Money used to be such a simple thing. A $1 weekly allowance from parents for all of your childhood chores was a pretty easy account to keep track of. Want to know how much you have? Open the piggy bank and count it up. Once the money was inhand it was 100% yours.
As time pressed on, and if you lived in the U.S. you were introduced to the IRS (or similar tax collecting agency elsewhere). These folks want to know everything about your money so they can get their cut. Not only that, they expect us to each keep track of it ourselves, and if they want to take issue with our records (or math, or interpretation of the rules) then they can make all kinds of trouble. Having money inhand all of the sudden got a lot less exciting.
There is a silver lining for the self-employed who have to deal with accounting: writing off business expenses. If I incur an expense that is required for my business, that gets written off against (read: deducted from) my income. Take the example of where I make $10,000 from a client's job. But in order to complete that job I had to buy a new $1,000 function generator which I paid for (i.e., was not reimbursed by the client). In order to make that $10k, I had to shell out $1k, so the government only makes me pay taxes on the $9,000 net profit.
As someone who works professionally with electronics and also loves tools, this can obviously have its benefits. The folks I left behind at my big company job can't write off neat equipment for their home lab like I can. In years that I have strong revenue, I rationalize buying equipment to lighten the tax burden since the next year might not be so fat. If there are large pieces of equipment, it may not be possible to write it off all in one year, so be sure to check with an accountant if you're looking to write off a $20,000 spectrum analyzer.
It needs to be said that the IRS and local taxation authorities do not like people to be improperly called a 'consultant' so the client and consultant can reap the tax advantages. The consultant can take the write-offs mentioned here, and the client doesn't have to pay employee overhead like unemployment insurance. It can be difficult to draw the line between consultant and employee, so the IRS sheds some light on it with a list of tests to run on the position (you can find definitions, as well as other useful references, at the end of this article). The tests, such as if you have a dedicated office at the client’s location (don’t), if you only have one client, or if the client provides equipment, specific instruction, and training can be difficult to interpret, but as a consultant you should be aware of them.
There are all sorts of things that can be written off. Writing off the office in your house is nice, and you can write off a percentage of costs like rent or mortgage, heat, electric, and water. If you have a 500 sq.ft. office in a 5,000 sq. ft. house, you can write off 10% of your housing expenses. Parts of a room can be written off as well in case you share an office with a spouse. While I've never had a visit from the IRS, they have been known in the past for coming to visit a home office and check that you're not calling a man-cave an office just because it has a laptop in the corner. When you drive your car for business (and track the miles) you can write off $0.56 per mile. New lab equipment, computers, internet fees, cell phones, all can be written off.
Writing off part of things like a house and car has some ripple effects to be aware of. I have to insure my home with a more expensive local State Farm agent because most of the faceless discount companies shy away from insuring a house that is also used for business purposes. I didn't need to make any changes to my car insurance (Geico), however they explained to me that my policy would not be valid if I used the car for business more than 50% of the time.
The obvious follow-up question is 'Where is the line drawn between business and personal expenses?' The IRS has pages on pages written about it, but does publish a decent summary. Each person/business must figure out how aggressive they want to be with their taxes. The most conservative only write off expenses that are 100% business use: for instance if a computer is bought for both personal and business use they would not write it off. The most aggressive write off everything that could look like a business expense, such as a video camera that they got for a family vacation, but which will also be used to take professional videos. I can suggest considering things as a business expense if they would not have been bought if not for the business. Services like cell phones and internet can be a tough call. I have an unlimited internet plan at home which I use for business and write off 100% because the personal use comes free. My cell phone, however, is on a metered data plan so I approximate how much I use it for personal and business and write off a percentage. Many people also like to take little holidays at a client's location, which can be another grey area. They will follow a business trip with an extra day or two of R&R before flying home (while not writing off the expenses incurred while on personal time). More aggressive people will schedule business meetings before a personal vacation which would be more difficult to defend in an IRS audit.
There are a few factors to keep on top of. It is important to write off a portion of the home for business use in order to write off the miles driven from home to a client. This is because travel from home to work is not a deductible expense, but travel from one work location to another is. When traveling, it is annoying to track every meal receipt. Instead, you can opt to write off a per diem (an assumed expense that the IRS says is reasonable without receipts), which can be looked up for any city on this website.
Once you have an understanding of the rules and risks, how do you keep track of all of this stuff? The best thing to do is have a separate checking account and credit card for business use to ease tracking on top of maintaining the corporate veil. Many consultants (myself included) prefer to use accounting software or cloud services like Intuit’s QuickBooks. However, no amount of engineering or mathematical training can prepare you for the education required to get started with the software. Serving a couple clients and incurring only a dozen expenses per month makes spreadsheet accounting a simpler alternative. Tracking the bank account and all expenses is about all new consultancies have to do. To get you started, I have attached the spreadsheet that I used early on.
Along with the spreadsheet, receipts are a must. You need to be able to prove that you made a purchase. Credit card statements prove that you spent $1,000 at Best Buy, but a receipt proves that you bought a computer instead of that HDTV you would rather buy. Keeping tabs on the receipts is a challenge. I had a system where there was a small envelope on my desk that I stuffed receipts into. At the end of the week or month (depending on how full it got), I'd enter each charge in my spreadsheet and put the receipt in an accordion file folder. Receipts were only allowed to be in my wallet, envelope, or file folder. Putting them on a bed stand, in my pocket, or in my car's cup holder was the same as throwing them away.
A word to the wise: do your bookkeeping often to prevent errors and mitigate memory lapses. It is difficult to handle 100 financial events in one sitting accurately, so spending one day a month to keep ahead of it can be helpful. There are two keys to success with accounting and taxes: honesty and good record keeping. If you have them both, you'll probably be fine.
Do you have any experience with write-offs? Think I'm too aggressive or conservative? Had a run in - the IRS about business expenses? Please leave a comment! I'd like to hear some stories.
Author’s note: I’m not a lawyer or accountant. These thoughts are based solely on my personal experience and do not constitute legal advice. When in doubt, seek out qualified legal and accounting counsel!
Useful Resources Mentioned In This Article:
- Look up per diems for food while traveling: http://www.gsa.gov/portal/content/104877?utm_source=OGP&utm_medium=print-radio&utm_term=perdiem&utm_campaign=shortcuts
- IRS definition of a business expense: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Deducting-Business-Expenses
- IRS definition of a consultant suitable for being paid on a 1099: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee
- Helpful Accounting Spreadsheet (2 tabs): <attached>
James Benson is writing a series on 'Engineers As Consultants' to educate and encourage salaried engineers to consider if hanging a shingle is right for them. New posts on the first Monday of every month.
Pt. 1: So You Want To Be A Consultant
Pt. 2: How Do Engineers Find Consulting Gigs?
Pt. 3: How To Price Consulting Services?
Pt. 5: Finding The Best Client Mix
Pt. 6: How To Turn Down A Client
Pt. 7: How to Write a Client Acceptance Clause
Pt. 9: Taxes, Writeoffs, and Accounting
Pt. 10: When Subcontractors Quit
Pt. 11: When a Client Turns into a Deadbeat
Pt. 12: Getting Paid with Company Stock
