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Contracting 101: A Crash Course on Becoming a Contractor

*Note- This site isn't spreadsheet friendly. To see a better view of pros and cons of W2 and 1099 contracting, please visit: http://bit.ly/2yUCmyI

According to the American Staffing Association (https://americanstaffing.net/), Temporary and Contract Staffing accounted for $127.5B in annual sales across the staffing and recruiting industry in 2016. On average more than 3 million temp/contract employees were on assignment during an average week with a total of 15 million temp and contract employees hired each year. Of the 15M contract employees, 76% work full time and 35% were offered a permanent position by the client they were assigned to. Contract and temporary revenue has been steadily rising since 2009 and has nearly doubled since 2002 which is no wonder why a majority of staffing agencies (55%) only provide temporary and contract staffing services.

*Note- These statistics don’t take into consideration the number of contractors working directly with their client/employers so the industry is quite larger than $127.5B with well over 15M contractors placed each year.

With contracting becoming more and more commonplace it is important to understand the differences between the types of contracts to get a better understanding what contracting model works best for you.

Types of Contracts

There are two main types of contracts: W2 and 1099 (which are both government tax forms). Under W2 we will discuss the differences between W2 salaried (of annual) vs W2 hourly. With 1099, we will discuss self-employed consultants vs Corp-to-Corp contractors. To note, there are similarities will all contracts in that they are considered temporary and will either be completed (or renewed) based on a predetermined length of time or project completion.

W2 Contracts

Generally speaking, W2 contracts are the most straight forward as they are set up very similarly to permanent positions with only a few exceptions, including an end/renewal date to the contract. The main similarity comes down to payment terms. W2 contractors are generally paid on a normal schedule with the employer taking care of withholding income taxes, social security, and Medicare. Come tax time, the employer will send a W2 form just like they do to all of their permanent employees. If you worked multiple W2 contracts throughout the year you will receive a W2 from each employer. Employers will also pay their portion of taxes and may pay for part of your healthcare premium (if benefits are offered).

W2 Salaried/Annual

W2 Salaried contracts can also be called W2 Annual contracts. W2 Salaried contracts are set up just like permanent positions where you are being paid an annual salary broken down into pay periods. These contracts are perfect temp to perm or for longer term assignments as salaried contractors are generally able to participate in company benefits such as healthcare, benefits, along with PTO which makes the temporary status feel more like a permanent position. Depending on job duty, W2 salaried contractors can be classified as being as Exempt (meaning employers are not obligated to pay overtime). Similar to their permanent counterparts, W2 Salaried contractors may work over 40 hours and only get paid for 40 hours. On the flip side, if they work under 40 hours, they may have to dip into their PTO bank to receive their full, regular payment. If non-Exempt, the employer may limit the hours to 40 per week.

Due to co-employment law (check out my blog “Why do companies use agencies when they have their own recruiters?” to learn a little more why co-employment law has become such a hot topic) there is usually a maximum duration of an assignment followed by a mandatory break before you are eligible to return to the assignment. For example, you may be allowed to contract for 2 years followed by a 6 month break in the assignment before you are able to return.

W2 Hourly

W2 Hourly is set up similarly, in many ways, as W2 Salaried in that taxes are still taken out by the employer; however, payment terms are a little different. Instead of being paid based on an annual salary you are paid based on an hourly rate. Payment is still on a set schedule which can include weekly, bi-weekly, or monthly. Depending if you are classified as Exempt or non-Exempt, companies may limit the hours to 40 per week (or 8 hours per day in some states like California which have daily overtime laws). If you are approved to work overtime, you will be paid for every hour you work with overtime hours being even more lucrative, time and a half (or 1.5 times your rate for those hours). You may not be eligible for company benefits (especially if you are working under a certain amount of hours per week); however, you may be able to decline company benefits and negotiate a higher hourly rate. This is a great opportunity for someone who has another source of healthcare benefits and is looking to make more per hour.

If you are planning on working full time hours on a W2 hourly assignment, an easy “hourly rate” to “salary” conversion is: “Hourly Rate” x 2080 work hours per year = Annual Income. Keep in mind this does not take into consideration any PTO or hours missed due to company shut down nor the potential of time and half for overtime.

Summary (More on 1099s below)

W2 contracts are pretty simple and straightforward compared to their 1099 counterparts. They can be a foot in the door when a company wants to “test” out a new employee before bringing them on as permanent headcount and if you are working hourly you can protect your home/work life balance or have the ability to build up your nest egg by earning overtime compensation.

1099 Contracts

W2 contract are pretty easy for most people to digest because the differences between permanent employment and working on a W2 contract are relatively minimal. In both situations you are being paid on a regular basis with taxes being withheld. 1099 contracts can be a little more confusing, but offer the most flexibility, allowing greater control of your workload and the projects you accept along with the highest hourly/project rates. In other words more risks = more rewards.

1099 contractors can be self-employed or business owners who are responsible for paying their taxes on their own, meaning their invoices are paid in full without any taxes being withheld. These types of contracts require an expert knowledge in bookkeeping and will generally have the additional cost of using an accountant to ensure proper IRS compliance along with maximizing tax deductions. 1099 contractors are generally reporting their taxes quarterly and are responsible for their own benefits.

1099 contractors can bill for each hour worked; however, their clients are not required to abide by overtime laws. They can still bill over 40 hours, but will only be paid straight time for all hours worked (unless otherwise negotiated in their contract).

Independent Consultants

As mentioned above, independent contractors/consultants are self-employed and are responsible for paying all of their applicable taxes and benefits. If you are on a 1099 you are not eligible to enroll in company benefits. Independent Consultants are strictly unincorporated and companies who utilize services from independent consultants MUST follow the IRS guidelines for 1099 classification. These guidelines are a laundry list of conditions that classify an individual as either an employee or consultant and can be interpreted in many different ways; however, if a project is short term or if you are working on multiple projects at a time, you may be just fine working under a 1099 without having a business set up. All of your profits are subject to self-employment tax and income tax and you are not protected by any minimum wage laws.

Regarding proper classification of consultant vs employee, according to the IRS (https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee) there are three common law rules that the IRS uses to determine whether someone is properly classified as an independent consultant. In short, summarize the 3 common rules as:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Best Practices: If you are thinking about contracting without having a business set up or if you are considering hiring a 1099 contractor who isn’t incorporated, spend some time researching classification of 1099 contractors along with co-employment law. It would also be worth reading up on “Microsoft co employment lawsuit” as there are sizable government penalties for violating compliance.

Corp to Corp (C2C) Consultants

Many agencies will only engage in a 1099 contract with people who are incorporated (also called Corp to Corp or C2C) to help protect themselves against co-employment law risks. One of the easiest ways to become a C2C contractor is by setting up a single member Limited Liability Company also referred to as a Single Member LLC. A Single Member LLC is a business entity that is registered to the state as a business and operates as such.

The business owner takes money out of the business for expenses to run their business. Expert level bookkeeping is required as one of the beauties of running your own business means that most expenses are taken away from revenue which means you are taxed on your profits. In other words, business expenses become tax deductible. Working with an accountant is highly suggested as they will make sure that you are deducting everything possible to save as much as you can come quarterly tax time.

LLC owners will generally carry liability insurance and members are not typically personally liable for debts of the business. For example, if the LLC gets sued (hopefully this never happens), or if the LLC goes bankrupt the owner’s personal assets are not at risk. Whereas, if you are working on a 1099 as an unincorporated individual (in other words you are working under your SSN) and are involved in a lawsuit, your bank accounts, home, etc. are all fair game!!

Single-member LLC's should register for an Employer ID Number (EIN), even if the business has no employees. Most banks require an EIN to open a business bank account.

If working through an agency, the contract will be between the agency and your company name. If they offer direct deposit they may require the bank account to be a business account (another step to ensure co-employment laws are being met).

Similar to 1099 consultants, C2C contractors are able to take on multiple projects at a time and have more flexibility to choose which projects to accept. There is an opportunity to add employees and grow the business if the opportunity arises, though many companies may classify a multi-member LLC as a vendor and may prohibit work being given to these types of companies to maintain confidentiality and quality.

Summary

1099 contracts require more work, more bookkeeping, no option for client paid benefits, and do not offer any tax withholdings. You are going to be physically seeing your tax dollars go to Uncle Sam every quarter and there is a lot of extra administrative time and costs associated with going 1099.

On the flip side 1099 contracts pay the highest hourly/project rates. The reason why they pay high is because of the lower cost to the client compared to W2 (no employer taxes, no benefits, etc.). You have the flexibility to be the boss of yourself and have the opportunity to pick and choose the work you accept, something that employees can only dream of.

Best Practices: if you are working on a 1099 basis, do yourself a favor and find a really good accountant. Unless you are an expert accountant or have a lot of free time on your hands, the costs associated with utilizing an accountant are offset by maximizing tax deductions along with the peace of mind knowing you are complying with all government regulations and policies.

If you are thinking about setting up an LLC or another type of business, Legalzoom.com is a widely accepted resource that will help educate you on the process and can walk you through the process of setting up your company at a cost that is generally much lower than an accountant or lawyer.

Like Like Celebrate Support Love Insightful Funny Comment Share 4 Comments Alex Benjamin, graphic

Alex Benjamin 8y

Thank you everyone who had given this a read. I am looking to continue to produce helpful content for both candidates and hiring managers in the weeks to come. If you have any topics that you would like to see covered, please reach out to me via LinkedIn or [email protected] as I would love to hear what is important to you.

Like Reply 6 Reactions 7 Reactions Kai Dawkins, CMIACR, graphic

Kai Dawkins, CMIACR 8y

Very good overview. These differences can be confusing for people who are new to the working world.

Like Reply 1 Reaction 2 Reactions Stacey Steele, graphic

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