Consultants are experts in a particular field who share knowledge and insights with paying clients or employers. Starting a consultancy is a way to start your own business and work on a contracting basis. Self-employment brings many freedoms and benefits, but it also comes with more tax responsibilities.
- Self-employed consultants run their own businesses that serve their clients.
- You’re responsible for income taxes ranging from 10% to 37% of your net profit and a self-employment tax of 15.3% when you're self-employed.
- You’re required to pay estimated quarterly taxes if you expect to owe more than $1,000 in federal taxes.
- You may also owe taxes to your city and state governments.
Consultants Are Usually Self-Employed
According to the IRS, you're self-employed if you’re a business owner or contractor who provides services to other businesses. To remain a contractor rather than an employee, you must:
- Have the right to direct or control the work you perform.
- Have the right to direct or control the financial and business aspects of your job.
- Have a relationship that is not like one between an employer and employee. It must be impermanent. Benefits such as insurance or vacation pay are not generally granted.
Some consultants are hired full-time by one company. They have their taxes withheld just like any employee, but self-employed people who run their own businesses must manage their own taxes. It’s critical for them to understand how self-employment taxes work.
How Self-Employment Taxes Work
Your clients will pay the full amount you bill with no taxes deducted if you're self-employed. You'll be paid $1,500 if your service costs $1,500, but this doesn’t mean that you don’t owe taxes on your earnings.
Self-employed consultants typically have to pay both federal income taxes and federal self-employment taxes. The amount you owe for income tax will depend on your tax bracket. Tax rates range from 10% to 37% in 2022. Your highest rate depends on your amount of net profit.
Self-Employment Tax Example
Here’s an example of how independent consultants' taxes work. You could potentially owe $39,776 in annual federal income tax if your consultancy’s net profit is estimated to be $120,000 in 2021 (the return you'll file in 2022), and if your filing status is single.
First, you would owe $14,751 in income tax plus 24% on the amount over $86,375 according to the 2021 Tax Rate Schedules. This works out to $33,625.
$120,000 - $86,375 = $33,625
That $33,625 is subject to the 24% tax rate, which equals $8,070.
$33,625 x 0.24 (24%) = $8,070
You would owe $14,751 plus $8,070 in income tax, totaling $22,821.
You also have to factor in self-employment tax by calculating 15.3% of $110,820 (92.35% of $120,000), which is $16,955. Your total estimated taxes would be $39,776. This is approximately 33% of your net income.
$22,821 + $16,955 = $39,776
You have to split it into four equal payments when you know how much you will likely owe for the year, because estimated taxes are due each quarter. Your quarterly payments would be $9,944 each.
This is a very simplified example. You may have deductions or other factors that could change the amount you would ultimately owe.
Consultant taxes summary:
- Net profit earned: $120,000
- Income tax: $22,821 ($14,751 plus 24% on amounts over $86,375)
- Amount over $86,375: $33,625
- 24% of $33,625: $8,070
- Self-employment tax: $16,955
- Total federal tax: $39,776
- Estimated quarterly payments: $9,944
- Federal tax % of income: 33%
You can work out your estimated taxes on the 1040-ES IRS form if you need help. Then, when you’re ready to make your payments, you can do so by mail, online using the Electronic Federal Payment System (EFTPS), via debit or credit card, or through IRS Direct Pay.
Up to $142,800 in earnings was subject to the Social Security part of the self-employment tax per taxpayer in tax year 2021. This increases to $147,000 in 2022. You don't have to pay Social Security tax on earnings over these amounts per year, but all earnings are subject to the Medicare self-employment tax.
Tax Deductions for Consultants
Deductions enable you to reduce your taxable self-employment income, which means you’d owe less in taxes. Your taxable income might be only $80,000. This would drop you into a lower tax bracket if you earned $120,000 but spent $40,000 on deductible expenses.
Here’s a quick list of some common deductions available to consultants:
- Self-employment tax deduction: You can deduct half of your self-employment tax each year, equivalent to what an employer’s portion would be.
- Capital investments: These include purchases you make to get your consulting business up and running, such as computers or furniture, which can be capitalized. Their depreciation can be deducted over time.
- Operating expenses: These are expenses you must pay to run your business, such as rent, internet service, phone bills, utility bills, or software programs.
- Career development: You can qualify for education tax credits if you’re attending a qualifying college program. You can write off the costs of webinars, seminars, conferences, and professional certifications.
- Advertising and costs for client services: You can deduct any costs spent on advertising of client acquisition, such as setting up a website, getting professional headshots done, travel expenses, dining expenses, and gifts used for business.
- Business use of your home or car: You can write off a portion of your housing costs if you have a home office, including rent, mortgage interest, insurance, utilities, depreciation, and repairs. You can write off expenses such as depreciation, lease payments, gas, oil, and tires if you use your car for business purposes in whole or in part.
- Financial fees: You can write off any fees you have to pay your bank or credit card companies.
- Other: Other deductible expenses include retirement savings plans and business insurance.
Keeping track of all of your expenses throughout the year can seem daunting, but it’s well worth it. Be sure you’re getting all of the deductions you qualify for, so you won’t pay more in taxes than you have to.
How to File Your Taxes
Most tax returns need to be submitted by the IRS deadline each year. This is usually April 15, but it can shift by a day or two to accommodate weekends and holidays. You must Form 1040 or Form 1040-SR as a self-employed consultant. You must attach Schedule C on which you've figured your business’s net profit or loss after accounting for deductible expenses.
Be sure to consult a tax attorney about any additional forms that may apply to you. Estimating your quarterly taxes on time (and correctly) can help you avoid any surprises.
Estimated quarterly self-employment taxes are usually due on the following dates:
- Payment 1: April 18, 2022
- Payment 2: June 15, 2022
- Payment 3: September 15, 2022
- Payment 4: January 17, 2023
Your payment will be considered to be on time as long as it's postmarked by the due date. You can also pay online at IRS Direct Pay. You can face penalties if you pay late or don’t pay the required amount. You can also be penalized if you underpay by more than 10%.
Don’t Forget State and Local Taxes
Don’t forget about the state and local taxes that apply to you in addition to federal taxes. Be sure to look up your state and local tax boards to see what you'll have to pay. Find out whether quarterly payments are mandatory. California requires you to pay estimated tax payments if you will owe $500 or more.
Becoming self-employed and starting a consulting business can be very exciting and profitable. Don’t let a large, intimidating tax bill discourage you. Avoid surprises by understanding your tax liabilities and staying on top of your quarterly estimated payments.
Frequently Asked Questions (FAQs)
Which employer taxes will I pay as a consultant?
You must pay 100% of your Social Security and Medicare taxes as an independent consultant. Employees generally split these with their employers. Their portion is withheld from their paychecks, but you must pay them in full when you're self-employed, although you can deduct half of your self-employment taxes from your income tax liability.
What percentage of your income should you pay for quarterly estimated taxes?
You must pay quarterly estimated taxes if you expect to owe more than $1,000 when your tax return is filed. You'll face a tax penalty if you don’t pay enough. The percentage of your total income you must pay will vary based on your earnings and tax status. Complete IRS Form 1040-ES to figure it out. The form includes a worksheet where you can enter your expected income and profits, deductions, credits, and more to figure out how much you should be paying each quarter.