Tax Tips for Independent Consultants | TFX (2024)

Editorial team of TFX

• 01.07.22 • 5 min read

How do I pay tax as a consultant? Self-employment may mean freedom, and more control in fulfilling your dreams. There is a right and wrong way to go about business success, however, The right way involves going into business as a consultant with an understanding of how consultants pay taxes, and their tax savings opportunities.

You may be used to an employer withholding taxes but a consultant needs to set aside federal and state income taxes, as well as self-employment tax. The self-employed think about how to reduce taxes while also staying on top of the amount and timing of tax payments..

Your Business Plan Also Needs a Tax Plan — Getting Started

One starter tax tip, before we get to how consultants pay taxes. Don’t let your up-front planning go on and on. College is great but it isn’t generally tax-deductible because you’re not “carrying on” a trade or business. It can help from a tax standpoint to get some revenue soon because business tax deductions come easier once your business begins.

Pre-opening expenses may qualify for amortization over 60 months or more. Examples of such expenses include ads for opening the business and compensation for employees being trained.

Who Is a Consultant?

Consultants have compensated service providers who eventually have to dig into the details of how independent consultants pay taxes. In tax terms, their fees make them independent contractors. This usually means those paying don’t withhold. They just issue 1099 forms.

Sales can add complications. Collecting sales tax may be necessary when a product is involved. For example, computer consultants may have income from the sale of software.

How consultants pay taxes can mean special reporting, such as a license tax.

The “when taxable” question is usually simple with fees. Fees are taxable when received. If you repay fees to a client, the repayment should be deductible, but the fee is taxable “up front.”

The terminology of income doesn’t matter for tax purposes. Bonuses, commissions, incentive payments, prizes - all are taxable.

When received, the fees become reportable on your year-end return. Fees are taxable whether or not reported to the IRS on Form 1099. They also need to be considered in making quarterly estimated tax payments. Your estimate will be increased by all your taxes - self-employment for Social Security and Medicare tax as well as income tax.

Due dates for 2022 quarterly tax are April 18th, June 15th, September 15th, then January 17, 2023. Penalties can apply for underpaying estimated taxes. File your taxes for 2022 by April 17, 2023.

You need to pay the estimated tax if you will owe at least $1,000 for 2022 after considering withholding and refundable credits. Another test is whether you expect your withholding and refundable credits to be less than the smaller of (a) 100% of your tax on the 2021 return, or (b) 90% of the tax to be shown on your 2022 return.

Self-Employment

The tax rules distinguish employees and independent contractors.

Occasionally, an employer may get special tax breaks for employees. A recent example was the temporary employee retention credit.

The consultant, an independent contractor, ends up with a tax bill equal to both halves of Social Security tax, as well as the health insurance Medicare tax - 12.4% and 2.9%, 15.3% times 92.35% of business income. The 12.4% self-employment tax stops at higher levels of earned income but there is no limit on the 2.9% tax.

You can, of course, incur the usual employer’s share of FICA tax on employees you hire to work under your direction.

Is the person paying you your employer, or your client? The IRS has many rules here but they focus primarily on control. The contractor usually controls the work, directs the details of the work, usually has a project rather than permanent relationship. Perks, such as insurance, vacation pay, usually aren’t included, which is among the reasons that hourly fees are usually higher than hourly wages.

How to Pay Taxes as a Consultant

When received, fees and business deductions are usually reported on Form 1040, Schedule C, Profit or Loss from Business.

How independent consultants pay taxes can involve an S corporation, which doesn’t pay income tax but flows through the business income and deductions to the owner, or owners. Consultants working together may operate as a partnership. Sharing your consultancy business is a topic beyond our current discussion.

Tax Deductions for Independent Consultants

Business equipment and capital expenditures with limited lives generally yield write-offs over time in figuring income tax. Yet faster write offs, full write-offs the first year, are often possible but there are tax rule limitations that may apply.

Operating expenses are rarely nondeductible. For example, business rent and utilities, as well as, business computers are generally fully deductible. Proving the business portion of rent and utilities can be an issue when there are mixed purposes of the property.

Advertising costs after you are open for business are fully deductible. Business use of the car is usually deductible if supported by proof. This includes mileage driving to the client’s place of business, as well as continuing education classes.

Business use of the home can qualify within limits depending on the circ*mstances.

There is a deduction for half of your self-employment tax. This deduction doesn’t apply for purposes of the self-employment tax but it is deductible for income tax purposes whether or not the taxpayer itemizes.

Tax Calculations in Planning

How do consultants pay taxes, and plan on reducing their tax bills? In making business decisions, you will learn, with the help of your tax adviser, to consider the incremental tax savings as you make expenditures for deductible items. For example, the seven tax rates for 2022 are 10%, 12%, 22%, 24%, 32%, 35%, 37%. If you look in at the tax brackets for the rates, considering your filing status, you can generally figure the after-tax amount for an expenditure.

In those calculations, also consider the impact on the business owner’s self-employment taxes. This could include savings in the 12.4% self-employment tax and the 2.9% Medicare tax, but the savings are somewhat less due to half the self-employment tax being a special income tax deduction. In doing that math, also consider the 92.35% factor. On really important business decisions, you may also want to seek the help of your tax adviser.

Consultants, independent contractors, tend to specialize. Keep in mind how to plan and save taxes usually means the consultant will need a consultant. Remember to ask your tax consultant about state tax and timing of those tax payments as well as federal taxes.