Some (US) tax implications of being an Independent Consultant
Disclaimer: The following information is general in nature and intended for informational purposes only. It is not to be construed in any way as tax or legal advice. You should consult with a trained professional familiar with the laws and regulations of your area for specific advice.
Recently I met with accounting professional Steven Palmer to discuss some of the tax implications that face consultants as independent contractors. He agreed to help me make self-employed consultants more aware of tax items that they haven’t had to think about as employees.
Steven M. Palmer is currently the Manager of Accounting for Chiyoda International Corporation of Seattle, Washington. Steven has been with this engineering design and construction company for almost nine years. Prior to joining Chiyoda, Steven was the Manager of Financial Systems Development for Safeco Title Insurance Company, of Los Angeles, for five years. In addition, he has been an independent accounting consultant for almost 20 years. Steven did his undergraduate work in business at the University of Washington and continued his studies at the University of California at Los Angeles (UCLA).
His specialties include insurance, manufacturing and construction accounting.
Q: Steve, I understand the IRS has a 20 point test that determines whether an individual is an employee or an independent consultant.
smp: That is really more an issue for the employer than the individual because there are serious tax penalties for improperly classifying an employee as an independent contractor. If you look into this for your clients, however, the IRS does provide some relief. It is spelled out in Section 530. (Here is the IRS Independent Contractor (Self-Employed) or Employee information.) If you work for several companies, direct your own work, and supply everything need to do the work you will probably be classified by the IRS as an independent consultant, not as an employee.
Q: Most of us know that self-employed individuals have to make quarterly tax payments to the government. Is there any way to avoid that?
smp: If you have paid at least 90% of your total tax liability by the end of the year you don’t have to make quarterly tax payments.
Q: If you are not making quarterly payments how do you get to that 90% level?
smp: Well, if your spouse works, he or she can have taxes withheld at the higher single level, claim zero exemptions, and even direct that additional amounts be withheld from each paycheck. Just make the appropriate changes on their W-4. Or if you do work for an employer in addition to your self-employed work you can do the same things with your W-4 with that company. I know a writer who also delivers newspapers. He has his newspaper employer withhold enough to cover his writing income too.
Q: If, at the end of the tax year, you find that your tax withheld does not exceed 90% of your tax liability can you just send the IRS a check on say December 30th to get it to the 90% level?
smp: If you do, the IRS will see that as a fourth quarter quarterly payment for the current year. Once you start making quarterly payments you will need to continue filing quarterly payments for as long as you are earning self-employment income.
Q: Well, if you make a fourth quarter quarterly payment is the IRS going to expect you to have filed quarterly payments all year?
smp: If you make a huge payment in the fourth quarter, the IRS will want you to go back and determine when the income was actually derived. You are supposed to go back and self-assess and pay penalty and interest for late payments.
Q: So if you are not making quarterly payments, and you get to the end of the year with less than 90% of your taxes paid, you are going to end up making quarterly payments retroactively for the entire tax year right?
Q: If I am not making quarterly payments what is the limit to the amount that I can owe on April 15th?
smp: If the amount of tax you owe at the end of the year is less than ten percent of your total tax liability you’re okay.
Q: How soon after the end of a quarter do I have to make a quarterly tax payment?
smp: Quarterly payments are due 15 days after the end of the quarter. For instance, first quarter tax payments are due April 15th. Second quarter payments are due July 15th and so forth.
Q: Okay, so I have determined that I am an independent consultant not an employee. As a self-employed individual what am I liable for?
smp: You have to pre-pay federal taxes to at least the 90% level. This includes income tax and social security tax. For social security tax you are liable for the "employee" half as you always have been, but you are also responsible for the "employer" half. However, you can deduct half the employer portion on the form you use to calculate social security tax liability.
Q: So you have to include social security taxes when you calculate the 90% threshold?
smp: Yes. It’s 90% of total tax liability. That includes all the other miscellaneous taxes that show on the Form 1040 (like alternate minimum tax) although most people don’t get into those.
If you keep your self-employed income below $400 for the year after deductions you don’t have to pay social security tax at all. This can be especially important in a year when you might elect to take a Section 179 write-off.
Q: Before we talk about Section 179 and deductions, what other taxes do we need to consider beyond income tax and social security tax?
smp: You really need to contact your local authorities on this. Washington State has a Business and Occupation tax, although it has a pretty high exemption for small businesses. Indiana has a gross receipts tax. Many states have a state income tax.
There is also the business license. You need one from the state and another from the city in which you live. You may also need one for the other cities in which you do work even if you don’t live there. Depending on what you consult on you may also need professional registration.
Q: But all those license fees are deductible as business expenses, right?
Q: What about Unemployment Insurance taxes?
smp: Since you are self-employed you are not covered by unemployment insurance. That only applies if you hire employees. In that case you would have to pay both unemployment and workers compensation for them. You, as a sole-proprietor, aren’t eligible for unemployment or disability, even if you are paying yourself a salary.
Q: I assume that we would report this income on the Schedule C attached to our Form 1040.
smp: Correct. As a sole proprietor you would. It’s different, of course, for anyone who has incorporated their consulting business.