Consultants are experts in a specific field who share knowledge and insights with clients or employers who pay them. Starting a consulting practice is a way to start your own business and work on a contractual basis. Freelancing brings many freedoms and benefits, but it also comes with more tax responsibilities. Consultants still have to pay federal income taxes and self-employment taxes, in addition to local and state taxes. Here’s how it works.
Self-Employed Consultants and Taxes
According to the IRS, you are considered self-employed if you are a business owner or a contractor providing services to other businesses. To remain classified as a contractor rather than an employee, you must:
- Have the right to direct or control the work you are doing
- Have the right to direct or control the financial and business aspects of your work
- Have a relationship that is not that of an employer-employee – it should be a non-permanent relationship and benefits like insurance or paid leave are typically not provided
Note: Some consultants are employed full-time by a single company. If you are a consultant employed by a company, it is likely that taxes are withheld from your salary just like any other employee.
If you are a self-employed consultant, clients will pay you the full amount you invoice without tax withholding. For example, you will receive $1,500 if your service costs $1,500, but that doesn’t mean you do not owe taxes on that amount of income.
Self-employed consultants typically must pay both federal income taxes and federal self-employment taxes. The amount you owe as income tax will depend on your tax bracket. Tax rates range from 10% to 37%. Your highest rate depends on your net income.
The self-employment tax rate is 15.3% – 12.4% for Social Security and 2.9% for Medicare. You usually pay self-employment taxes on 92.35% of your net earnings.
How Taxes Work for Consultants
Here is a simple example (without deductions or tax credits) of how taxes work for self-employed consultants:
Let’s say you are tax liable and your net profit as a consultant is $120,000 for the tax year. This places you in the 24% tax bracket. Here’s how you can calculate the amount you owe as tax on that net profit of $120,000. We will use the tax year 2022 (the return you file in 2023) as an example:
First, you will want to know the amount you owe as income tax. Because $120,000 falls within the 24% tax bracket, you will pay 24% on the amount over the minimum of that bracket:
$120,000 – $89,075 = $30,925 × 24% = $7,422
Next, you need to determine the amount you will pay as tax on the net earnings below the threshold of the 24% tax bracket. You will pay:
- 10% on the first $10,275 (which equals $1,027.50)
- 12% on the next $31,500 (which equals $3,780)
- 22% on the next $47,300 (which equals $10,406)
This all depends on the tax brackets for the tax year. With the total taxes calculated above, you will owe a total of $22,635.50.
Next, you need to find out how much you will pay as self-employment tax. You can do this by calculating 15.3% of 92.35% of your net earnings:
92.35% of $120,000 = $110,820 × 15.3% = $16,955.46
Add $16,955.46 to the income tax of $22,635.50, and you get $39,590.96. This amounts to about 33% of your net income.
It’s wise to make estimated quarterly tax payments to cover this tax bill if you can. For example, if you know in March that you will earn $120,000 for that tax year, you can calculate your tax bill and then divide it into four equal payments, sending a check to the IRS by April 15, June 15, September 15, and January 15. So, if you know you will owe $39,590.96, that would equal four payments of $9,897.74 each.
Summary
- Net
- Earned income: $120,000
- Income tax bill: $22,635.50
- Self-employment tax bill: $16,955.46
- Total federal taxes due: $39,590.96
- Tax rate to net income: 33%
- Estimated quarterly payment amount: $9,897.74
You can calculate estimated taxes on IRS Form 1040-ES if you need assistance. Then, when you’re ready to pay your taxes, you can do so by mail, online using the Federal Electronic Payment System (EFTPS), by debit or credit card, or by direct payment to the IRS.
Note: Earnings up to $147,000 are subject to the Social Security portion of the self-employment tax per taxpayer for 2022, and up to $160,200 for 2023. You do not have to pay Social Security tax on earnings exceeding the annual amount, but all earnings are subject to the Medicare self-employment tax.
Tax Deductions for Consultants
Deductions allow you to lower your taxable income, meaning you will owe less in taxes. Your taxable income might only be $80,000. You could drop to 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 that may be available to consultants:
- Self-employment tax deduction: You can deduct half of your self-employment tax each year, which is equivalent to half of what the employer portion would be.
- Investment r
Source: https://www.thebalancemoney.com/tax-impact-independent-consultant-2275048
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