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Consultant : 1099, Corp to Corp or W2?

You are planning to launch your career as an independent contractor and the questiton haunting you is “W-2, 1099 or Corp-to-Corp?” Here are few information which might guide you to take the right decision. Remember information here 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.

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.

W-2 Employee


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


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.


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.


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.


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 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:
[                     | 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!!

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Launch your career as independent IT-consultant

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