Retired Military Career Tracks. So, You Want to Be a ConsultantTaxes Transition
I think there is something in our blood. A Colonel or Captain retires, and he or she decides it is time to become a consultant. That’s fine. You can bring a lot to the table. But there is more than a little bit to becoming one. The first thing is getting your mind right. If you want to become an independent consultant, you want to become a business owner. Because that is what you’ll be. You’re not just some guy or gal spreading knowledge around the country. You own a business and are responsible for everything that comes from that.
Forming Your Consultant Business
The first thing you’ll need to do is select a business form or, said another way, what type of entity you will be? Even if you do nothing, you will form some sort of business. Here are the options:
- Sole Proprietor. If you do nothing and go into business by yourself, you’ll be a sole proprietor. For all practical purposes you and the business are one in the same. Your business debts are your personal debts. You’ll report your income from the business on your individual tax return and all of your income will be subject to self-employment tax. You’ll also have the lowest amount of required bookkeeping and formalities
- Partnership. If you go into business with someone else and don’t do anything, you’ll be a partnership. A partnership can be formed on a handshake or can have a more formal written agreement (I’d lean towards a written agreement). Like a sole proprietor, you’re personally liable for any debts of the business. This is true even if your partner signed the partnership up for the debt and you didn’t even know about it. Partnerships aren’t taxed at the entity level, but rather file an informational return with the IRS and provide partners a statement of what the partnership earned and lost. This is reported on Schedule K-1. You will enter the information from the K-1 onto your personal tax return and pay taxes on it as part of your individual tax. Like a sole proprietor all income earned in a partnership (with some exceptions) is subject to self-employment tax.
- Limited Liability Corporation (LLC). This seems to be the golden ticket in a lot of people’s minds. That may or may not be true. First of all, an LLC provides a layer of separation between the company’s assets and liabilities and your personal assets. To get any level of protection though, you’ll need to keep company assets separated from your personal assets. For example, you’ll need a company bank account and should probably have a separate credit card. You should pay all your bills with company funds (don’t take the easy way and pay bills out of your personal account). While you should definitely consult with an attorney, you may want to also have corporate formalities like an annual meeting. It is also important to note that an LLC never provides you protection from your own actions. While this article is about consulting, let’s assume your LLC owns a bar. If you’re working one night to help out and over-serve someone who then has an accident, you are personally liable for that act regardless of the form of your business. From a tax standpoint an LLC accomplishes absolutely nothing. You’ll elect to be taxed as a sole proprietor or partnership (if more than one person) or a corporation (C or S).
- S Corporation. If an LLC is the golden ticket, it seems like S Corps are nirvana for CPAs. That is because they can come with some tax benefits. Like an LLC, an S-Corp is a pass-through entity. But unlike an LLC you are both an owner and an employee of an S-Corp. When forming your S Corp you’ll file a Form 2553 with the IRS. You will earn (eventually) a salary from your S-Corp. The salary has to be reasonable, but that doesn’t mean that everything your clients pay you needs to be converted to your salary. You can look at different sources for what a reasonable salary for the many different jobs you do as a business owner and come up with your reasonable compensation. A CPA or EA might be able to help you with this. In general, make sure you consider that if your salary is below the Social Security wage base, you’ll be sacrificing future Social Security benefits. After you pay yourself your salary, earnings are paid out as a distribution and not subject to self-employment tax (unlike a sole proprietor or partnership). This is the major tax advantage of an S-Corp. At the end of the year the S-Corp will give you a W-2 for your wages and a K-1 for your ownership results. As you move into the corporation realm, the formalities become more important so make sure you talk to an attorney about this. While they insulate your personal assets from your business assets (potentially even more than an LLC), they don’t protect you from liability for your own actions either. One other last note. S-Corps have limitation on who can be a shareholder so make sure that won’t be an issue for you.
- C-Corp. When you look at a big corporation, you’re most likely looking at a C-Corp. C-Corps don’t seem to get used a lot for small businesses. The common reason heard for this is that C-Corps are subject to double taxation. For a small business that may not necessarily be the case. Unlike all the entities we’ve talked about up until this point, a C-Corp pays its own taxes. If the corporation has a profit, it will pay taxes. Then if it distributes those profits to shareholders (you) the shareholders are subject to taxation on those dividends (by the way, the dividends are not deductible by the business…hence double taxation). But earnings can be retained and not taxed beyond the corporate level. This isn’t always the case, but it may apply if your earnings are small, or you are preparing for some major capital needs (granted a little unlikely for a consultant). Corporate formalities become more important, but at the same time in my opinion the liability protection is at its highest level.
Ultimately the choice of business entity is yours to make, and each option has its own plusses and minuses.
Taxation When You're a Consultant
Handling your taxes as a business owner are a lot different than as an employer. Let’s talk about self-employment taxes first.
Self-employment taxes are just another word for FICA (Social Security and Medicare). But if your business as taxed as a sole-proprietor or partnership you are required to pay both the employer and employee portions of FICA. That is a total of 15.3% up to the Social Security wage limit (currently $147,000). You pay 2.9% on everything above that. You pay this on your profits prior to any deductions for medical insurance (which self-employed individuals can deduct without itemizing) and/or contributions to retirement plans. That is a pretty big chunk off the top of your earnings. Then you’ll have income taxes on top of that. A retired O-6 is probably going to be in the 22% tax bracket at the minimum and if your consulting business does well, you’ll likely be in the 24% bracket. Tack on a nominal 5% for state income tax and you’re looking at giving close to 45% of your profits to the government. Ouch. With that said, you do get a couple of tax advantages. First, you’ll be able to deduct a whole lot more than you could as an employee. My basic rule is if you’re spending a buck to make a buck, you can deduct it. For at least the next few years you’ll get a 20% deduction on your Qualified Business Income (QBI). QBI isn’t exactly your profits. There are a couple of adjustments, but it is pretty close to that amount. It is also worth noting that if you’re really good at consultant and make a lot of money, you could lose some or all of the QBI deduction as consultants are considered a specified service company.
If your business is taxed as a Corporation (S and C) you as an employee will pay Social Security and Medicare taxes just like you do now. The company (which is also you) will match those payments. You’ll also owe income tax on your wages.
If your business is a C-Corp, it will pay income taxes and they can range from 20% to 39.6%. As mentioned earlier, distributed dividends are taxed as income (potentially qualified dividends that are taxed at a better rate). S-Corp distributions are subject to income tax but not self-employment tax.
Other Taxes Consultants Need to Know About
When you form a business other than a sole-proprietor or partnership you’ll file articles of some sort with the state. When you file them, you’ll pay a fee. This fee will probably be due every year.
When you become a business, you become a lot more interesting to your city and/or county. You’ll probably need some sort of license, and it won’t be free. You’ll likely need to renew your license every year. Fees can vary. In some jurisdictions (Northern Virginia) the license fee will be based on revenue (not profits). Some counties (Northern Virginia) charge a personal property tax on the company’s personal property. Personal property includes things like your business computer, your desk, your chair and even your stapler.
One last thing to consider is Zoning. Your home is probably zoned residential, but you’ll be operating a business there. You may need a variance from code (just another tax), to operate from home. Or you might not. You may want to check and after COVID, this may not be a thing.
Consultants Need to Have an Accounting System Too
If you're a business owner you're going to have to keep the books. At a minimum you'll need accounting info to complete your taxes. You can also use your books to figure out whether you're charging enough or whether you can afford an assistant. If you have a background in accounting (or at least took an accounting class in the past), you can probably track your finances on QuickBooks. If you have no idea what a balance sheet is, you'll probably want to hire a bookkeeper or accountant.
Wrapping it up
There are a lot of people that went before you and ventured into consulting world. Many are successful. And with your military pension you have a pretty nice cushion of income. Before you take the leap though, make sure you’ve look at the issues above and think about this endeavor as a business, not a job. Good luck!
Military Finances are Different
While you'll be just like every other business owner when it comes to your business. But the rest of your financial life is significantly different than your civilian counterparts. That's why we think you should work with a financial advisor or planner that deals with issues just like yours every day. If you'd like to find out how we do things, use the button below to schedule a free initial consultation.
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