Taxes for IT Consultants and Other Consultants

As a Phoenix tax CPA and accounting firm, I am seeing a large increase in the number of IT consultants. Many companies are trying to reduce their costs due to the new ACA health care law and due to the requirements to offer retirement plan benefits to employees. The consultant is new to being on his or her own. There are a plethora of benefits available that are only offered to an independent contractor.

For example, if Joe becomes the only owner of his S corporation, he can establish a SOLO 401K for himself and his wife resulting in putting away a very large amount of retirement while reducing taxes.

He can get reimbursed legally for a percentage of the business use of his home as long as he dots the “I” and crosses the “t”! The correct legal agreement must be signed and proper documentation must be retained.

In most cases, cash basis should be elected instead of accrual basis.

Some of the confusion that a consultant has is when he or she reads a large number of articles on the internet that includes misinformation.

For example, an individual may use a company to help him obtain a federal ID# with the IRS and the company is ignorant regarding the tax ramifications of selecting a sole proprietorship, partnership, S corporation or C Corporation.

Many consultants think that an LLC is automatically a partnership when an LLC can be any time of legal tax structure. I explain to my clients, that LLC does not mean a partnership. I teach them to think of LLC like dessert. A dessert can be ice cream, cake, pie, or candy. An LLC can be taxed as a sole proprietorship on the personal tax return, a partnership, S Corporation or C regular corporation where the income is taxed on the C Corporation tax return.

IRS audit activity in the consulting profession is fairly high because of the mixed personal versus business nature of many expenses of both the consultant and companion/family members. Additionally, the question of employee versus independent contractor often arises, particularly for displaced workers who have taken on the consulting role and are now engaged by the same company and/or industry that previously employed them.

Furthermore, there is a perception, right or wrong, that consultants are more likely to understate their income and/or overstate their expenses because they are less subject to the information reporting and tax withholding rules applicable to employees.

One priority of an IRS audit is to verify that gross receipts have been properly reported. This means that the business return and the sole proprietorship Schedule C will be examined to determine that all income has been reported.

Examiners usually attempt to reconcile deposits to bank accounts with income reported, considering such non income sources as loans, gifts, and interbank transfers.

While a bank deposit analysis is a common procedure, an in-depth analysis of deposits or requests for substantial additional information may indicate the examiner suspects there is unreported income.

In such a case, the examiner’s manager must be consulted to decide whether to expand the audit to include prior and/or subsequent tax years. The examiner and manager must consider whether the case warrants referral to the Criminal Investigation Division for possible tax fraud prosecution.

In July 2011, the IRS updated its Audit Technique Guide (ATG) for business consultants. The guide identifies several examination issues that are prevalent on consultants  tax returns:

a.Travel Expenses of Consultants. The guide identifies two potential areas of concern, the first being spousal/family travel, and the second being personal travel. The guide also addresses “temporary” versus “indefinite” travel expenses.

b.Employee versus Independent Contractor. The guide again identified two areas of concern, the first being a former employee coming back to a company as an independent consultant with a minimal break in service, and the second being the continued use of the same strategic alliance.

c.Meals and Entertainment. Four specific areas of concern are identified:

  • expenditures for personal meals and entertainment where a lack of business purpose exists
  • the 50% deduction disallowance rule for meals and entertainment,
  • limiting meals and entertainment while an employee is in travel status if the expenses are not reimbursed by employer, and
  •  meals and entertainment in non-travel status.

d. Personal Service Corporations.

e. Not-for-profit Considerations (i.e. hobby losses)

In addition to the specific audit concerns described in the ATG, IRS audits often also focus on—

a. Business versus Personal Use of Assets. This can include the personal use of automobiles, computers, DVD players, etc., where a personal element may be involved. Consultants should keep detailed records of business use for mixed business/personal assets, including automobiles, computers, copiers, etc.

b. Compensation and Fringe Benefits. In particular, examiners focus upon arrangements with the spouse and/or children of the consultant. Again, records documenting the hours worked and responsibility areas, clearly justifying any compensation and fringe benefit programs, tend to prove highly beneficial in the event of an IRS examination. The objective is to prove that a valid employer-employee relationship exists with the spouse and/or child.

c. Barter and Cash Transactions. Consultants, like other small business operators, need to maintain detailed books and records summarizing all transactions, including cash and barter transactions.

Properly maintaining business books and records are critical due to the highly personal nature of the business. Detailed records and thorough documentation (substantiation) can minimize or eliminate many IRS audit adjustments.

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

Certified Public Accountant
Address: 4647 N 32nd Street, Suite B245
Phoenix, Arizona 85018
Phone: 602-292-2009
Email: jeff@jbrookswa.com