Shifting from W2 to 1099 consulting

[Kronk]

My consulting firm is allowing me to switch from being a W2 consultant to a 1099. My rate as an 1099 contractor will be $5 per hour higher than as a W2 consultant. So, it looks worth it to me.

I'm talking with my accountant today, so I'm interested if there are any thoughts here about things I missed, or things I might want to ask my accountant.

The plan is to:

Establish an S-Corp. I created a different corp a couple years back with a lawyer. Anyone establish one through a web site (such as Incorporating, Limited Liability Company, How to Form an LLC, Incorporate Online)?

Create a Solo 401k through Fidelity. My corp will contribute 25% of my W2 wages.

Establish a home office. Minimal portion of the house, but will allow me to deduct commuting mileage.

Run my own payroll taxes.

Set my salary to be a "reasonable" salary and take the excess in distributions.
​

On the plus side: higher rate, higher 401k savings, can roll over my current 401k to an IRA, lower taxes, more deductible expenses (including HSA premiums).

On the down side: accountant fees, paperwork


Any thoughts, or other considerations to keep in mind?

 

[brewer12345]

Sounds about right. I haven't looked in a while, but would an LLC be a better/more flexible choice?

 

[Peter]

Will your 'client' be your old employer? If so, be careful! The IRS has a list of criteria for determining whether contractors are actually independent, or whether they are really just employees.

The best way to avoid this trap is to have other clients that you bill directly.

Also, you didn't mention health insurance ...

Peter

 

[retire@40]

...things I might want to ask my accountant.

The plan is to:

Establish an S-Corp...Set my salary to be a "reasonable" salary and take the excess in distributions.​

You can ask how you are going to justify taking any distributions at all if you are doing all the work yourself within the corporation.

IOW, If you are earning all the income from your own labor, what is the justification to treat payments to yourself other than being classified as wages?

Unless you charge "unreasonable" fees, isn't it all "reasonable wages?"

 

[One-Zero]

Kronk:
I have numerous friends who are IC's and went 1099 route...If you're talking about a 5 dollar diff you may want to run the numbers carefully.

Did your accountant mention the SE tax you're liable for as an IC 1099'er Unless you are prepared to do some serious shell gaming with deductible expenses, it can eat up much of your 'apparent' higher rate of pay. You really have to stay on top of it...IRS has targeted many of these indy small bizs for audit.

If your mind is set on this move I offer this website for your consideration - she has been quite helpful to a few folks who initially were consireding the single entity 'S' corp: June Walker: Tax advice for self-employed & indie

cheers,
1-0

 

[pfpelican]

..If you're talking about a 5 dollar diff you may want to run the numbers carefully.

I agree that $5 per hour might not be worth it. As an independent contractor, you might now be responsible for your own liability insurance, unemployment insurance, and disability, not to mention self-employment taxes (alert: you'd probably have to estimate vs w2). The $5 extra could be quickly eaten up by extra taxes and required insurance.

I am 1099, but get about double the w2 rate....and have retiree insurance that is not employment dependent. The extra money makes it worth it. $5 wouldn't.

 

[aenlighten]

Benefits average 30%

The only way $5/hr makes sense is if you plan for large deductions and deferrals. Will you set aside 22.5% in retirement accounts, spend large amounts on junkets, aka education and travel, and expend a lot on direct costs?

 

[Kronk]

Thanks for the comments.

Part of the plan is forming an S-Corp. So I wouldn't technically have self-employment taxes. I would, though, be responsible for the employer side of things, which appears to be on the order of $4,500 to $7,500 per year, depending on the salary I give myself. Unemployment looks like $300 per year. I have no disability insurance right now.

One of the biggest tax advantages, though, will be the 25% company match into my solo 401k.

As far as employee vs. contractor, I'll look into that a little more. There are people doing 1099s in a similar situation. Most 1099 contractors that I know do what I described: salaries that are less than the full amount of their pay, plus distributions.

Breaking it down, in any case I'd be contributing the max amount to my 401k as an employee.

1. W2 rate ($70/hr) - 1880 hours - 131,600 gross - $7,950 payroll taxes - $28,750-ish total taxes. $102k-ish income/sheltered accounts.

2. 1099 rate No Distributions ($75/hr) - 1880 hours - 141,000 gross - salary of $106,725 - $26,681 company match into 401k - $15,485 payroll taxes - $21,606 total taxes. $111k-ish income/sheltered accounts.

3. 1099 rate w/$60k salary ($75/hr) - 1880 hours - 141,000 gross - salary of $60,000 - $15,000 company match into 401k - $61,000 distributions - $9,480 payroll taxes, $22,000-ish total taxes. $114k-ish income/sheltered accounts.


Or I could do something in between 2 and 3. And there would be some business expenses as well that help me out as a 1099 contractor.

Oh, and BTW either as W2 or 1099 I provide my own health care insurance.

 

[retire@40]

...
1. W2 rate ($70/hr) - 1880 hours - 131,600 gross - $7,950 payroll taxes - $28,750-ish total taxes. $102k-ish income/sheltered accounts.

2. 1099 rate No Distributions ($75/hr) - 1880 hours - 141,000 gross - salary of $106,725 - $26,681 company match into 401k - $15,485 payroll taxes - $21,606 total taxes. $111k-ish income/sheltered accounts.
...

Not sure how you are calculating your payroll taxes, but with gross wages (from your prior employer) of $131,000, your payroll taxes (FICA only) are 131,600 x 7.65% = $10,067 (not $7,950). Some may even argue correctly that part of your pay is also consumed by the employer matching FICA since they factor that into the cost of employing you and give you that much less in gross pay.

$141,000 of wages from your own corp, your payroll taxes are $141,000 x 15.3% = $21,573 (not $15,485).

 

[Kronk]

There's the federal cap on SS contributions for W2 income at $6045. so 6045 + 1908 = 7950-ish. But actually now I forget whether the cap is on the employer side or the employee side or both. Google...

Hrm. 12.4 of the 15.3 self-employed tax caps out at 97,500 as well. So (even though I wouldn't be paying self-employment taxes as a S-Corp), that'd be $12,090 + 2.9% of earnings for 6-figure earners in 2007. Still not sure about the 6.2% of the employer's share of SS.

 

[EngineeringMyFinances]

R@40 seems to have forgotten about the wage base limit of $97500 for payroll taxes.

Speaking of which, you should think about switching over at year end. While you can recover your excess payroll taxes, I understand that the employer (your S-corp) could not. So if you switch now there could be additional payroll taxes that would otherwise not be paid.

 

[Kronk]

Yeah, that was a thought of mine as well (switching at end of year). Of course, if I started billing as a 1099 for November, I wouldn't get paid until late December, and probably wouldn't run my payroll until January anyway. I guess the accounting method of the corp might affect taxes in that situation as well.

 

[perinova]

$5/hour doesn't seem enough to compensate for the many hours and costs of managing a corporation. You will have to deal with quarterly and yearly federal and state filings and fees as well.

In addition to the time and cost of an S-corp be carefull of the benefits you might loose by incorporating/ becoming independant. Mostly you loose the benefits of downtime pay (vacation, sick time...). Close second consider health insurance if this is important to you. There is a special rule for S-corp that prevents you from deducting health insurance cost! So if this is a problem choose LLC or C-corp instead.

It seems to me that you might wnat to go 1099 and file schedule C instead.
- The SE taxes are equivalent as the employer taxes
- The business deductions are the same
- You can now deduct health insurance on your taxes
- YOU CAN USE A SOLO 401K ALSO!!! (It seems the most important factor for you). The max you can put aside is the same. You do not need to incorporate for that.

Trust me I have an S-corp. At this time I maintain it but it costs me thousands of fees and insurance. It is very costly in time spent and understanding the forms you have to file. You have to do that on time every quarter without fail.
You are at the head of a corporation that you can use for other purpose in the future if you would like to expand your business or get a management job. This is why I did it in the first place.
On the other hand if you are only interested in consulting to close the gap between work and ER IMHO it doesn't worth it.

 

[perinova]

There's the federal cap on SS contributions for W2 income at $6045. so 6045 + 1908 = 7950-ish. But actually now I forget whether the cap is on the employer side or the employee side or both. Google...

Hrm. 12.4 of the 15.3 self-employed tax caps out at 97,500 as well. So (even though I wouldn't be paying self-employment taxes as a S-Corp), that'd be $12,090 + 2.9% of earnings for 6-figure earners in 2007. Still not sure about the 6.2% of the employer's share of SS.

Kronk the employer and employee share of medicare and SS are identical. So multiply by two what are deducted on your current paycheck this will be the cost to you on a 1099 (incorporated or not).
There is also a small une,ployment tax to consider and also do not forget your state employment taxes as well!!!

 

[eridanus]

Set my salary to be a "reasonable" salary and take the excess in distributions.

Be careful. Without any employees (not including the owner), paying a distribution is risky. It'll work until it doesn't, and then you'll end up paying $$ to hire a tax lawyer and possibly penalties and interest. Or not.

"What kinds of abuse could the IRS be looking for? One maneuver involves using S corps to avoid wage taxes on shareholders who are also employees--a common setup in many small businesses. The sneaky play here is to minimize the salary paid to owner-operators, who thereby avoid a social security tax (FICA on W-2 forms), and simply flow the income through as a distribution."

The Shady Side To S Corps - Forbes.com


I do straight 1099. With the 401k deductions, 401k match, and HSA contributions, I can reduce my income significantly.

 

[Kronk]

To clarify one thing... I currently have NO benefits other than 401k (no match). I pay my own health insurance. I have no paid vacation/sick/holidays. I'm paid by the hour with no benefits. Had I been getting benefits, it wouldn't be anywhere close to worthwhile.

Thanks for more info on S-Corp vs others. I do have an S-Corp now, and don't find it too onerous (though for that one I used a payroll service). But it might be overkill in this situation.

 

[Kronk]

Okay, here's an update, for anyone who might find this useful or interesting.

I was able to get an additional $2 per hour increase in my 1099 rate. Now the differential is $7 per hour. That makes my decision easier.

My accountant's take on taking company distributions from an S-Corp is less conservative than some of yours. He hasn't seen nor heard of people really getting dinged by the IRS for taking company distributions, unless they are abusing the system badly (i.e. $20k salary and $150k distributions). Nothing in this world is certain, obviously.

One interesting note about LLC's. If you have a 25% matching solo 401k, even the company match amount is subject to self employment taxes. Which for me would be 2.9% since I'd be over the SS cutoff point if I went this way. Pennsylvania also requires a business tax return for LLCs, even though you don't need one for federal returns.

If I have problems as a Contractor vs being an Employee, it would be the same as how I'm working now as a W-2 hourly consultant. So I'm not going to get into that.

Unemployment looks like $300 or so per year, so I'm not too concerned about that.

The decisions I need to make now are when to switch over (wait until 2008?); and whether I want to go the LLC route. I'm leaning towards S-Corp, since as an S-Corp if I gave myself all my income as salary (no distributions), I'd still end up a bit better off financially (even after accounting costs) as opposed to an LLC. I'm not too worried about the paperwork.

 

[TromboneAl]

From my experience:

Over the years, every time I looked at the pros/cons of forming a corporation, I decided it was not worth it. Extra paper work, not as much extra protection as you might think. For me, qualifying as an independent consultant wasn't an issue. YMMV.

SEP-IRA much simpler than 401K -- almost no paperwork.

Note also that there are other advantages of being independent. You can have a medical expense reimbursement plan, and make ALL of your medical expenses deductible.

 

[FIREd]

An independent contractor MUST have several clients. If he doesn't then he is just an employee. I have heard many employers who, in an effort to cut costs, are asking their employees to become independent contractors while expecting them to devote 100% of their time to the employer's company. It is illegal (tax evasion?) unless you truly become an independent contractor and seek new clients.

 

[retire@40]

An independent contractor MUST have several clients...

Tom Hagen: I have a special practice. I handle one client.

 

[FIREd]

Actually, after further reading, the line separating an employee from an independent contractor is a bit more blurry than I thought: See how the IRS determines whether you are an employee or an independent contractor.

Independent Contractors vs. Employees

You have to at least demonstrate a certain level of independence from your client but it does not say anything about the need to have several clients. But a lawyer friend of mine said that the IRS could look suspiciously at your case if, as an independent contractor, you have only one client. But apparently, in itself, it is not against the law if you can prove you are independent enough from your client.

 

[Manuel & Dawn]

If you are paying your own health insurance, is the company contributing anything and isn't that exempt from pr taxes as a cafeteria plan? Or is that why the 401k contribution is so high? Which has the better advantage tax wise?