Some (US) tax implications of being an Independent Consultant (part 2)
Disclaimer: This 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 tax implications that face consultants as independent contractors. This is a continuation of the interview that begins here.
Q: All these taxes is the downside. What about the good side of being an independent consultant? You can deduct all the things your employer used to deduct when you were an employee. You can deduct all these things up to the limit of your income I assume.
smp: Actually, IRS rules that you have to make money three of five years to be considered a business and not a hobby. You might be able to get by with two years as long as you are showing an ongoing business concern. A loss the first year is not unusual due to start up costs. The second and third years you might have net income. Then the fourth year you could have a bad year where an accident lays you up, for instance, or some other costs hit you. The IRS isn't going to do a strict interpretation.
You've just got to be real careful about appearing to be a business not a hobby.
Q: What kinds of things, in general, can you deduct?
smp: Office supplies, travel expense, magazine subscriptions for business. You can deduct a pro-rated share of your home expenses if you qualify for a home office deduction. Even your insurance premiums can be deductible for key employee coverage or health care coverage if you don't have it thorough any other job.
Q: What about telephone costs for Internet access?
smp: You can deduct that portion of the cost that is business related and not for personal use.
Q: I understand the IRS allows you to write off (deduct) a certain amount each year as direct expense before you begin to depreciate capital items over time. I think it's about $1500.
smp: Section 179 of the tax code, that we mentioned before, lets you deduct up to $18,000 in 1997 (it's scheduled to climb to $25,000 by 2003) in the year you purchase equipment, provided that the amount deducted can't exceed your revenue for the year. They are just trying to prevent hobby deductions. The calculation is part of the depreciation schedule that gets attached to your Schedule C. You can carry forward that section 179 exemption to next year if you don't use it all in this year.
Q: So before we deduct anything we first have to determine how much of the expense is business versus personal?
smp: Correct. If, for instance, you have a computer at home that you use for your consulting business, your kids use for games, and your wife keeps her Christmas card list on, you have to calculate how much of the use is business versus personal.
Q: But if you buy a separate computer and use it exclusively for business you can write off as much of the cost as is below your business income or the $18,000, whichever is lower?
smp: Correct. You have to either make the section 179 determination or depreciate. Once you start to depreciate an item you can't go back and use section 179 for that particular asset.
Q: What about other costs of doing business? For instance trips.
smp: Depends on how much is business versus personal. They want to see how you're using that expense to earn revenue. In an audit they will look at whether you are showing a profit or a loss on your business. If a profit, they will be a lot more lenient in allowing specific deductions. Especially if you are doing consulting, maintaining a database of information collected from the trips, and giving out information that you are getting revenue from. They will also look at, for instance, how many trips you take to the same place.
If you made five trips, could you have collected the same information in two trips?
Q: What about the years you just break even? Are they going to be as lenient as if you were making a profit?
smp: You have to make a profit in three of five years. The burden of proof is on the taxpayer. You have to be able to show what business benefit you've derived from this entertainment.
Q: If you claim a deduction and they disallow, you have to pay the tax plus penalty and interest, right?
smp: Usually there is no penalty, unless they feel there was a deliberate attempt to defraud. They will always open with penalty, but back off. The auditors performance is graded on their ability to get revenue. And remember, you can always ask to speak to a supervisor. Don't be afraid to challenge the auditor's findings. There is an old adage "It's a legitimate deduction until you're audited."
Q: The business lunch deduction is only 50% now?
smp: Yes, but that restriction only applies to meal costs, not to the incidental expenses associated with a trip. You don't have to have a receipt for items under $75 except for lodging, but you need the business purpose, who was entertained and their title, where and how much.
Q: Thanks, Steve. You've given us self-employed individuals a lot more to be aware of. Any final thoughts?
smp: Yes. I recommend keeping a log. Document your contacts, where you're going, substantiate your business deductions. You're not filing an expense report any more like you did as an employee so here's where you can keep track. Auditors will accept receipts, but they love a diary. It can be on paper or on the computer. Log who your phone calls were to and the time. Document your activities. It will help you determine the percentage of time that was work versus personal. Use it to substantiate what business benefit you are going to derive from an activity, As a consultant you tend to forget some things.
Credit cards are important, but some things are done in cash. Going back through you diary can help you find other legitimate deductions that you might otherwise have overlooked.