Tax Tips for IT Consultants and Contractors

I live and work, quite literally, down the road from the main Microsoft campus. No surprise, then, that Im commonly asked by freelance consultants for free advice about how these self-employed independent contractors can minimize their income taxes.



If I can, I try to weasel my way out of the discussion, offering up such basic tidbits as, Well, be sure to look at the home office deduction. And make sure youre taking advantage of deductions for health insurance and pension funds.



Usually, those simplistic answers work. Everyone once in a while, though, I encounter some guy whos really motivated to save on taxes. Usually, someone now making good money consulting or contracting When I cant deflect their questions in some other way, I tell them about the three best ways that independent contractors have to save on taxes.



Technique #1: Smooth Your Income



Whatever you think of the US Internal Revenue Code, you need to know that its quite progressive. That progressivity means the more you make, the more you pay. The progressivity also means that if your income fluctuates, your income taxes go up even if you make the same money on average as someone else makes.



To give you an example of this, suppose that you compare two consultants, John and Jane. If John makes a steady $60,000 a year and has a mortgage, a spouse and couple of kids, he might pay about $1000 over four years (net of tax credits for these like his children.)



In comparison, suppose that Jane averages $60,000 a year, but sees her income fluctuate between $30,000 a year and $90,000 a year. If she also has a spouse, two kids and a mortgage, shell probably pay $8,000 to $10,000 over those same four years.



Please note that over the same four years, the two consultants make the same amount of money: $240,000. But what they pay in taxes differs radically. Jane pays eight to ten times what John pays. Bummer.



What can Jane do? Well, lets bring this back to the example of working consultants. Jane can probably smooth her income. She can make sure that shes not stacking two big retainers or performance bonuses in the same year. She can spread out year-end payments over the ending and beginning year in ways that smooth her income out. She can even try to stuff more of her expenses into the good years. In the good years, for example, she can buy new computers, take those graduate classes, or top off her pension.



Technique #2: Setup an LLC and Elect S Corporation Status



Ive written and talked much about how S corporations save taxpayers money and how the right way to set up an S corporation is first create a limited liability company and then ask the IRS to treat the LLC as an S corporation for tax purposes.



Let me review the basics here again, however. Suppose that youre making $90,000 a year as a consultant or contractor. If you just treat your business as a sole proprietorship, you might pay $12,000 in income taxes on the $90,000 and then another 15.3% self-employment tax, or roughly $13,500 on the $90,000.



If you set up an LLC and have the LLC treated as an S corporation, youll still pay the same $12,000 in income taxes. But youll only pay the 15.3% self-employment tax on that portion of the profit that you categorize as wages. If you categorize, say, $50,000 of the profits as wages, youll pay $7,500 in self-employment taxes. (The other $40,000 in remaining profits, by the way, gets paid out as a dividend-like distribution.)



Note, then, that the S corporation saves you roughly $6,000 every year. Sweet, right?



Two quick points about S corporations: First, S corporations require some extra tax and accounting so you dont get to spend all of your savings. Some of the savings go to the lawyer, the accountant, and the bank. Second, you absolutely must set your salary to a reasonable level.



Technique #3: Relocate Your Residency



One final, easy planning gambit if you telecommute. Remember that there are states like Alaska, Florida, Nevada, Texas and Washington that dont charge residents state income taxes. Accordingly, if you relocate to one of these states, youll automatically drop your overall tax bill because you wont have state income taxes.



Sometimes, one of the benefits of independent contracting and freelance consulting is that is that you do get to live wherever you want. Why not choose a place that doesnt tax your income?



But a caution: Do be careful that you dont get blindsided by the other taxes a state levies. For example, Washington state where I live charges a one and half percent excise tax on service revenue. This is probably still less than the income taxes that many other states charge. But it highlights an important caveat: Before you move to some other state, you definitely want to run the numbers and compare your current state to the possible new state.






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