 and 1099 earnings, we start seeing some differences in taxation when it comes down to Social Security and Medicare taxes. As a W-2 earner, you’ll see this show up on your paycheck as either “FICA” or “OASDI” and “Medicare.”
Let’s understand the calculations on these two taxes.
Social Security taxes equate to 12.4% of your earnings up to a certain maximum dollar amount (for 2020, that number is $137,700 and usually increases each year). Medicare taxes have no earnings limit and are another 2.9% on all of your income. If your income is >$200,000 as a single filer or >$250,000 as MFJ (Married Filing Jointly), you’ll also pay an additional 0.9% “Medicare surtax” as part of the current law as stated in the Affordable Care Act.
Add this all up, and we’ll see that the total Social Security and Medicare tax calculation is 15.3% (12.4% + 2.9%) on the first $127,200 in 2017.
Now, let’s discuss who pays what in these calculations
- If you are a W-2 employee, 50% of the Social Security and Medicare tax liability (7.65%) is paid by your employer, and you pay the other 7.65%.
- If you are a 1099 independent contractor OD, you are responsible for paying “both sides” or the full 15.3%.
Essentially this is where the term “self-employment” tax came from—it’s the other 7.65% that an employer would otherwise pay. However, because you are your own employer as a 1099 contractor, you’re responsible for paying both the employee and employer part of the tax . . . hence “self-employed.”
Excluding all other benefits, you can now see part of the financial implications practice owners face when bringing on an associate OD as a 1099 independent contractor vs. employee.
Avoiding 1099 Independent Contractor Tax Hell—A Case Study
One area where we most often see people get into trouble from a budget and planning perspective is in the first year or two out of school.
It’s easy to fall down this rabbit hole: you graduate, sign on with a practice as a 1099, and get your first paycheck. If it covers two weeks’ work, you may experience a bit of what I call “earnings shock.” In other words, the number on that one check may be larger than what you were asked to live on for the good part of an entire semester during optometry school.
If you don’t understand the full implications of your earnings on your tax situation, you may unknowingly set aside either not enough or, in the worst case, mistakenly assume that taxes were withheld and therefore not set aside any of your paycheck for the future tax bill.
Let’s look at a hypothetical example
An OD (who is not married and thus filing as a single taxpayer) is brought into a practice/organization as a 1099 independent contractor and makes $400 a day. For easy math, we’ll assume two weeks off per year and working 5 days a week for the other 50 weeks.
Total 1099 fees paid to the OD: $100,000.
If we assume standard deductions and exemptions, we can estimate that their marginal federal tax is on the high side of 20%. If we estimate state taxes (every state is different, and some states don’t have a state income tax) at 5%, that’s total federal and state taxes of 25%, and for this example, we’ll exclude any local taxes that would also apply.
That’s the easy part that would apply whether she was 1099’d or brought in as a W-2. The only difference is that, as a W-2, those taxes are withheld with the processing of every payroll based off how she filled out her W-9. Most individuals in this situation are accustomed to receiving a tax refund every year.
As a 1099, she would be responsible for calculating and setting aside a percentage of her earnings on a periodic basis to cover this upcoming tax liability.
Now, we look at the delta between W-2 wages and 1099 fees paid.
As a W-2, her FICA tax liability would be $7,650 (7.65% of $100,000), and this would have been automatically withheld from her paycheck on a per-pay-period basis by her employer.
But, as a 1099 contracted OD, her liability is the full $15,300. Again, she’s responsible for setting this aside on a periodic basis to ensure that she has “the scratch” to write the check come tax time because, unlike the W-2 employee, none of this tax liability is withheld from her earnings.
Add it all up and we see that her total tax paid is 20% federal + 15.3% FICA + 5% state = 40.3% of her income goes to taxes. In other words, that $8,333 per month paycheck just got knocked down to $4,974.
Deductions Available Only to 1099 ODs
One caveat is that self-employed individuals have a few deductions available to them that W2 employed ODs do not. The first is that 1099/self employed ODs can deduct ½ of their self-employment tax on their tax return, so the end amount of tax payable is not a true 40.3% because of this and other possible deductions . . . but we can certainly see the difference.
Another deduction that has only recently become available since the passage of the Tax Cuts and Jobs Act (TCJA) to self-employed individuals is something called the Qualified Business Income (QBI) deduction (a.k.a. 199A deduction). There are many caveats to the 199A deduction which I’ve written about at length, but specifically for 1099 IC ODs it could allow you to deduct up to 20% of your QBI if your combined household’s taxable income is within or under the income thresholds set by the IRS.
For example, let’s say that our OD in the above example ended up with QBI of $80,000 (after expenses, adjustments, etc.) and is able to claim the full 20% deduction. $80k x 20% = $16,000 deduction.
As you can see, the 199A deduction is a big deal. A 20% deduction off your taxable income can have a sizable impact on your net tax bill and it’s actually caused a number of practice owners and W2-employed associate ODs to collectively re-evaluate whether or not switching them to 1099 IC status would be a better fit for all involved. Of course there are many more variables that play into the equation (such as benefits, retirement plan contributions, scope of work and responsibilities in the practice, etc.), but the QBI deduction is not something to gloss over. If you have specific questions about it, please consult with your CFP® or CPA.
Stay Ahead of The IRS
If you’re not careful and don’t proactively plan to set aside your estimated tax liability throughout the year, you can very easily find yourself with the “deer in headlights” look and gasping for air at the same time when you file your taxes for the first time post-graduation.
If that’s the case, you now have an uphill battle of (a) coming up with the money to pay last year’s taxes and (b) setting aside enough of your earnings to cover your current year’s tax liability. Add to that the fact that, in your second year of reporting 1099 income, the IRS will now ask you to make estimated tax payments on a quarterly basis to cover your current year’s tax liability, so you don’t get the luxury of having a full year to “recover.”
Note: the estimated payments, while required, are still voluntarily submitted by the taxpayer. If you fail to pay the estimated tax payment, a penalty will apply when you file and submit your taxes for that year. For more information on this and everything else mentioned in this article, please consult your CPA or other qualified tax professional.
While recovery can be accomplished, it’s certainly no picnic and can be even harder to do if you’ve already become accustomed to a higher-than-you-should-have lifestyle (think expensive house, higher-than-anticipated student loan payments, brand new car payment, vacations already planned, etc.).
This is just one example of why it’s prudent and responsible for going into your first year or two of practicing with your “eyes wide open” to the full picture and scope of what your financial circumstances will be in all aspects of your life.