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Consultants: W-2, 1099 or Corp-to-Corp?

Do a quick search on Google and you'll find thousands of pages with people trying to figure out how to answer this question: I have a new consulting gig, should I go W-2, 1099, Corp-to-Corp? This seems to be the $64,000 question for consultants and independent contractors. So what is the answer? I've laid out the answer in three ways:

Each will provide more detail than the previous. I'll also provide example scenarios so you can see the financial impact of each type of business organization.

Caveat: I've tried to be as complete as possible. However, for the sake of clarity I've had to make some pretty broad simplifications. This document tries to present the basic issues you should consider in a balanced way. Remember information is not advice. Consult with your own accountant or tax professional if you want professional assurances about the information presented here, and your interpretation of it, is appropriate to your particular situation.


The Really Short Answer

Be sure to consider you own personality, however, nine times out of ten it is financially more beneficial to go Corp-to-Corp, provided you:

  • organize as an S-Corp and you make all the tax filings and deposits on time.
  • hire some help to handle all the taxes and other administrivia.

Most people will find handling the payroll, taxes and filings overwhelming. You will probably spend less on the help than you would on interest and penalties if things go awry.

The Short Answer

The biggest factor that should impact your decision is your own personality. The three options (W-2, 1099, and Corp-to-Corp) vary in complexity with W-2 being the simplest and setting up your own corporation the most complicated. You need to weigh the trade-offs of each approach and pick the one that fits your lifestyle best. Because in the end the money you save on taxes won't seem worth it when you start pull out your hair, or what's left of it. :)

Based on your personality, here are the three options:

Are you a procrastinater? Consider W-2

If you're the kind of person that absolutely hates tax time, procrastinates until 10pm on April 15th, and would rather get a root canal than fill out a government form, you should consider W-2. You may not find the extra tax savings worth the headaches.

Are you detailed-oriented? Consider Corp-to-Corp

On the other hand, if you balance your check and credit card statements to the penny every month, you always get your tax returns in early or, ideally, have some accounting background, setting up and maintaining your corporation may not be that big a deal.

Do you like to challenge authority? Choose 1099 at your own risk

If you're not easily intimidated and the idea of taking on the IRS gets your juices flowing in a good way, you might consider the 1099 (AKA self-employed) option. But there are some downsides to being self-employed that will probably lead you to choose one of the other two options: like your return is more likely to catch the eye of the IRS than any of the others discussed here.

The other option: Regular Salaried Employee

Remember to consider being a regular employee instead of a consultant. You will probably pay more in taxes but you will get substantially better benefits. With 46 million uninsured Americans and abysmal savings rates, the advantages of the benefit packages offered by most employers should not be ignored.

The Long Answer

Now we're going to get in to the nitty-gritty details. I've broken this section down further and we'll discuss the issues you'll face for each of our three options.

Remember to take a look at the comparisons to see how the specific details impact the trade-offs you have to make in coming to your decision.

First things first: Are you really an independent contractor and why does this matter?

Employees are entitled to certain legal standing and benefits that are not available to independent contractors. In addition, employers are required to pay certain taxes on employee wages. The distinction of independent contractor or employee may not matter to you now, but it will likely matter very much to your client and the IRS. It may also matter to you later if the IRS later rules that you were an employee and disallows your independent contractor status. Your client will probably make decisions based on this distinction and it behooves you to understand the distinction to avoid getting stuck between your client and the IRS later.

The general rule is that an individual is an independent contractor if the organization for which the services are performed has the right to control or direct only the result of the work, and not what will be done and how it will be done or method of accomplishing the result. However, whether an individual is an employee or independent contractor depends on the facts in each case.

As listed in IRS Publication 1779: Independent Contractor or Employee?, the courts have determined there are three categories of facts that are relevant in determining your work status:

  • Behavioral Control: These facts show whether there is a right by the business to direct or control how the work is to be done. A worker is an employee when the business has the right to direct and control the worker. The business does not have to actually direct or control the way the work is done as long as it has the right to direct and control the work.
  • Financial Control: These facts show whether there is a right to direct the business part of the work. For example if you have a significant investment in your work and your expenses are not reimbursed, you may be an independent contractor. If you can realize a profit or incur a loss you may be an independent contractor.
  • Relationship of the Parties: These facts relate to how the parties view their relationship. These include things like benefits such as insurance, PTO, etc. If you have these, this is an indication you're an employee. A written contract may show what the parties intend if it the relationship is otherwise unclear.

There is also more detailed information in Chapter 2 of IRS Publication 15-A Employer’s Supplemental Tax Guide.

OK, so let's say you are indeed an independent contractor. Now we get back to the main question: W-2, 1099 or Corp-to-Corp?

W-2 Employee

Definition:

You are an employee of the broker selected by your client. Your wages are subject to the same tax withholdings as a regular employee.

W-2 Pros:

  • Easiest and simplest option.
  • No bookkeeping needed other than submitting time sheets.
  • Some limited benefits may be available.

W-2 Cons:

  • Limited ability to defer income if a 401(k) benefit plan is unavailable.
  • Deductibility of unreimbursed business expenses and medical insurance premiums are very limited.
  • Getting health insurance coverage if none is provided can be a challenge.
  • Any benefit package is likely to be less generous than if you were a regular employee of the client.

The Simplest Option: W-2

You are basically an employee of the third-party broker hired by your client, although any benefits package offered is likely to significantly less than if you were a regular employee of the client company.

Usually the client has a head hunter, broker or other third-party service that will act as the intermediary between you and them. Your client may prefer this option because it mitigates the risk that you or IRS will come to them later and claim you were really an employee.You will receive wages from the broker with the requisites taxes withheld. The broker will probably receive 15-35% above your hourly rate to cover its expenses. Something to keep in mind when you're negotiating your rate.

Benefits? Maybe.

Some brokers will provide you with medical and dental insurance options, life insurance, Section 125 flexible spending and even a 401(k) plans. The costs of these benefits to you are much higher than if you were a regular employee of the client. If there's no 401(k) plan, your only retirement plan option is either a traditional or Roth IRA.

Any Way to Reduce Your Taxes? Few, If Any.

Your ability to deduct unreimbursed business expenses is only available on amounts over 2% of your Adjusted Gross Income (AGI). Medical expense deduction, including premiums, is limited to amounts over 7.5% of AGI. (Note: any premiums paid with pre-tax dollars are not eligible for the deduction.) You may be able to defer some income by contributing to a traditional IRA that can help reduce your AGI.

1099 Self-Employed Sole Proprietor

Definition:

A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether used in the business or personally owned. You include the income and expenses of the business on Schedule C of your own tax return.

1099 Pros:

  • Easy to get started.
  • Easy to discontinue when your contract ends.
  • Losses might be used to offset other income (limits apply).
  • Small business retirement plans offer the opportunity to defer more current income than traditional IRAs.
  • You might be eligible to take the Home Office Deduction.

1099 Cons:

  • Unlimited liability for the owner.
  • All profit is subject to self-employment tax in addition to the income tax.
  • More administration and bookkeeping than W-2 option.
  • You must make quarterly estimated tax payments.

Most companies are wary of going 1099 to an individual. The IRS can review your situation after the fact and decide you were really an employee and nab the company for back payroll taxes and massive penalties. Therefore, to limit their exposure, most companies prefer either W-2 or Corp-to-Corp relationships.

Starting Your Self-Employed Business

If you manage to make this arrangement with your client you don't need to do anything special to get started, at least as far as the IRS is concerned. Your state, county or city may required you to get a business license or make a Fictitious Name or DBA (Doing Business As) Statement. You'll need to check with your local governmental agencies to find the requirements in your area. You may also need to check for zoning restrictions. Check out the IRS Small Business Website for more information than you could possibly consume. A good place to start is the recommended reading list, especially Tax Guide for Small Business.

One advantage is you can start right away; you can deposit you checks right into your personal checking account. Although, if you can find a no fee checking account it will make your bookkeeping a lot easier if you have a separate bank account for your business and pay all your expenses from this account. You can keep track of your books in something simple like Quicken or MS-Money.

Filing Your Income Taxes

As far as taxes go, you should receive a 1099-MISC from your client indicating the payments made to you for the calendar year. This is what people are talking about they talk about "going 1099". What they really saying is you're a self-employed sole proprietor and the client is required by IRS regulations to report the amounts they pay you on Form 1099-MISC. They report this amount both to you and the IRS. You report the
income and deduct expenses that are directly related to the business on Schedule C. The net income from your business will flow through to your 1040, line 12 and you will pay tax on the net income at your personal marginal tax rate.

Income

The IRS will match the total income you report on your Schedule C to the total of all 1099s you receive. If you under report income the IRS will come knocking looking for a good explanation.

Expenses

As a contractor, expenses usually don't amount to much compared to the income most professionals receive. Any expenses incurred to purchase books, subscriptions, professional organization dues, education for maintaining and improving your skills, etc. are all deductible. If have a second phone line dedicated to business use, you deduct all expenses for that line. However, if you have only one land line in to your home, you can only deduct the charges for specific calls you can identify as business-related. Your client may require you to get business liability insurance and those premiums are deductible. If you hire a bookkeeper, payments to that person are deductible, too. As are any amounts you pay to have the Schedule C, SE and related tax forms prepared as part of your personal return. See IRS Publication 535, Business Expenses for all the details on what's deductible and what's not.

If you have to purchase equipment look into the Section 179 election which allows you to expense in the current year amounts paid for new equipment used in business. There are some limitations but it's usually worth doing if you can. See IRS Publication 946, How To Depreciate Property, Chapter 2, Electing the Section 179 Deduction for more information.

The Home Office Deduction

It seems like everyone who starts a business wants to take the home office deduction. There are some definite gotchas to watch out for with the home office deduction. The biggest one is the IRS itself. Deducting your home office can increase your chances of an audit. Additionally, if you elect to depreciate your home office, you may incur additional taxes when you sell your home. Take a look at IRS Publication 587, Business Use of Your Home for all the hairy details of the Home Office Deduction. Note these rules apply to all three options, W-2, 1099 and Corp-to-Corp.

The hairiest detail of them all is if you qualify. The standard test is: You must use part of your home exclusively and regularly as your principal place of business. "Exclusively" means just that! If you use the same space to pay your personal bills, call your mom to wish her happy birthday, or it doubles as a guest room... You've just blown the qualifier and you can't take the deduction.

Is the Home Office Deduction worth it?

First, you have more forms to fill out:

  • Form 8829, the form to list the home office expenses
  • Form 4562, if you depreciate the business portion of your house.

The major expenses of your home are likely to be the mortgage interest and the property tax. You can only deduct this once, so you need to allocate the portion of these expenses that apply to the personal and business portions of the house. The personal part goes on your Schedule A as part of your itemized deductions; the business part goes on Form 8829. (The allocation is usually done on a square footage basis.) So unless your itemized deductions are being limited, you don't get any additional tax benefit because you can deduct these on your Schedule A anyway.

The other things you can deduct, like insurance, utilities you have to allocated between personal and business too. So say you spent $1400 on home owners insurance and $3000 on utilities (excluding telephone) and your business use of the home is 10%. That gives you a deduction of $440. If you're in the 25% tax rate, that's a total tax savings of $110.

This is where your personality comes into play. Personally, the $110 isn't enough for me to risk the red flag this may raised when the IRS is looking for returns to audit.

Depreciating Your Home Office

Now we come to the depreciation part. I'm not going to do a disertation here on what depreciation is but suffice it to say that you are allowed to expense in the current year the portion of your home used for business purposes. You have to depreciate the home over a 39 year period. Here's a simplified version of the thrilling formula used to calculate the depreciation expense:

[(basis of your home - land value at purchase) X business use %] / 39 years.

Say you started your business on January 1st to simplify the calculation. You purchased your home for $250,000 and land value was $75,000 and your business use percentage is 10%. You're looking at $449 annual depreciation expense. [($250,000 - $75,000) * 10% / 39] Again, if you're in the 25% tax bracket that equates to $112 in income tax saving. I'll grant, that's per year, but even with the $110 from the example above $222 isn't enough for me to tempt fate, or the IRS at any rate. Again the calculation goes back to your personality and risk aversion.

OK, Say you decide to go ahead and depreciate your home office for 10 years, you've depreciated $4490 of the value of the house. Now you decide you want to sell it. That $4490 is not eligible for the $250,000 exclusion on the sale of your primary residence and you must pay taxes on that amount when you sell the house. So unless you plan to live in your home until you die, the home office depreciation deduction is really a deferral of taxes.

If you're really up on being self-employed, you'll know that any deduction will also save on self-employment taxes. We'll cover this in a later section. The $889 home office deduction in the example above ($440 for insurance & utilities and $449 for depreciation) will also save you about another $127 in self-employment tax. Now we're up to a total tax savings of $349 in the current year. Again you need to take your own personality into account to determine if the tax savings (or deferrals) are worth it to you.

Pay Yourself First and Reduce Your Taxes: Retirement Saving Plans

There are several ways to defer taxes on current income that have strings attached. The most popular are the retirement savings plans. By saving money in a Retirement Savings Plan now, like a SEP-IRA or Individual 401(k), you can reduce your taxable income in the current year.

Congress has been adding to and changing the rules on existing retirement plans trying to increase the US savings rate. The good news is you can get more bang for your buck as self employed than you can as a regular employee when it comes to getting your retirement savings to reduce your current year's income taxes. To get more information see IRS Publication 560, Retirement Plans for Small Businesses.

Briefly, options are the traditional and Roth IRAs, SEP-IRA, Qualified Plans, and the new Individual 401(k). For example, the maximum contribution for the Individual 401(k) is $44,000 in 2006 (subject to income limitations). That will go along way to reducing your tax liability. Be sure to check the requirements deadlines for setting up and funding the plan and the limitations on withdrawals before you get started. Usually any withdrawal prior to the year you turn 59&½ are subject to a 10% penalty. Each plan has different rules for exceptions to the 10% penalty rule.

Self-Employment Taxes: The Unexpected Tax

This is where the self-employed really lose out over corporations. Any profit on earned income that accumulates in your business is subject to self-employment taxes. This is true of partnerships and LLCs, too. Only corporations are not subject to this tax on accumulated earnings. They have their own tax on excess accumulations to worry about, but it usually doesn't affect small corporations.

Before we get too far, just what are self-employment taxes? Self-employment (SE) tax is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.

You may not be aware that your employer matches every dollar that is withheld from your W-2 paycheck for social security and Medicare taxes. Employees pay 6.2% and employers pay 6.2% for a total of 12.4% on the first $94,200 of wages (that's the social security cap for 2006) and 1.65% each for a combined total of 2.9% on the remaining amount for Medicare. As a self-employed individual, you get to pay both halves, but the IRS gives you a bit of break and you can exclude the first 7.65% earned income. Plus you get another "break" because you can deduct half of your SE tax from your taxable income (Form 1040, Line 27).

So many people go into business with no idea this tax is out there then come April they get slammed with the SE tax. Then the IRS will get them for interest and penalties because they didn't make any payments toward it throughout the year. It can be quite a shock!

Pay As You Go: Making Quarterly Esitmated Tax Payments

Our tax system is a "pay as you go" system. That's why taxes are withheld from your regular paycheck and the self-employed (and others) have to make estimated payments. Estimated taxes are used to pay taxes (including SE tax) on income not subject to withholding.

You generally have to make estimated tax payments if you expect to owe taxes, including self-employment tax, of $1,000 or more when you file your return to avoid an underpayment penalty.

The tricky part is you have to make your quarterly payments even though you may not know exactly what your income, and therefore your taxes, will be. That's why they're called estimated taxes, but still it's a source of stress and confusion for many.

Estimated tax payments are due on April 15th, June 15th, September 15th and January 15th.

Other things to keep in mind

Fringe Benefits

As a self-employed individual, you will receive no benefits. This can be a lot more important for families than individuals. With the cost of health insurance rising for everyone, this benefit alone is enough for some people to prefer regular employment with full benefits.

If you had insurance with a previous employer, look into continuing coverage with a COBRA plan. Failing that, you should be able to get an individual policy under the HIPAA laws, that's the health insurance portability legislation that went into affect several years ago. It can help you get at least some kind of insurance.

For the self-employed health insurance premiums are deducted on the front of your 1040. That's good news because you aren't subject to the 7.5% AGI limit for itemized medical deductions. But it's bad news too because these expenses don't reduce your SE taxes.

Financing

If you're planning on a major purchase you may have more difficulty qualifying for a loan. Banks like to see the regular income of a W-2 or pay stub. If you want to get a home loan you'll probably have to provide the two previous year's tax returns, financial statements, letters regarding the state of your business, etc.

It's generally takes little longer to get a loan and you may not get as good an interest rate. It is possible to get a loan, all things being equal, but it can be a pain and a bit stressful. (This can apply to all small business owners regardless of how their business is organized.)

Corp-to-Corp

Definition:

Corp-to-Corp means that your client, a corporation, pays your business, which is organized as a corportation, for the services rendered by you. Your client may prefer this as it protects them from the same risks regarding the employer-employee relationship discussed in the W-2 option above.

Pros & Cons apply to S-Corps: only an S-Corp can avoid the 35% Personal Services Corporation (PSC) flat tax.

Corp-to-Corp Pros:

  • No self-employment tax.
  • Using small business retirement plans, you can defer tax on a larger percentage of income.
  • Double taxation of earnings is avoided as compared to regular corporations.

Corp-to-Corp Cons:

  • Most complicated option. Much more bookkeeping and tax reporting required.
  • More difficult to organize and dissolve.
  • Some states have a minimum tax you will have pay regardless of profitability.
  • You must receive at least some salary from the corporation, which means the corporation is subject to payroll taxes and filing.
  • S-Corp shareholders pay tax on undistributed profits.
  • If you don't make the S-Corp election you can get stuck with the 35% Personal Services Corporation (PSC) flat tax.

The biggest draw back of setting up your own corporation is the extra time, yours or someone else's, required to set up and maintain the records of your corporation and all the required tax filings. If you like this kind of stuff, it's not a big deal. If you hate doing this kind of stuff you should probably hire someone else to do it for you. Or reconsider the W-2 option above.

Incorporating your Business

First a caveat. When you incorporate it has to be in a particular state. Every state has different rules so you should check with the Secretary of State, Department of Corporations, or other equivalent governmental agency in your state. Each state has different rules and tax regulations. For instance, if you are doing business in California, you must pay and file taxes in California, even if you are incorporated in another state. California has an $800 minimum tax requirements so your corporation will end up paying taxes each year it does business in California regardless of its profitability. You need to find out the rules in your state before incorporating your business.

There are several services that will do all the paperwork of incorporating your business. There are also several software programs that will walk you through the process. It isn't too difficult but it is a little time consuming. Remember each state is different.

Separate Entities: You Are Not Your Corporation

Once you incorporate, you and your business are two entirely different and separate legal entities. This protect you from personal responsibility for liabilities incurred by the corporation.

You should treat transactions between you and your corporation the same as you would any other business. You wouldn't go pulling the money out of another business' cash drawer, so don't do that with your company. At least not without proper documentation and record keeping.

Record Keeping

As a corporation you will not receive a lot of the tax documents you do as an individual. You won't receive a 1099 from your client. You have to keep track of all this. You will need to invoice your client on a periodic basis. Make sure they are paying you in a timely manner. As a corporation, be prepared to wait 45-60 days to receive payment on your invoices, especially the first one.

You will have to get a separate checking account for your business. Your bank will not let you deposit checks to your business into your personal account.

The IRS requires you to keep written records of your business. Make sure you keep receipts associate with each payment. Avoid making checks to "Cash" or paying non-business expenses form your business checking account.

If you personally pay for valid business expenses. Reimburse yourself, just as if you were requesting a reimbursement from an employer, providing valid receipts for each item being reimbursed.

So if you can't just take money when ever you want, how do you get money out of your corporation? The business writes you a paycheck!

Payroll: Things are starting to get a little complicated....

If you incorporate your business, you are an employee of the corporation and you will need to pay yourself a salary. This is true even if you are the only shareholder of the company. Therefore, you will need to set your up your corporation as an employer with the IRS, pay federal, and potentially state, payroll taxes, make timely payroll tax deposits and file quarterly and annual reports with the IRS, and possibly state employment department.

For most people this is quite a headache. Interest and penalties on late deposits and filing are quite onerous. This is one item you don't want to let slide. If you have the cash available, it's easiest to make the payroll tax deposits when you deposit your paycheck.

You can avoid most of these headaches by hiring a payroll service like ADP or Paychex. Intuit's QuickBooks accounting program also offers an integrated payroll service.

You will also need to know some of the rules about what things are subject payroll and income tax and which are not. For example, if your company pays health insurance premiums on your behalf, those premiums are subject to income tax withholding, but not social security and Medicare withholding. In addition, this amount is included in the Officer's wages portion of the corporation's tax return, not the employee benefits line. You can deduct the amount paid for your health insurance on line 29 on your individual Form 1040 (this assumes you own more than 2% of the shares and your corporation is indeed an S-Corporation).

With just this one example, you can see how convoluted things start to get. It isn't impossible: but it can be confusing and should give you an idea of how much you'll need to keep track of as a corporation.

Payroll Taxes: How Many Can You Name?

If you're doing a strict cost-benefit analysis to make your determination you need to know about payroll taxes. You're probably already familiar with a lot of them if you've ever received a paycheck but here's an overview from the employer's perspective.

Social Security and Medicare

You're probably familiar with these. For 2006, an employer is required to withhold from employee wages 6.2% of earnings up to $94,200 for social security tax (AKA FICA) and 1.45% on all earnings for Medicare tax.

As mentioned above, employers must match this amount. If you pay yourself a wage of $100,000, you will pay $5840 in social security tax plus $1,450 in Medicare tax for a total of $7290. Your corporation will pay another $7290 in employer taxes. So for $100,000 in wages the total FICA (AKA social security and Medicare) tax is $14,580.

You have to pay these taxes, along with any federal income tax withheld, on at least a monthly basis through EFTPS, Electronic Federal Tax Payment System. You report these payments and payroll tax liability quarterly on Form 941.

Federal Unemployment Tax

This is another tax most people don't realize employers pay. The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. You report and pay FUTA tax separately form social security and Medicare taxes and withheld income tax. Employees do not pay this tax or have it withheld from their pay. The tax is 6.2% of the first $7,000 of wages per employee. You can get a credit for state unemployment taxes you pay that brings the rate down to 0.8%. So if you're the only employee that's $56. You report this annually on Form 940-EZ as you should be able to qualify for the simplified form.

State Taxes

Again, every state is different. You will likely have an unemployment insurance and potentially other taxes the employer pays. In California, there is State Short-Term Disability insurance (SDI) the employee pays that you must withhold and remit to the state. Check with your state's employment department. The IRS provides links to the various state websites here.

While you're at your state site, look for or ask about other requirements imposed on employers, like worker's compensation insurance. Also ask about exemptions for owners. In California, corporate shareholders can get an exemption for certain payroll taxes and worker's compensation on themselves. More forms to fill out, but at least you only have to do it once.

Filing Income Taxes for You and Your Corporation

There are basically two kinds of corporations as far as income taxes are concern: C-Corporations and S-Corporations.

  • C-Corporations file a separate tax return and pay taxes at a different rate structure than individuals. The marginal tax rates range from 15 to 38%. Personal Services Corporations (PSC) pay a flat tax of 35%.
  • S-Corporations are corporations with less than 100 shareholder and a calendar tax year that make an election to be treated as an S-Corporation on Form 2553. Income and expenses are passed on to shareholders. Shareholders pay taxes at their personal rates for their share of the S-Corporation's taxable income. For the most part, the S-Corporation does not pay federal income taxes directly.

Personal Services Corporation and the Flat Tax

The only reason we care about any of this is because of the Personal Services Corporations (PSC) classification. Most people aren't too thrilled with the idea of paying a flat 35% income tax so want to avoid the being a PCS.

A PSC is a corporation with a majority of its income from personal services provided by employee-owners. Personal services are defined as, among other things, consulting and engineering.

By definition, an S-Corporation is never a PSC. Additionally, there are other regulations that by definition don't apply to S-Corporations that simplify matters. Because of the PSC gotcha, all the information in this page assumes your corporation qualifies to be an S-Corp and makes the election in a timely manner on Form 2553, instructions here.

S-Corporation Tax Reporting: Information Only

S-Corporations report their income and expenses on Form 1120S, (instructions here). The rules for what is income and what are deductible expense and what are not, including the home office deduction, is pretty much the same as the rules for other businesses. See IRS Publication 535, Business Expenses for all the details.

The thing that is sometimes tricky for people to understand is that the S-Coropration does not directly pay any income tax (there are exceptions but they probably wont apply). Instead, the S-Corportation reports its taxable income to the shareholders on a Schedule K-1, (instructions here). Each shareholder is required to report the K-1 amounts on their personal return. This pretty much precludes doing your return by hand (although I'm not sure if anyone even does that anymore). Getting each amount from the K-1 to the appropriate location in your personal return is pretty tricky. If you use tax preparation software like Turbo Tax or Tax Cut, it's pretty straight forward as the software handles the details for you.

What this means is you will end up paying income tax at your personal tax rate on the yearly profit of the company irrespective of any distributions paid to you. So if your S-Corp has profits of $200,000 you are going to have to pay taxes at your personal rate. The good news is, subject to certain limits, if your corporation has tax losses, you can use those loses to offset other taxable income on your personal return.

More Ways to Save: Retirement Savings Plans for Corporations

As a corporation, you have more retirement plan options than a self-employed individual. The most popular plans are available to both the self-employed and corporations. Some plans like a regular 401(k) is likely too expensive and administratively heavy to recommend to a small business.

The contribution limits for the self-employed and corporations are different for each plan. However between salary reductions and profit-sharing contributions, corporations are able to defer as much, and sometimes more, income than the self-employed. You can significantly reduce your taxable income by maximizing retirement plan contributions. To get more information see IRS Publication 560, Retirement Plans for Small Businesses.

Estimated Tax Payments for You and Your S-Corp

Technically, you should make estimated tax payments on the estimated taxable income of your S-Corporation that will flow to your personal return. However, by increasing the federal (and state) income tax withholdings from your salary, you can compensate for the anticipated additional income from your S-Corp and avoid making estimated tax payments. Take care here and review this as needed. You can change your payroll withholdings at any time to make adjustments for changes in your anticipated income.

Let's Work Through Four Example Scenarios

Is your head spinning yet? Mine is and I know what's going on here! :) Perhaps an example or two is in order. Let's take a look at the following scenarios and see how just the numbers come out.

Scenario 1: Josephine Baker - The Gorey Details

Josephine Baker is a software engineer that is about to take her first contract. She's already checked that she qualifies to be considered an independent contractor and is trying to decide how to organize her business. She is single, owns her own condo, has no kids and will be working out of her home office. The client has offered her $80/hr as a W-2 employee through their broker (no benefits) or $100/hr as 1099 or Corp-to-Corp. She expects to work 2000 hours for the year to allow some time off.

Let's assume here expenses will be pretty much the same for all three options except she will have bookkeeping and tax preparation fees for the 1099 and Corp-to-Corp options. A detailed breakdown of the calculations is included as an attachment to this page. Note this example only accounts for federal taxes as the situation is different for each state.

What are the tax implications for each option? Take a look at the total taxes liability including income, self employment and payroll taxes:


[table=theme   | W-2 | 1099 | S-Corp
Income Tax | $34,617 | $30,598 | $29,929
Payroll/SE Tax |   $8,160 | $16,422 | $14,580
Total Taxes Paid | $42,777 | $47,202 | $44,509]

At first glance you may say that the W-2 option is the best because it yields the lowest taxes. But hidden in the details is the fact that in both the 1099 and S-Corp options Josie has $44,000 socked away for her retirement but only $4,000 with the W-2 option. In addition, because of limitations she was unable to deduct any of her legitimate business expenses in the W-2 example. But she also had very few complications in preparing her return and she had little or no record keeping to deal with.

You can see that the 1099 option ends up paying quite a bit in SE taxes. Imagine if you hadn't planned for that at the beginning of the year! That would be quite the shock! The point is the 1099 business model makes a lot more sense if you have more legitimate expenses to reduce the SE tax than Josie does. Notice the income tax is actually the lowest with the 1099 option. The SE tax is the killer. With this option Josie does have $44,000 in retirement savings.

The S-Corp option seems to be the best solution on paper. The taxes paid include both the employer and employee portion of the payroll tax. It's only about $2,000 more compared to the W-2 option but Josie has an additional $40,000 tuck away for retirement. She thinks she can do all the bookkeeping and payroll reporting her self but has budgeted an extra $600 for accounting services.

Josie decides to go with the S-Corp option. She's single and lives alone so she doesn't have a lot of other demands on her time. She organized, enjoys learning new things and isn't too intimidated by all the legalese in the IRS publications. Josie's excited about getting her new S-Corp up & running and starting her new contract!

Scenario 2: Josephine Baker - Short Term Contract

Let's use the same details as the Scenario 1. However in this scenario Josie is going to be going to graduate school in the fall and wants take a contract for the summer. This will be her only income for the year. She lives and works in California which has an $800 minium tax for S-Corporations.

Establishing and then dissolving her corporation will be a big hassle and time consuming. Even though she could save quite a hunk in taxes, Josie doesn't think it seems worth it to create an S-Corp for the short duration of the contract.

Since she can save quite a bit more tax deferred as a self-employed sole proprietor than as an employee, Josie opts for the 1099 option. Josie knows she can use her SEP-IRA tax deferred savings next year to help pay for her graduate school tuition without paying a penalty.

Scenario 3: Joe Snow - Loves Fun, Hates Paperwork

Joe Snow is easily board and he hits the slopes winter and summer. Between snow boarding and mountain biking he's always outside. Except when he working at his computer thrashing out code.

Joe absolutely abhors paperwork. He would much rather be out having a good time. But he likes learning new things and enjoys changing jobs frequently. He's a consultant and loves it. He goes with the W-2 option because he knows it would be a disaster if he tried to do all that tax stuff and record keeping himself. He's too
busy having fun!

Scenario 4: Sam Adams - The Need for Benefits

Sam Adams has been offered a job at Pre-IPO Company. They are willing to bring him on as a consultant for a specific project or hire him as a regular employee with full benefits and a reasonablly good stock option plan.

Sam has a wife, 2.3 kids, a mortgage and a dog. His wife is pregnant and his youngest son has juvenille diabetes. This means getting and keeping good health insurance for his family is paramount. He's tried to get an individual insurance plan for his family before and has been denied because of his son's pre-existing condition.

The benefits Pre-IPO Company offers its employees are much better than Sam could ever get on his own. Therefore Sam opts for the benefits and the stability of regular employment and will become a salaried, full-time employee of Pre-IPO Company.

The Choice is Yours

None of the examples above will match your exact situation, but it does give you an idea of both the quantitative and qualitative trade-offs associated with choosing your business structure as an independent contractor.

Remember, keep your personality and life style in mind as you're balancing these trade-offs. The hair you save may be your own!!

Good Luck!


Feel free to contact me if you have any suggestions, questions or comments. This is a complicated topic and I've tried to make things a simple as possible and still be complete. If there are any points that you feel have been left out or need clarifying, please let me know and I'll update this document.

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W-2 Contracts for S Corp

Hi Mike,

Feel free to make changes to the spreadsheet. It's really intended to be a starting point for you to consider the differences. :) The idea of a time-value-of-money column would be cool. If I ever get some down time I'll try to add the. No promise. :)

Bummer about the new contract being W-2. I would be shocked if you can get someone to pay you more as a W-2 as there are more expenses for the "employer" (FICA, UI, worker's comp, etc.) compared to a corp-to-corp contract. You might bring it up, but I'm guessing they're already factoring in the lack of benefits into their rate.

Good Luck!! Let us know if you're able to either get the higher W-2 rate or snag a corp-to corp contract.
L:)

1099 Vs Corp to Corp

This is one of the best articles on the internet. I found it very informative.

Linda, I am being offered $80/hr for 1099 and $85/hr for corp to corp through a consulting company, with W2 it will be less than this. I am thinking of opening a s-corp or LLC to take advantage of the extra $5/hr. is it worth opening a corp for this?
In my case should I go for S-corp or LLC?
There will be a heavy travel involved in this job.

Thanks in advance.

1099 vs Corp-to-Corp.

Hmmm, for $5/hr, probably not.

Will your travel expenses be reimbursed? If not, then the S-Corp (or LLC taxed as an S) might work out for you.

Depends on what state you're in, too. In CA, there's a $800 minimum tax for an LLC or S-Corp which will eat in to that extra $5/hr pretty quickly.

L:)

1099 vs S-corp/C-corp, maximizing retirement funding thru corp.

Scenario based question. I can make 250-300K in 1099 status. I'm 45, no "retirement" plans currently. RE equity 1.5-2 million at this point in time. Of the 250-300K I could make a year, I need none of it due to rental income. Standard of living low. Looking to maximize the amount I can set up in qualified retirement accounts from the 250-300K yearly earnings. I'd essentially like to set aside as much as is allowable over the course of the next ten years, til the age of 55. Seems like anyone I talk to is unsure of these amounts and how to maximize my situation. Additionally I'd like to set up as much as is possible into self directed/managed REIT, something I believe an individual is allowed to do. Can you help make this clearer for me? My plan was to set up corp., pay myself a tiny fraction of what I earn and defer the rest into qualified retirement accounts and plans...

Maximizing Retirement Contributions with a Defined-Benefit Plan

If all you're concerned about is maximizing retirement contributions you should consider a defined-benefit plan. These types of plans usually aren't recommended to small business because of the high administration costs and reporting requirements. However, in your situation it is probably the best way to defer the most current income into future years.

You'll need to get some help setting one of these up. A brief discussion of the pros, cons & requirements are available on the IRS website here Note the maximum deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit. Some discount brokers offer services to help you setup one of these plans. For example, Charles Schwab has a brochure on its website that discusses these type of plans in general and their services and fees in particular.

There are also non-qualified defined benefit plans. You can contribute as much as you want but it's not tax deductible by the corporation until included your personal taxable income.

If you wanted to go with something a little more typical, you could opt for an Individual 401(k) plan but the most you could contribute is $45,000 for 2007. That's the highest limit of all the defined contribution plans. Keep in mind the limit is based on your salary so if you create a corporation you'll need to pay yourself of $120,000 to maximize the contribution.

As far as I know REITs can be part of your IRA or 401(k) portfolio.

I hope this helps.
L:)

Speedy reply

Thanks for the information, my goal is to keep my tax liability to nothing, legally. Thanks..

No Taxes?

Good luck with that!!

L:)

no taxes

Linda-
I have a unique tax situation that benefits from using the "paper" losses from my real estate to offset my regular income. As As my RE equity increases, my debt decreases. At the point I desire to stop working the income from the property will take over for the loss of job income. Maximizing the retirement plans is a way for me to help minimize the tax liability I would have from the income I currently enjoy now and 10 years into the future.
Jeff

Passive Loss Limitations

Hi Jeff,

Losses from residential rental activities are considered passive (unless special rules apply). You can only deduct $25K of passive losses against non-passive income like your 1099 income. In addition, the $25K passive loss allowance starts to phase out at $100K of AGI and is completely gone when your AGI reaches $150K. Given that 1099 income you're talking about, I'm not sure you'll be able to use the rental losses in the current year (although they will carryforward).

If you're a real estate professional you can treat the residential rental losses as non-passive to offset your 1099 income without regard to the loss limitations. However, there are special rules in order to qualify for this.

You said you had wanted to legally reduce your tax liability to zero. :) Keep in mind that when you contribute to any retirement plan you're only deferring the tax to future years. You're not eliminating it. Plus, you'll pay ordinary income tax rates on all distributions vs only capital gains rates on appreciation if you paid tax on the income now.

L:)

RE Professional

Linda-

Your absolutely right. I'm classified as a real estate professional as well as doing my other gig. I met all the requirements and had my return reviewed by the governmental tax people. They concurred with my return, etc. Again, your right about only being able to defer until later on. The income that I'll receive will still be decreased by "RE Losses on paper", though to a much smaller scale. When I do take the distributions my income will not include the 250-300K income to boot, etc. Thanks for sharing your expertise.

Jeff

RE Prof...

Hi Jeff,

Good job checking out the details before hand. So many wait until they try to do their tax return and then end up with a big surprise in April.

Good Luck!!
L:)

s corporation vs 1099

If you are making over the 96,000 on a W-2 for a regular day job, and will be doing extra work, per diem at roughly 20,000 a year, is there a benefit to forming an s corporation if you can keep accounting expenses under $400? I am looking to take some additional classes that may cost 5-8,000, along with some other expenses. It seems that if the corporation would be able to pay for course work and other expenses, than this would be a smart idea. Does this also hold true for self employed 1099 forms?

Education Expenses

Hi HL,

If the courses you're planning to take improve your existing skills and help you get more jobs or charge more for the ones you have, those costs should be a legitimate business expense and deducted directly on your business return, whether it's a Schedule C or 1120S. IRS Publication 970 has a great chart that outlines more specifically what qualifies as work-related education expenses.

Assuming your education expenses are deductible, your SE tax will be about $300-500 as a sole-proprietor. For that small a savings, I don't think I'd go to the trouble of forming the S Corp.

Also remember you should consider your state tax situation. For instance in California, S-Corps must pay an $800 minimum tax each year, regardless of profitability.

Hope this helps!
L:)

s-corp or LLC

Linda,

amazing website with great info. i want to become a contractor and a recruiter said i need to have a corp as they (client) will do a corp-to-corp for $70/hr and she said i can have $50.00/hour taxable and $20.00/hour as expense allowance which would be non taxable. how does this work
2. when i open a s-corp or llc i want to have my wife as a partner/employee as she is going to do the paperwork and in general all the administration, i want her to have a salary. how will this work
3. if i open a s-corp in texas and start working in NJ should i open 1 more entity in NJ too

thank you for any info

S-Corp

Hi Prisha,

First off, your recruiter is wrong about the $20/hr expense allowance being non-taxable. This is called a non-accountable plan (you don't have to account for actual expenses). This is taxable to the extent it exceeds your actual expenses. What you'll need to do is report all $70/hr as gross income, then you can deduct actual business expenses.

Your corporation/LLC hire's your wife as an employee. If you operate as a single-member LLC taxed as a sole proprietor then her salary is subject to federal tax withholding, social security and medicare taxes but not federal unemployment tax (which is only $56/yr). If your business is incorporated or an LLC electing to be taxed as a corporation then her salary is also subject to the unemployment tax.

I don't see much point in opening another corporation. For each business entity it's another tax return. Unless there's a really good business or legal reason, it just more tax headaches and administrative overhead to deal with.

Hope this helps!
L:)

Which tax form/schedule on expenses for W-2 contractor?

I am a independent consultant and did 3 or 6 month long contracts.

What tax form or schedule to use on expenses while looking for next project?

Thanks,
Alex

Job Search Expenses

These are deductible on Schedule A as a miscellaneous expense subject to 2% of AGI. The detail ends up on Form 2106 or 2106-EZ.

L:)

tax deduction form for job search when out of contractor

Thanks, Linda. Per IRS instruction, Schedule A is for job search while on a job. What tax form for the expense when not working on a contractor?

Job Search Expenses for Contractors

If you were paid as a W-2 contractor, then it still goes on the 2106. If you were paid 1099 it goes on your Schedule C. If you were paid as an S-corp, then on the 1120S.

tax form for job search expense when out of W-2 contract

Thank you, Linda.

Will do Schedule A and Form 2106 as W-2 contractor.

W2 VS Corp to Corp

With all your discussion about the differences and the calculations required to compare $ earned via W2 vs Corp to Corp, you are making one assumption that has gone unstated.

You are assuming that the W2 employee will only be paid for hours worked. Ie. he will not receive a bonus; he will not receive alternate internal projects in between real projects; he will not be paid for on the bench time. In effect he will not really be a full time employee.

I think this is a relatively new game Consultant companies are playing: paying you as a W2 but not paying for the risk of this being the only job they will use you for.

Possibly a more realistic comparison would be to compare being a member of the staff (what used to be thought when you were paid as a W2) vs being paid as a corp to corp for the hours that you work, and then going out and finding your next gig....

Given that, I would add a premium, say 25% to 40%, to the rate that the corp to corp would charge to account for the down time finding your next gig.

Benefits of W-2 Employment

Good points. Actually, I do note that PTO and other benefits, especially health care, are a very important part of the calculation.

However, most contractors offered W-2 contracts don't get any benefits at all. No PTO, no health insurance, no 401(k) or other plans. In those cases the advantages of being a regular employee don't apply.

Also don't forget that salaried employees don't get overtime or often even comp time. So you might make more as an independent contract just because you're getting paid for the actual time you spend at work.

L:)

Scenario Spreadsheet: Understanding S-Corp calculations

Linda, excellent articles on this website, it makes things much easier to understand. And the spreadsheet has been very helpful, but I think I'm confusing myself with the calculations, and so have a few questions on how some of them came about that relate to the S corporation:

1) In cell e29, you've used a hard coded value of 100,000 to calculate the Medicare tax on. Why that? Shouldn't that be taken from the gross salary amount in e71?

2) In a related question, 1/2 of that payroll tax is really the obligation of the corporation. I assume that means that it has to be paid by the corporation, coming out of the corporate bank account, right? And that the only reason it is included in e29 is to show your total tax obligation.

3) In cell e48, the number 15,000 is used for the profit sharing. If I understand the section down at the end, this should really come from the field e105 (Maximum profit sharing contribution) which is 30,000. If not, then where did the number 15,000 come from?

4) Finally on e68, where do those numbers come from / go? I'm assuming that the 30,000 comes from profit sharing which would be what is in line e48 and therefore is an expense to the business. But what about the 15,000 which looks like it would be the salary deferral amount? Should that be subtracted from the W2 wages in e9 instead of the 25% of salary that is being subtracted now?

Thanks for putting this website up, it really is very helpful.

Scenario Questions

Hi George,

Thanks for really going over the scenarios.:) I tried to make examples that were relatively simple and yet relatively realistic. Over simplified examples rarely show the complexities people face in the real world.

1. Good catch. The FICA tax is imposed on total wages, even those contributed to retirement plans, but not the value of medical premiums. I've fixed that in the spreadsheet. It increased the total tax liability by about $600.

2. Yes. I'm trying to show the total tax liability for both the company and the owner to make as equal a comparison as possible between the three options.

3 & 4. This assumes the owner has an Individual 401(k). Under this type of plan there is an employer and an employee contribution. The $15,000 is the employer's contribution and the $30,000 is the employees contribution that is withheld from the paycheck. Yep, I got those backwards in the spreadsheet and the profit sharing amount should have been $30K and the wages deduction $15K. The change is reflected in the W-2 wages in cell E9. The owner's salary is $120K, less the $15K withholding plus the $3250 in medical premiums paid total is the (new) W-2 wages of $108,250. The FICA is calculated on the full $120K. (In this situation W-2 wages doesn't equal FICA wages.)

Because the S-Corp's income flows to the owner's 1040 the misclassification doesn't affect the overall tax burden of the owner.

Thanks for catching the mistakes. There's definitely a lot of stuff going on in the spreadsheet!

L:)

Health deduction question...

Thanks Linda. There definitely is a lot of stuff going on in that spreadsheet and I can't even begin to tell you how helpful it is in figuring out the best option for a given situation.

One more question. In reading some of the posts that you wrote after this one was originally posted, it seems the IRS either changed the rules or made a clarification saying that S-corporations could not take an above the line Health deduction. If that is the case, then should we remove the amount in e15?

regards,
George

Health Deduction

It depends on what state you live in.

The IRS clarification for S-Corps is that you can only take the deduction if the health insurance policy is in the name of the business.

Insurance is regulated by the states and in some states you can get a group policy for one member and in other states, like California, you cannot. If you live in a state that does allow for a single member group and the policy is in the business name, then you can deduct the health insurance premium.

The information in Healiner 163 is not technically binding, and not of the authority of a ruling or regulation. It's likely that is will be challenged and, hopefully, overturned so that all business entity types are treated equally.

Some single shareholder S-Corps are using Health Reimbursement Accounts (HRAs) to bypass Headliner 163. There is some special setup to do this, but it appears to be a loophole in the IRS guidance on this.

L:)

Get article

Does per diem affect what direction I should go when deciding which option(W2-SCorpt-1099) I should take?

Income ratios

Superb site, excellent post - thank you!

I am in the midst of trying to determine what $1 of W2 salary equates to in a corp-to-corp situation. I am fairly clear on what I need to factor in to 'load' into this $1 - i.e. soc security, medicare, health care, 401k, tuition reimbursement costs that I must foot from a corp-to-corp perspective.

What I am not so clear on is what I need to factor *out* of it - that is, what expense or other costs can I take advantage of as a corp that I can't as a W2? I'll have opportunity to contribute to a SEP, deduct my home office, recoup mileage costs(?), pay for some equipment and any business dinners, etc. Am I missing any big ticket items?

The insinuation from my potential employer was that $1 from a corp-to-corp was worth more than $1 from a W2, thereby justifying a reduced rate as a corp-to-corp. My calculations are not getting me there!

RE: Income ratios

"The insinuation from my potential employer was that $1 from a corp-to-corp was worth more than $1 from a W2, thereby justifying a reduced rate as a corp-to-corp. My calculations are not getting me there!"

Don't believe this! It will actually cost your potential "employer" more to hire you as an "employee" since he/she will have to pay FICA/FUTA and also have the extra accounting/reporting overhead. You should tell them that you want more money if you do corp to corp. Never take less for this - they are trying to bamboozle you.

In the same boat!

Watching this thread for guidance as well...

W2 vs Corp hourly rate

Wow, I've never heard of anyone saying that you should charge a reduced rate as a corporation vs a W-2.

Regarding deductions, most of the items you list as possible deductions are also available for employees if you itemize your deductions. For W2 employees, these deductions go on Form 2106 and are subject to 2% of your Adjusted Gross Income or AGI. (This is the subtotal at the bottom of the first page of Form 1040). So say your AGI is $100,000, you can deduct any unreimbursed employee expenses over $2000. Note meals and entertainment are limited to 50%, but that is true for businesses and employees.

Even if you buy a new computer for $2,000 and use it 100% for business you still have to spend the money to buy that equipment you probably wouldn't have to if you were an employee. Yes you can deduct it on your taxes, but even if your combined state & federal marginal tax rate is 50%, you're "tax break" is only $1000. And your still out the other $1000. Just because something is deductible, it doesn't mean you still don't have to fork over the cash to someone.

You can make higher pension plan contributions as a corporation than you as an employee, but if you don't have the business income, you can't sock it away in a tax-deferred account like a 401(k), anyway.

Also, don't forget all the time and money you'll be spending on the administration of your corporation.

I think you need to figure out what rate works for you (and what the market will bear) and charge that. Taking advice from the person who's trying to get your work for the lowest rate doesn't seem like the best approach to me.

Hope this helps a little.
L:)

What about Canadian corporate

Hi,

Thanks for the very informative article..

I'm a Canadian working on W2 in the states, I got an offer to work for another company and they give me the choice to work on W2 1099 or Corp-to-corp.
I have a relative in Canada who has a corp and is welling to list me on it.
The question is, what taxes I will pay in the states and what about the deductions , can I deduct my expenses?

I appreciate you time answering my questions.
Thanks in advance

Canadian Consults

I'm not sure exactly what you mean by "list me on it." Is your relative making you a shareholder in the corporation or are they going to make you an employee of the corporation.

Is this a Canadian Corporation? If so, I can't really help you as I don't have the expertise in that area. :(

As far as deductions go, yes you can deduct your business expenses. If you opt for 1099 or corp-to-corp you'll deduct your expenses on your business return. If you're W-2 you can either request reimbursement from your employer or you can get an itemized deduction for unreimbursed business expenses (See Form 2106 for more information). Note that employees can only deduct expenses above 2.5% of their adjusted gross income.

Hope this helps a little. If you're comfortable with it, send me more details as to what you're planning and maybe we can see if a deal with your relative is beneficial.

L:)

Thanks for reply on Canadian results

Thanks for your reply. and appologies for not being clear

My relative has a Canadian corporate that he is the only share holder.

He offered to list me as an employee at his corp. in Canada if I want.

Lets say that the contract offered to me is 100K and I will take it as corp to corp

my questions are:
1- If I get paid, by the canadian corp as an employee 60k, how the IRS handles the taxes over the border? would they tax the whole 100k or only the 60K

(as I'm sure that there will be tax on canadian side too)

2- For medical insurance /car lease/rent , expenses , are they tax deductable?

3- Will I be still able to shelter some money under 401K and Retirement plans here in the state or there is no meaning for that in the case here?

Thanks again for the prompt response.

Hi, I have read the article

Hi,
I have read the article about w2 and corp to corp. I liked it , but I coun't figure out how much should be the rate for corp to corp if $50/hr is on w2? can you please give me the answer

Thanks

Equivalent Corp-To-Corp and W-2 Rates

As usually the answer is... It depends.

If as a W-2 employee you're getting any medical benefits or profit sharing plan, then you need include that in your rate calculation. Likewise, you need to figure in your time for billing and administrivia that you don't have as an employee. I can't really give you an answer on that.

But if you're talking strictly what an employer pays out of pocket for payroll you're looking at about $52/hr. But to get close to the same take home pay as an employee making $50/hr then you should charge $53.00 at an absolute minimum. This will cover all your payroll taxes and give you the equivalent of a paid two week vacation and assumes California payroll taxes.

Keep in mind this will not cover additional time or expense like the bookkeeping and tax prep costs, professional liability, health or dental insurance.

If you're looking for a general rule of thumb, I'd mark up the W-2 rate by 10% as long as there are no employee benefits you're giving up.

Hope this helps.
L:)

what about for a person

what about for a person that has a fullt time position, but on occasion does side work on a consulting basis, what would be the best option?

Consulting on the Side...

I think that would depend on the salary and benefits from your full time job. If your regular wages are near or above the FICA cap of $94,200 for 2006, the self-employment tax has a much smaller impact on your decision. You would only end up paying the 2.9% Medicare tax on your consulting income (of which 50% is a deduction) in addition to income tax at your personal rate.

It would also depend on the state you live in & its rules and how much you make on the side. In California there is an $800 minimum tax for all corporations and LLCs. If you're only making $10,000 on the side in CA, it might be more advantageous to consider the 1099 or W-2.

It's unlikely that any third-party service is going to be able to beat the benefits you get from your full time position.

So in this case, I would think 1099 might be the most advantageous. However, with the caveat that you understand you are more likely to be audited. So make sure every expense has supporting documentation. Btw computer records do not suffice. I don't want to call the IRS folk Ludites, but they do require supporting documents be hard copies. And keep your records for an absolute minimum of 4 years.

Hope this helps!!
L:)

Consulting on the Side...

Hi - in your previous post you seem to indicate that if the amount you make- as consulting on the side - is high one should not go with a plain 1099. I will soon have a W-2 for approx 160K and a consulting contract for 100K in the software development industry. I am torn about a simple 1099 and LLC. My understanding is that the LLC (single member) will provide limited liability protection, but everything else will be the same. I live in CA. Any other legal entity ( C- or S/corp) does not seem bring me any advantage. Do you agree?
A rough calculation tells me that I will have to pay 2.9% addtn (on top of income tax)in tax on the 100K, since the rest of the SE taxes will be covered by the first 94K of the W-2.

You got it! :)

Yep. You'll pay only 2.9% of the SE tax on the $100K of your 1099 income.

The single-member LLC would give the liability protection, but you would still report your income on Schedule C.

There will be some tax advantaged programs that you won't be able to take advantage of. For instance if you participate in a 401(k) at your employer, you could make a salary reduction contribution to your own solo 401(k). But you could make an profit sharing contribution.

L:)

Very informative

Very informative posting--thank you! I'm in the position of 1099 consulting from 20+ years full-time and I feel in a better position to talk to my tax consultant.

What about LLCs?

After all the questons about LLCs. I realized I needed a separate page so I just posted Consultants: What about LLCs?

Please take a look and, as always, your questions and comments are welcome.

What about C corps?

From talking to a few accountants, they seemed to think that a C-corp was a better deal for many small businesses than the S-Corp because of additional medical reimbursement plans and other fringe benefits.

Can you comment on the benefits of S versus a C for a sole business owner (in California, say)?

Again, this assumes that you don't leave money in the C to be "double-taxed" - it's either paid out in salaries, or used in pension plans, etc.

This is a good topic for a new page :)

This is a good topic for a new page. I've tried to answer your questions here. Please add a new comment or add a new forum topic if you'd like to discuss this futher.

The short answer is if your corporation is a retail or manufacturing company a C-Corp is likely the better option. The problem is for consulting firms who fall into the PSC classicifation (more details on the link above). They are subject to the 35% flat tax. Also, the rules for deducting medical premiums have changed in recent years allowing
S-Corp shareholders to deduct 100% of medical premiums paid on their behalf by the S-Corp. The mechanics of this is kind of convoluted, but doable.

L:)

Why is it overwhelming?

In your post you say:
> Most people will find handling the payroll, taxes and filings overwhelming.

Why is that? I am pretty organized. I should be able to do it without help.

Is Payroll Overwhelming?

Well, if you really are organized and detail oriented you probably can do it yourself. The trick is there are a lot of rules just for the Feds, and then each state has it's own rules too. Everything has to reconcile to the penny (no wiggle room for rounding) and tax reporting and deposits must be made in a timely manner to avoid penaties and interest. To add to that, the rules for when deposit are due differ for each employer.

For most people, they'd rather be spending their time in their main occupation rather than dealing with payroll. There are several payroll services available. If you use Quickbooks they have a service that is fully integrated into the software. There are other web-based services available, too.

As a for instance, say you have a corporation, you are the sole shareholder and you want to set up a Individual 401(k) tax deferred account. How are the employee contributions to be taxed? Is the contribution subject to FICA tax? What about FUTA? And what about my state's taxes? This is just one limited example. Most peole aren't interested enough in payroll to research all this & would rather pay for a service to answer all these vexing questions.

L:)

LLC

Forgive me if this is a stupid question, but where would a Limited Liablility Corporation fall into all of this?

LLCs

LLC's are actually a sort of hybrid. If you are the only member of the LLC, you can elect to be taxed as a sole proprietor or as a corporation.

By default a single member LLC will be treated as a sole-proprietor and a multiple member LLC will be treated as a partnership. Both are subject to self-employment taxes.

You can file form 8832 to make the election to be treated as a corporation and then 2553 to make the S-Corp election. There has been some recent guidance that you can just file the 2553 and the corporate election will be assumed, but filing the 8832 wont hurt.

L:)

LLC's vs. S-CORP

Incorporating a company as LLC and then opting for corporation status using 8832 followed by S-CORP election by 2553 for taxation purpose.

What benefit this has compared to Incorpoarting INC in the first place with S-cor option election.

Are there any pros anc cons bewteen the above two options?

LLC vs S-Corp

From a federal tax perspective, there is no difference between forming a corporation and forming an LLC and election tax treatment as a corporation.

From the state level, most states will follow the federal election and you'll file a corporate state return. If that's not the case in your state there could be a difference between the taxes between corporations and LLCs. In California, for instance, follows the federal election and LLCs opting to be treated as S-Corps file Form 100S, the California S-Corp return.

From a legal perspective, your LLC still has all the legal protections of an LLC. Other legal differences I'll leave to the lawyers out there. :)

There may some reasons at the state level to form your organization as an LLC rather than a corporation like lower filing fees or simpler compliance requirements. One item I see a lot is there's no requirement to have annual shareholder meetings & minutes for LLCs. But I've never found that to be particularly onerous as long as there are only a few shareholders and no travel is required.

Hope this helps.
L:)

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