Does this mean the employee is paying less in taxes overall since not all income is subject to Social Security tax?

Yes, it effectively means you're paying less in Social Security tax than you would if there wasn't a wage base limit. Social Security tax stops once you hit the annual limit ($168,600 for 2024), regardless of how much more you earn. However, Medicare tax continues to apply to all earnings with no cap, and you'll actually pay an additional 0.9% Medicare surtax on earnings above $200,000 for single filers. So while you get a break on Social Security tax, the Medicare portion continues and even increases at higher income levels.

Box 1 shows total taxable wages, which would indeed be the full income (minus any pre-tax deductions like health insurance or 401k contributions). Box 7 shows tips that are subject to Social Security tax, which is capped at the wage base limit. Box 3 shows non-tip wages subject to Social Security tax. Since OP's tips already reached the Social Security wage base limit, there's nothing additional to report in Box 3.

Is the depreciation recapture rate really 25%? I thought it was your ordinary income tax rate, but capped at 25%. So if your ordinary rate is lower than 25%, you'd pay the lower rate?

I used TurboTax last year for a similar situation. It does technically handle PALs, but I found it confusing. It asked a series of questions that didn't seem directly related to my situation, and I wasn't confident it was doing things right. Ended up going to a CPA who found several mistakes in what TurboTax had done. For something this specific, I'd recommend a tax pro.

Thank you for mentioning health insurance - I totally forgot about that! The company did say something about a stipend for health coverage, but I should definitely calculate what that would really cost me vs. employer-provided insurance. Do you have any recommendations for tracking all those business expenses? Is it just like a spreadsheet or should I use some kind of app?

I started with a spreadsheet but quickly found it too tedious to maintain. Now I use an app called QuickBooks Self-Employed that lets me connect my bank accounts and credit cards, then swipe left or right to categorize transactions as business or personal. It automatically calculates my quarterly tax payments too. If you're just starting out and don't want to pay for software yet, even something as simple as taking photos of receipts and saving them to a dedicated folder can work. Just make sure you have some system in place from day one - it's much harder to reconstruct everything at tax time if you haven't been tracking throughout the year.

This is super important advice. I got misclassified as a contractor when I was really doing employee work and ended up paying thousands in taxes I shouldn't have had to pay. The IRS has a form called SS-8 you can file if you think you're misclassified.

That's an interesting suggestion! Would forming an LLC change anything about how I file taxes or would I still use Schedule C? And would there be any benefits for someone making such a small amount ($3k-ish per year) from this work?

You would still use Schedule C with a single-member LLC unless you elect to be taxed as an S-Corporation or C-Corporation. The LLC doesn't change your tax filing method by default - it's considered a "disregarded entity" for tax purposes when it has just one member. For someone making only around $3,000 annually from this work, an LLC probably isn't worth the administrative costs and annual fees unless you have significant liability concerns. The main benefit of an LLC is limiting your personal liability, but for patient advocacy work with minimal income, the protection may not justify the expenses. Some states have annual LLC fees of $800+ (California), while others are much cheaper ($50-100).

I use TurboTax Self-Employed and it works great for this. It asks if you have self-employment income and then automatically puts you on Schedule C. It doesn't really distinguish between "independent contractor" and "sole proprietor" either - it just asks about your business income and expenses. The software walks you through all the deductions you might qualify for too.

This explanation makes a lot of sense - thank you! So essentially, my accountant only did half the correct accounting (increasing my capital account) but missed recording the actual liability on the business books? If I understand correctly, I should be able to correct this going forward by properly recording the liability now, which would reduce my capital account but allow the business to pay off the debt as a legitimate business expense without triggering capital gains? Would this correction potentially trigger any penalties or raise audit flags?

You've got it exactly right. Your accountant increased your capital account but failed to record the corresponding liability on the business books, which created this imbalance. Correcting this going forward is possible by properly recording the liability now. This would reduce your capital account (essentially correcting the artificial inflation), but then allow the business to properly pay off the debt as a legitimate business expense without triggering capital gains or being treated as a distribution to you. This type of correction typically wouldn't trigger penalties if properly disclosed as an accounting method change using Form 3115. The IRS recognizes that accounting methods sometimes need correction, and they provide this form specifically for that purpose. It's considered a voluntary correction rather than something that raises audit flags. Include a clear explanation of the circumstances of the inheritance and how the debt was always intended to be a business obligation based on your agreement. Having good documentation of the original intent (like your contract with the family member) will strengthen your position if there are any questions.

This makes sense, but wouldn't reclassifying the debt now as a business liability be better for tax purposes? Even if it means adjusting the capital account? I thought business interest expense was deductible while personal loan interest isn't (or is limited).