Most of us would rather not think about taxation. After all, as Benjamin Tucker once said, "To force a man to pay for the violation of his own liberty is indeed an addition of insult to injury." This accounts for the Internal Revenue Service's preference for taking its due from wages, so taxpayers don't even have a chance to consider when they can afford to pay it. Quoting Chris Rock, "You don't pay taxes — they take taxes." Those of us who run our own consulting business, however, need to ensure that we pay our taxes in full and when due because, typically, our taxes aren't withheld automatically.
The taxes for which you may be liable vary from place to place depending on national, state/provincial, county, and city laws. Taxes generally fall into one of three categories: income, sales, and property.
In the United States, all for-profit business owes tax on that profit to the federal government, whether it's reported as Schedule C income for a sole proprietor or on a Corporate or Partnership return. Most of the states (as well as some cities and counties) also assess a tax on business income. Sometimes these lesser taxing authorities base the amount you owe on net income (like the federal government), but in other cases, they base the amount you owe on gross revenue minus deductions and credits — thus it's possible to lose money yet still owe taxes, or to make a profit yet owe nothing.
Here are some questions you should ask your accountant about taxes on business income:
- Who are all the taxing authorities you must pay? Federal/national, state/provincial, city, county, other?
- What income do you need to report? You might be able to exclude some income. For instance, revenue generated in another state might not be taxable in your home state — but check the laws, and also check to see if you must pay taxes in that other state.
- What expenses can you deduct? The U.S. Federal tax allows businesses to deduct most business expenses from income, but those same expenses may or may not qualify for deduction from other returns.
- Do you qualify for any other deductions and credits? Make sure you do indeed qualify. For instance, Washington State offers a credit for purchase of Energy Efficient Commercial Equipment. You might be seeing dollar signs on all your LCD screens until you read the fine print and find that the credit only applies to freezers, refrigerators, clothes washers, ice makers, ovens, fryers, and food warmers.
The United States also levies a second tax on sole proprietorships, known as the Self-Employment Tax. This amounts to a combination of the employee and employer portions of FICA (Social Security and Medicare). Although the Fed sets aside these monies ostensibly for your later benefit (except when they need to raid it), at 15.3% it's a big chunk out of your revenue that you can't afford to ignore until tax time.
Many states, cities, and counties in the United States, as well as provinces in Canada, levy a tax on final sales — usually payed by the buyer but collected by the seller. The United States does not (yet) have a federal sales tax. Countries such as those in the EU, India, Canada, and others collect a Value Added Tax (VAT) on sales of goods and services at each level.
Here are some questions you should ask your accountant about sales tax or VAT:
- Who are the applicable taxing authorities? For instance, in the United States the state typically collects the total sales tax from the seller and then distributes the correct portion to the county and city. For out of state or international transactions, are you required to collect tax for some other authority?
- What's taxable? If you're selling a product such as equipment or software, is that product taxable? Is the buyer tax exempt? What about services? Some authorities tax services as well, so you need to know if that applies to consulting services. For example, Washington State does impose a sales tax on services, but it only applies to a limited number of services like construction, physical fitness, and recreation.
Even though sales taxes or VATs are ostensibly collected from the buyer, they nevertheless effectively raise the price of goods and services; thus, they create yet another tax on self-employed consultants where they're applicable to our services. Sales taxes never apply to services provided by regular employees to their employers, so any sales tax on consulting services favors the use of employees instead.
Freelancers may not realize that some areas require businesses to pay property tax on assets used in the business. For instance, in Kitsap County where I work the rate is 1% of the assessed value per year. Fortunately, there is a $15,000 exemption for sole proprietorships.
Benjamin Franklin famously wrote that "nothing is certain but death and taxes." While we can be certain about the inevitability of taxes, most of us are far from certain about their rules for compliance. Before you conclude that you've got it all figured out, you better ask someone who specializes in the business tax laws of your place of business. Spending a few hundred dollars on a good tax accountant could save you much more in the long run.
Chip Camden has been programming since 1978, and he's still not done. An independent consultant since 1991, Chip specializes in software development tools, languages, and migration to new technology. Besides writing for TechRepublic's IT Consultant blog, he also contributes to [Geeks Are Sexy] Technology News and his two personal blogs, Chip's Quips and Chip's Tips for Developers.