Consultants Money Saving Tax Tips & Deductions Guide
When you love the work but hate the corporate politics that come with it, life as an independent contractor (IC) is sometimes the perfect solution. As an IC, you set your own pay rate and hours, doing the work your way on your time. Before you clean out your desk and go rogue, however, understand that being self employed doesn’t really translate into total control. You’ll still have to make some concessions.
You must, for instance, charge reasonable rates. Charge too much and companies won’t hire you. Charge too little, and you won’t be able to eat or cover expenses that are all on you now, such as health insurance. You may also find that, although being self employed technically means being your own boss, you might actually find that you suddenly have more bosses than ever before. The buck stops with you now, so it’s your job to meet the demands of every single client. This can feel a lot like having an entire army of bosses, all with different expectations.
If you’re still interested in working as an IC, know that there is one more hurdle to conquer. You’ll have to learn how to file taxes as an independent contractor. This is absolutely do-able, so you shouldn’t let it intimidate you. It does require a bit of time to learn the ropes, however. Doing so will help you avoid issues with the IRS and help ensure you take all the deductions you’re entitled to.
Who Qualifies as an Independent Contractor?
As an IC, you’re basically your own, independent small business. As such, a company you do work for can only classify you as an IC if they allow you to operate as such. In order to be an IC, you must determine what you will do and how you will do it. This guideline is pretty vague and leaves room for interpretation, so the IRS offers some guidance to help clarify.
To determine independent contractor status, the IRS first looks at control. If a company hires you as an IC, they can tell you what end result they want but not how to get there. If they control not only what you do but how you do it, you’re not an IC.
The IRS also looks at the financial aspect of the work done. Does the company pay for any supplies you need, or are you responsible for acquiring what you need to do the job? An electrician hired as an IC, for instance, would buy his own wiring, tools, electrical outlets and other supplies. He may charge his client for them as part of his fee, but he is ultimately responsible for getting what he needs to get the work done. An electrician working as an employee, on the other hand, would get his wiring and other supplies from his boss and then go do the job.
The nature of your relationship with a client can also tell you if you’re an IC. If your company pays some or all of your health insurance, provides you with paid vacation or offers a pension plan, you’re probably an employee. If you receive assignments one at a time knowing that you may not have steady work, you’re likely in IC territory. If you expect to be working long-term on many different projects, you might be an employee.
The bad news is, there are tax penalties for misclassifying an employee as an IC. The good news is, the IRS assesses those penalties on the payer, not the payee. Unfortunately, companies sometimes intentionally misclassify employees as ICs so they can avoid shelling out for payroll taxes and benefits. If you think you’ve been misclassified, file IRS form SS-8. The IRS can then make a determination for you.
How is Consultant Income Paid and Reported?
If you work as an IC, you’ll get paid a little differently than you did as an employee. While employees tend to get weekly or biweekly checks, ICs get paid when they finish a project. If you work on a big project or one that will take a long time to complete, your client may also pay you when you reach certain completion milestones.
Exactly how a client pays you is something the two of you will have to work out. Some ICs accept checks. Others may receive a direct deposit or go through a service like Paypal or Payoneer. You’ll need to work out the specifics of how and when you get paid with each client — and make sure you put the agreement in writing!
No matter how you get paid, your income should get reported to you the same way at income tax time. If you aren’t incorporated and you received more than $600 for services over the year, your client must send you a Form 1099 reporting the amount they paid you. This is a common form: so much so that many people refer to ICs as 1099 contractors. Before you receive your 1099, your client may ask you to provide them with a Form W-9. They are allowed to do so, as this form verifies your taxpayer identification information.
At tax time, keep in mind that the absence of a 1099 at the end of the tax year doesn’t mean an absence of income. For example, let’s say you have a client you did a small $300 job for. That was all the work you did for them during this tax year. Because your total payments for the year are less than $600, the client doesn’t have to send you a 1099. But you must still report the $300 they paid you as part of your income on your Schedule C. You can’t pretend the job didn’t happen.
How Much are IC’s and Consultants Taxed?
As an IC, you’re taxed in the same way as those earning traditional wages, but you take a roundabout route to get there. When you work for an employer, there is a 15.4% tax paid on the wages you earn. This tax is the social security and Medicare tax. Ordinarily, you pay half (7.65%) through a payroll deduction, and your employer pays the other half (7.65%).
When you work as an IC, you must pay the entire 15.4% since you have no employer to pay the other half for you. This is the tax people refer to when they talk about self employment tax. You do, however, get to deduct half of the tax. This deduction ensures that ICs don’t pay a tax penalty for being self employed.
How to File Taxes as an Independent Contractor
Filing taxes as an IC isn’t difficult, but you’ll need to fill out an extra form when filing your tax return. This form is the Schedule C, and it lists your business income as well as your business expenses and deductions. Doing so determines your business profit, which is the amount of income you’re taxed on.
This form isn’t difficult to complete, but it does attempt to be thorough, and this makes it somewhat lengthy. If you have business expenses of $5,000 or less, you can use the shorter Schedule C-EZ form. When filling out your form, simply follow the provided instructions. They will tell you exactly what to do and where to record your business income on your Form 1040 or other tax return.
After filling out your Schedule C, remember to complete a Form-SE. This is the form that determines how much self employm3nt tax you must pay and how much of it you can deduct. It also tells you where on your tax return to claim the deduction.
Estimated & Quarterly Payments
When you receive a regular paycheck, your employer withholds income tax from it for you. Payments that come from clients rather than employers, however, don’t have any payroll taxes withheld. You’re responsible for paying these taxes on your own, and doing so takes some careful planning.
You’ll want to plan for your taxes for two reasons. The first is simply to avoid an unpleasant surprise at tax time. If you’ve been spending your money all year without setting any aside for taxes, you could find yourself in trouble at the end of the year. Even little jobs can add up and leave you with a hefty tax bill.
The second – and equally compelling – reason to plan for your taxes is that the IRS requires it. If you expect to owe more than $1,000 or more when you file your taxes, the IRS requires you to make estimated tax payments.
Typically, ICs estimate how much tax they expect to owe and break that figure down into four quarterly tax payments. This works most of the time, but don’t hesitate to adjust your payments if you need to. If business unexpectedly picks up halfway through the year and you’ve already made your first two estimated payments, you can increase the amount of your last two payments if you like.
Save Money With Consultant Tax Deductions
Even if you’ve only skimmed the rest of this article, read this section carefully! There are tons of deductions available for consultants and ICs that can significantly reduce your tax liability. We’ve already mentioned the self employment tax deduction, but there are many more.
One is the home office deduction. If you use an area of your home exclusively for business, you can take a tax deduction for it. The key word here is exclusive. If you use your home office to work and surf the internet looking for cat pictures, you’re not using the space exclusively for work. But if you work from home often, it behooves you to set up an exclusive space.
Why? Because the home office deduction is even better than you think. Once your office is set up, figure out what percentage of your home’s total square footage it occupies. Does it take up 20% of your total space? Great. You can now deduct 20% of your deductible mortgage interest, depreciation, homeowners insurance, utility bills and home repairs you make during the year. So if you’re not using part of your home exclusively as an office, start now.
As a word of warning, know that a lot of people misunderstand or abuse the home office deduction, forgetting that key word “exclusively.” As such, taking this deduction could increase your risk of an audit. You have nothing to fear, however, if you map out your home and your home office space with accurate measurements to back up your claim.
Internet, Phone, & Business Utilities
As an IC you can also deduct the cost you pay for your business’ use of your internet and telephone. If you have a dedicated internet or phone connection used just for business, you can deduce the total cost. Otherwise, you can only deduct a portion of the expense based on the percentage of the service your business used.
Health Insurance Premiums
One disadvantage of being an IC is that you need to provide your own health insurance. If you aren’t eligible for health insurance under a spouse’s employee plan, however, you can deduct the cost you pay for medical insurance on your taxes. Health, dental and long-term care insurance premiums are all eligible for the deduction. So are premiums paid for your spouse and children. The Self-Employed Health Insurance Deduction Worksheet in IRS publication 535 will help you calculate your tax deduction.
Travel, Entertainment, & Meals
Grab a bite while traveling for work or entertaining a client? Keep your receipt and you can deduct 50% of the cost of the meal. If you keep detailed records to back this up and make sure you don’t pick an overly lavish restaurant for the occasion, you’ll have no trouble defending this deduction if asked. Be careful mixing meals with entertainment, though. Under the Tax Cuts and Jobs Act, you can’t deduct a meal that came with entertainment unless the meal is billed separately or itemized on the receipt.
ICs can also deduct travel expenses if the travel was work-related, lasts long enough to require sleep and is located outside of the normal work area. You need to be legitimately traveling for a specified work purpose, so keep receipts and a journal of your business activities on the trip. Like the home office deduction, you might need to defend this one to the IRS. Document your trip and you can do so easily. Travel expenses including airfare, gas and hotel accommodations are generally 100% deductible while meals are only 50% deductible. (You would have to eat even if you were at home, so the IRS limits the meal deduction.)
Business Vehicle Usage & Milage
If you use your personal automobile for work, keep track of how many work miles you drive it. This mileage is deductible as a business expense. The IRS allows you to use a standard mileage rate to calculate the deduction or you can track your actual expenses. Pro tip: it’s a lot easier to simply use the IRS standard to calculate this one.
Interest on Loans and Credit Cards
Small businesses often rely on loans when they need a cash infusion or wish to expand. If you’ve taken out a business loan, be aware that the interest you pay on that loan is deductible. So is credit card interest paid on business purchases.
Educational Materials & Courses
An often-overlooked business expense is the cost of subscribing to business journals and trade publications along with the cost of purchasing books and technical manuals. The deduction must be for reading material directly related to your profession. If you’re an architect, you can deduct your subscription to the Architectural Digest. A doctor can deduct her New England Journal of Medicine subscription or the purchase of a Physician’s Desktop Reference book.
In some professions, such as accounting, additional education is necessary to keep abreast with industry trends and law changes. The cost of education needed to improve your skills or keep them current is a deductible business expense.
Money paid to protect your business is also deductible. Liability insurance, insurance on company vehicles and fire insurance all charge premiums that you can deduct. You can also deduct the cost of rent if you lease an office, warehouse or other business space.
Capital Expenses Or Startup Costs
Struggling startup? You’re not alone. Getting a business off the ground can require a substantial amount of cash. Fortunately, your startup costs are also tax-deductible, but you probably won’t be able to claim them all at once. The IRS will likely require you to deduct them as capital expenses over time, limiting you to a $5,000 deduction per year. This can be a good thing, though, as it means your startup costs can help reduce your tax liability for several years. Market research, equipment, attorney fees and many other costs count toward your startup expenses.
Retirement contributions can also reduce your tax liability as an IC. You can get a deduction for contributing to a SIMPLE IRA, SEP-IRA or solo 401(k). The IRS limits how much you can contribute every year and the number changes based on the current tax law and your age. This deduction is definitely worth looking into, though, as it can reduce your tax liability now and help you prepare for your future, providing a double bonus.
ICs also overlook other basic expenses. Advertising, legal fees and equipment purchases all count as business expenses. So does the cost of supplies and depreciation on capital assets. It’s important to understand business deductions so you can use them properly, but make sure you leave no stone unturned when searching for them.
DIY or Hire a Pro?
If you have a simple business structure, an accounting background or a willingness to wade through a few IRS publications, you can absolutely handle your taxes yourself as an independent contractor if you wish. If you’re unsure of your ability, lack the time or simply want to make sure you get every deduction coming to you, consider hiring an accountant. Not only can a CPA help you plan for and minimize your tax liability, but their fees also count as a business expense.
Come tax time, the choice is yours. If you feel confident going it alone, simply do your research and make sure you keep accurate records. If you want or need a little extra help, we’re here and happy to provide it.