Employee Vs. Independent Contractor
 (or how to get a pay cut and not even realize it)

By Scott Hill C.P.A.

Your employer comes to you and says, “Joe, we’re making some organizational changes and we want you to become an independent contractor instead of an employee.  Don’t worry, your pay will stay the same.”  Is this cool?  As usual, the answer is “it depends.”

 Shifting the Burden

 First, let’s look at why your employer would propose this.  Employers are responsible for withholding federal and state income taxes and employee FICA taxes. They also must pay the employer share of FICA taxes.  In addition, there are usually state and federal unemployment taxes that the employer must pay.  All this requires a lot of administrative expense.  Payments made to independent contractors are not subject to these responsibilities and expenses.  More and more companies are attempting to shift these burdens to the employee/contractor.

 Things to Consider:  Disadvantages

 So, should you do it?   Assuming you have a choice, here’s what you need to consider.  First, you will be taking an immediate pay cut.  As a self-employed contractor, you must pay self-employment tax (basically, the self-employed version of FICA taxes).  This is in addition to federal and state income taxes.  Self-employment tax runs 15.3 % of your net business income (up to $76,200 - above that, the rate drops to 2.9%).  As an employee, you pay 7.65% and the employer pays the other 7.65% (subject to the same income limits).  So, on the first $76,200 of your earnings, you will pocket - after taxes - about $5,800 less as a contractor than you would as an employee.

 The other big negative to being a contractor is the additional responsibility.  As a contractor, you bear the responsibility for paying in your income and self-employment taxes on time.  Generally, this requires that you begin making quarterly estimated tax payments.  If, on the other hand, you are paid as an employee, your employer has the responsibility of withholding the proper amount of FICA, federal income tax and state income tax.

 As the responsibility shifts to you, your administrative burden gets heavier.  As mentioned above, you may need to begin making quarterly tax payments.  Your annual tax return will become more complicated with the addition of Schedules C and SE and possibly other forms.  If your tax return has been relatively simple in the past, this is where it gets significantly more complex. 

 Things to Consider:  Advantages

 So why would you ever accept the change from employee to independent contractor?  There can actually be some advantages if you accept it on your own terms.  First, insist on additional compensation of at least 8 per cent to cover your increased tax and administrative burdens.  This just equalizes the shift in the tax and administrative burden between the employer and you.

 Note the term independent contractor.  If you are going to be paid as an independent contractor, you should have the freedom to exercise that independence.  That means you should have the predominant say in what hours you work and how you go about accomplishing your tasks.  By definition, the employer is giving up the power to tell you how to do your job.  As an independent contractor, you are obligated to achieve the results your client (your former employer) specifies, but how you go about getting those results is largely up to you.

 Giving you this freedom is actually in the best interest of your (former) employer.  Unless the contractor is given this freedom, there is a risk the IRS will reclassify the contractor as an employee.  If that happens, the former employer once again becomes the employer.  Suddenly, the employer becomes liable for employment taxes that should have been withheld from the employee’s wages, the employer’s share of FICA, unemployment taxes. There are also penalties and interest associated with all the back taxes.  These can be substantial.  More than one company has been put out of business by having contractors reclassified as employees.

As an independent contractor, you may be able to deduct business expenses you were unable to deduct as an employee, including equipment and car expenses.  Self-employed people typically have greater flexibility in setting up retirement plans than employees.  A tax professional can give you guidance concerning these issues.

 Before You Make a Decision

 I’ll leave you with a couple of things to think about. There are a lot of technical issues that can arise in the employee vs. contractor issue.  As confusing as the above discussion is, believe me, I have simplified it quite a bit.  Before accepting a change from employee to independent contractor, you owe it to yourself to fully research and understand all of the ramifications.  Also, maybe as important as the significant tax effects are the more philosophical considerations.  By becoming an independent contractor, you are making the very real change from being an employee to being a business owner.  Each role requires a different mind-set.  Some people are better employees; others enjoy the freedom (and associated risks) of self-employment.  Think long and hard about where you stand before making such a far-reaching decision.

Till later,

Scott

To Contact Scott.  Please click here.

Prior Months Articule: Click link below to view.

Navigating the Retirement Saving Maze: Part 2 

Bio:

Scott Hill is a certified public accountant in Norcross, Georgia. He holds a Masters of Accounting degree and has over 18 years of experience. His firm, Scott Hill and Company, P.C., concentrates on accounting, income tax and financial planning for individuals and small businesses.

Financial advice for busy professionals with Scott Hill©

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