Hiring freelancers and taxes

Question

This is a repost from here:

http://programmers.stackexchange.com/questions/75302/hiring-freelancers-and-taxes

Let's say I provide back-end consulting for Bob's Software. And then I have a front-end developer named Joe that works under me who I manage. Bob and I agree to split all pay we receive 50/50. And then Joe and I agree to evenly split my 50 percent that I get from Bob. How do I pay taxes under this scenario?

Let's say the contract is for $20k. So Bob gives me my $10k. Do I have to pay taxes on the $10k before I pay Joe his $5k? Or do I only have to pay taxes on my $5k after I give Joe his $5k?

Also, do I need anything special in order to pay other people? Or can I just use my social like I do to receive payment?

I am located in the USA and will only be dealing with others in the USA.

Answer 1

I am not a lawyer or a tax accountant, but from the description provided it sounds to me like you have created two partnerships: one in which you share 50% of Bob's revenue, and another in which you share 50% of the revenue from the first partnership.

If this is the case, then each partnership would need to file form K-1 and issue a copy to the partners of that partnership. I think, but I'm not sure, that each partnership would need an Employer Identification Number (EIN; you can apply for and receive these online with the IRS). You would only pay tax on the portion of profits that are assigned to you on the K-1.

(If you've accidentally created a partnership without thinking through all the ramifications, you probably want to straighten this out. You can be held liable for the actions of your partners.)

On the other hand, if your contract with Bob explicitly makes you a contractor and not a partner, then Bob should probably be issuing a 1099 to you. Similarly for you and Joe -- if your contract with Joe makes him a subcontractor, then you may need to get an EIN and issue him a 1099 at the end of the year. The money you pay to Joe is a business expense, and would be deducted from the profits you show on your Schedule C.

In my opinion, it would be worth the $200 fee paid to a good CPA to make sure you get this right.

Answer 2

You need to clarify with Bob what your agreement is. If you and Bob are working together on these jobs as partners, you should get a written partnership agreement done by a lawyer who works with software industry entity formation. You can legally be considered a partnership if you are operating a business together, even if there is nothing in writing. The partnership will have its own tax return, and you each will be allocated 50% of the profits/losses (if that's what you agree to). This amount will be reported on your own individual 1040 as self-employment income. Since you have now lost all the expense deductions you would have taken on your Schedule C, and any home office deduction, it's a good idea to put language in the partnership agreement stating that the partnership will reimburse partners for their out-of-pocket expenses.

If Bob is just hiring you as a contractor, you give him your SSN, and he issues you a 1099, like any other client. This should be a situation where you invoice him for the amount you are charging.

Same thing with Joe - figure out if you're hiring him as an independent contractor, or if you have a partnership.

Either way, you will owe income and self-employment tax on your profits. In the case of a partnership, the amount will be on the K-1 from the partnership return. For an independent contractor who's operating as a sole proprietor, you report the income you invoiced for and received, and deduct your expenses, including independent contractors that you hired, on your Schedule C.

Talk to your tax guy about quarterly estimated payments. If you don't have a tax guy, go get one. Find somebody people in your city working in your industry recommend. A good tax person will save you more money than they cost.

IRS Circular 230 Notice: Please note that any tax advice contained in this communication is not intended to be used, and cannot be used, by anyone to avoid penalties that may be imposed under federal tax law.