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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.

AttachmentSize
Scenario1_Details.xls31 KB

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Employee vs Officer

Hello Linda!

If you have a S-Corp, do you have to have a minimum of 1 employee?

also

In stead of listing myself as an employee, can I just say that I am an officer, and just pay myself quarterly dividends instead?

Thanks and have enjoyed your posts!

Vince

Fed EI Reporting

Linda:

How are you?

I am being paid corp to corp. I reference my Federal E.I. number on my invoices to the company that I am contracting with.

I was wondering...at the end of the year, what form will they be filling out, where does it go and what is it exactly that they are reporting?

Once again, thanks in advance!
Tony
Delaware

No Income Reporting for Corps...yet

Hi Tony,

Because your business is formed as a corporation, the client has no obligation to report to the IRS payments made to your corporation (unless the payments are for health care or legal fees).

However, it's likely this could change with in the next couple of years. But for now, there's no reporting.

L:)

Agency to Corp to Corp?

Hi Linda

What a great content. This was so very helpful as I am considering going C2C. My 1 yr contract with an employment agency is ending in Sept. They want me to stay on and have agreed to C2C for another contractor in the same position so I am going to suggest that for my case as well. I have access to the invoices and know my agency is charging $85/hr while I am being paid $50/hr so I am happy to go solo when my contract with them has ended and obtain some of their cut :D

My question for your insight would be (1) if S Corp would be the best way to go and (2) do you have any insight as to that transitioning time when it looks like I might have to wait 30-45 days etc. for billing. (3) In light of the $800 CA fee is there anything else fee and payroll and deposit-wise I need to beef up for throughout the year? I plan to use Turbo Tax and Quickbooks for tracking and an Accountant who also uses Quickbooks.

Please note all work is done on sight with the exception of traveling inner city to their offices so I don't expect to have a lot of expenses, however I do want to negotiate a work from home policy so that may change. Still, desk/phone/laptop/office all is provided for. Lastly, the company is struggling and may not be around for the long term using the S Corp long term is undecided however (4) if I should accept a regular salaried job, do I dissolve or suspend or just put all zeros to keep the status?

Thx for your help!

After S Corp

If I should accept a regular salaried job after being an S Corp, do I dissolve or suspend the status while I go back to a W-2?

Individual consultant - 1099 vs S-Corp

Thanks so much for all your posting, very direct and detail answers.

Linda,
I have started to work as an individual consultant starting this 2008.
I've been research on this topic and want to do it right, but still confuse. Your answers are much appreciated.
From this article: "An SMLLC that is a disregarded entity and does not have or will not have employees does not need an EIN. It should use the name and TIN of the single member owner for federal tax purposes. However, if a SMLLC, whose taxable income and loss will be reported by the single member owner, nevertheless needs an EIN to open a bank account or if state tax law requires the SMLLC to have a federal EIN, then the SMLLC can apply for and obtain an EIN. If the SMLLC has no employees, it will not use this EIN for any federal tax reporting purpose."
Do I still need an EIN to pay quaterly tax?
If I do, as I clarified on W-9 form as Corporation, which one should I select from: sole proprietor or S-corporation?
I also would like to max out the retirement plan to reduce my income.
Can I re-clarify on W-9 as Sole Proprietor?

Thank you so much,
cva

Grate article

I was looking the some information that was mentioned in the above article in other blogs, but this article was the most helpful so far. Thank you. payday cash advance

LLCs Completing W-9

Hi,

Usually your bank will require an EIN for you LLC. The IRS seems to be making changes with regard to LLCs and EINs.

I would get a separate EIN. But use your SSN to make your estimated payments.

On the W-9, the newer version of the form has a separate box for LLC you can check and then it asks how you're taxed. In your case, select sole-proprietor.

If you get an old copy of the W-9, check both sole-proprietor & "Other" with "LLC" in field next to it.

Hope this helps.
L:)

Thank you Linda!

Hi Linda,

I was exploring various options for working as a consultant and found your article "Consultants: W-2, 1099 or Corp-to-Corp?" very informative. Thanks a lot.

Peter

Hiring another consultant

Hello again Linda!

It seems you're very busy and have a lot of questions to answer. I hate to do this, but I have to add another question to your list.

The company that I am consulting for wants to hire specific person for another tech position, but isn't allowed due to nepotism within their organization. I am thinking about offering to hire this person as an employee of my S-Corp and having them pay my company his salary has I, in return, will pay him either as W2 or 1099.

I like this idea, because it gets my new company's name out there as well as bringing in more income for the business. Since they have already talked with this person, prior to the hiring dilemma they had already set an hour rate with him, I was considering, if they go for this, requesting 33% above what he was asking, so that it will cover my administrative cost, i.e' payroll service and tax expenses.

Is this a good idea or will I be spending more than I will have come in?

Also, if he agrees to be paid as a 1099, do I have any cost to me other than his salary?

Once again, thanks in advance.

Tony A.
Delaware

Acting as Middle Man

Hi Tony,

I'm glad this site is helpful. I try to get all the questions but I do get behind sometimes. :(

If you pay the worker as an employee, you are subject to employment taxes plus worker's comp insurance. Also, if you have any benefit plans, like an HRA or 401(k), hiring employees can complicate things for you.

If you pay the worker as an independent contractor your risk is that he is really an employee. Be sure to get a W-9 from the worker prior to the first payment, otherwise you must withhold 28% for federal income & SE taxes, which must be deposited with the IRS.

To more directly answer you question, the only other expense you will have is the time & paper to bill the client, collect the money, pay the contractor & report the payments at the end of the year on his 1099. You might also have some cashflow issues if you're promising to pay the contractor within say 10 days & you don't get paid for 30. You might add some text in the contract that you'll pay the contractor within 3 business days of receiving payment for their work. Or something similar so you don't get stuck with the float.

A hint: don't refer to payments to independent contractors as "salary". That term infers that the worker is an employee.

Hope this helps!
Good Luck!
L:)

NY resident working for OR company - 1099, W2 or C2C?

Hi Linda,

One of our company's technical folk is moving to NY for personal reasons. We want to retain him but need more information about the tax implications for us (an Oregon company), as the employer, if we keep him as W2 or he works as a 1099 or Corp to Corp.

He will be telecommuting.

Thanks,

Mark

NY Employee

Hi Mark,

If he is in New York and your employee, you will be a New York employer and need to pay & withhold NY taxes.

With 1099 or C2C, he is on his own. The question you have with 1099 is: is he an employee or an independent contractor? That's a whole can of worms unto itself.

If you have direction and control over how he does his job, then he's likely an employee. If you just give a specification and based on his expertise let him determine how to meet the specifications, then he could be an independent contractor. Just stating in the contract he's an independent contractor is not enough.

The IRS usually doesn't reclassify workers who are employees of other corporations (in a C2C situation your technical folk is an employee of his/her own corporation).

From your perspective, C2C would provide the most protection without you having to start being a New York employer.

Payroll companies, like ADP & PayChex can do all the state payroll reporting for you. Another option is employee leasing. With this approach, your NY worker is an employee of another company and they bill you for his/her work. The worker get's a W-2 from the leasing company. Some, like Payrolling.com, also offer benefits.

Hope this helps!
L:)

W2 Vs SCorp

Hi linda,

First of a wonderful site with lot of information for small business. Good effort putting it up.

Let me come to my actual questions. I am planning to move from Full time to Contractor using SCorp. I have a LLC which I am planning to use and file SCorp status. Right now, i have an offer which I am negotiating. I am harding time figuring out which way to go. Whether W2 or contract. I know the benefits of W2 and also SCorp but money and tax wise which is better. Let say for example, I earn $75 an hour and 2080 hrs per years to get to a total of $156000. In W2, employer and employee contribute to Fed tax, I get paid after the withheld after other benefit deductions. Thats straight forward.

On the SCorp, that 156,000 comes to my company. Lets say I pay myself as W2. If I choose to only pay myself, 125,000. Do I have to pay the same 15% fed tax since I am employer and employee or less tax. Also what other benefits other than SEP and mileage deduction at the year end of tax return filing..

Please help with your answer which will guide me better..

Thanks

S Corp Taxes.

Hi Anand,

Usually Corp-to-Corp pays more than the W-2 rate because the client (or middle-man) doesn't have to pay all the employment taxes & worker's comp insurance. It's unlikely you'll come out ahead if their offering you the same rate for Corp-to-Corp.

Yes, you & your S corp each would pay 6.2% of the first $102,000 of wages for Social Security tax and 1.45% of the total for Medicare taxes. Based on your example of $125K, the combined employment taxes would be $16,273.

You can make contributions to a 401(k) or SEP-IRA plan. But those are limited to 25% of your W-2 income. In your case the maximum contribution would be $31,250.

You can also have the company reimburse you for medical expenses including health care premiums. Those payments are included in your W-2 wages (and deducted on your 1040). That increase in your W-2 wages allows you to contribute more to your retirement plan. (This is only available if you or your spouse are not covered by a subsidized employer plan).

The business could also reimburse you for a portion of the expense for a home office.

If you opt to be a W-2, you would be limited to the $4000 IRA contribution and any medical expense is only deductible after you reach the 7.5% of AGI limit.

Hope this helps.
L:)

S Corp, Payroll, and Tax Deductions

I have really enjoyed this thread and the advise that you have posted on "Consultants: W-2, 1099 or Corp-to-Corp?". I have just accepted my first consultant position, the pay isn't that great, but at least I broke into the business. I have excepted about $40 hr doing some light IT work. I revived an old S-Corp that had once established and have contacted a payroll company to pay me W-2 disbursements and take care of the taxes. I am a procrastinator and spender, so I think this was the better choice although costly. Is this correct?

I am not to worried about the business turning a profit at first, just pay me, the taxes and the expenses, hopefully things will grow later down the line. My wife works and we elect her benefit package through her employer...so we are set there too. Is my way of thinking safe?

I do have two additional questions. 1) with an S-Corp, what can I consider a personal tax write off vs. a business expense or write off? and 2) What did you mean when you said "S-Corp shareholders pay tax on undistributed profits"?

Sorry for the overwhelming questionnaire, but I want to make sure I do this right.

Thanks in advance,
Tony A.

New S Corp

Hi Tony,

Sounds like you're on the right track. You might be paying a little extra, but you're making sure you're meeting the tax obligations which will save you money and stress down the line. I would just make sure that your wages are a little less than the S-Corps income. Otherwise, you won't have the cash to pay for the payroll taxes or other expenses.

On the undistributed profits part, say your S-Corp has sales of $40K, wages & PR taxes of $30K and other expense of $5K. The net profit of the company is $5K. You leave that in the business checking account. When you file the 2007 1120S return, you will have taxable income of $5K even though that money is still sitting in the business checking account. The S Corp will issue you a K-1 with the $5K of profit which you will report on line 17 of your 1040.

Make sense?

L:)

Dedcutions vs. Write Offs

I do not want to ask too many questions or over stay my welcome, with an S-Corp, what can I consider a personal tax write off vs. a business expense? Basically, what can I claim at the end of the year and what can the business claim?

Thanks again,
Tony A.

Very clear now. Thank you

Very clear now. Thank you so very much!

Minimizing SE tax

Linda, I'd like your thoughts on this situation and how best to minimize SE tax. I'm a medical professional working at a clinic and I'm considered an independent contractor. However, the job doesn't really require me to fork out much of anything for expenses. I work for one clinic which has a couple offices in nearby towns but doesn't require much hopping back and forth. If I form an S-corp as the sole owner-employee and all the money made by the S-corp is from me(through working at this clinic), can I get by paying myself a salary that is less than 100% of the revenues? The way I understand, a shareholder is entitled to have some type of return on investment....therefore doesn't have to pay everything out in salary since there may be equipment to purchase, etc. If I don't really have alot of that stuff to buy, are there other ways I can justify not paying everything out in salary? Maybe having a retirement plan set up and therefore the business needs some money to contribute to my plan, or I am entitled to keeping some money in case I want to invest elsewhere, etc? If I get $90,000 in revenues can I pay myself a salary of $70,000 or so? What do you think about this situation? Thanks in advance for any input.

Reducing SE Tax

Hi JJ,

I like your idea. :)

In your example you & your S Corp would pay combined employment tax of $10,710. As an sole proprietor you would pay $12,717 in SE tax. So you would save at least $2K in SE tax.

I bet you can find other things that you're paying for out of pocket now that you're not deducting for SE purposes. For instance if you make a SEP contribution, it doesn't reduce your SE tax, but if the S-corp makes it on your behalf it's not subject to employment taxes. The same is true of are HRA payments (which isn't even available to sole proprietors).

I'm sure you could save even more in your overall tax burden than just the $2k, but it's a nice starting point.

L:)

re: reducing SE tax

Linda,

Thanks for the reply. I guess my only other question would be...do you think that would fly with the IRS? (paying a salary of $70,000?) I'm worried that they would argue since I am the only employee and the only reason the company has the revenues of $90,000 that I deserve a salary of $90,000. What do you think?

Thanks again.

Reasonable Salary.

Hi JJ,

Sure that sounds fine. Remember, if you give yourself a salary of $70K the company will have to pay 7.65% of that just in FICA taxes or $5355. Plus if you want to company make a SEP or 401(k) contribution on your behalf you'll need funds for that too.

L:)

Did anyone respond to your

Did anyone respond to your question. I have a similar situation I am trying to figure out.

social security, health insurance and take-home money

Hi Linda,

Thanks for the great site.

For scenario 1:

(Question 1) What is the social security calculated for the S-corp? Which row on the spreadsheet?

(Question 2) Did you mention health insurance in the spreadsheet? How is this calculated for W2 vs. S-corp? What if her health insurance is already covered by her husband who is employed?

(Question 3) How you calculate the take-home money that she can spend now? Is it AGI - Total Tax Liability?

Thanks!

Filing Late

Hi Linda. Thank you so much for your information.

Back in late 2005 I was to start consulting and was told from a friend I trusted to open a corporation and he will take care of my taxes for me when it comes time to.

My company is based out of Texas, I live in Washington, and I have been working as a computer engineer out of different states for different contracts in MA, CT, and NY since then for 6 months at a time each.

Short story, I am no longer speaking to the "trustworthy friend" and he has done nothing for me but open the corporation for me since. All of my clients have been paying my business identity and I have deposited all the checks to my business account and have paid myself by writing a check from the business account.

I have not paid my taxes or sent anything in to the IRS since 2005 because I have no idea where to start now and I've gone to H and R block for help, but they seem as confused as me on where to start.

I make about 60k a year and have a lot of expenses since I travel that I'd like to deduct. How do I find out where my corporation stands and how do I take care of my taxes now? Do I file as S corp or 1099? I'd like to make sure I'm doing what's going to be least costly for me and I'm sure it might end up me doing something one way for the past couple years and doing something different for the future so this won't happen again.

Appreciate your advice.

Late Filer

Ok. You definitely need some help. You will likely owe quite a bit of tax, penalty & interest. But it's better to take care of it as it will only get worse.

First you need to find out if you filed the S election. You can call the IRS Business & Specialty Tax line at 800-829-4933 and ask them if Form 2553 was filed. If not, then you need to get that sorted out before you can tell which return to file for the corporation (1120S or 1120). I would ask them to send a copy of the S Election acceptance letter.

Once you get that sorted, you need to pull together your financial data so you can file the returns. If you did make the S election you'll need to amend your individual tax returns to include the income or loss on your personal returns.

You'll need to have the returns prepared and mailed in just like a current year return. You cannot e-file late returns.

The bad news is you're looking at ~$500 per year for a late filing penalty. This will be expensive to clean up. But the longer you wait the worse it gets.

Let me know if I can help further.
L:)

Neet Claculation Page

I also agree that this is a good break down. Thanks for all the work to make my life easier! :-)

though, the calculation page is not functioning, can you repost it or send it to us via e-mail?

Thanks,
Tony A.

Scenario1_Details.xls file not found

Linda - thank you for maintaining such a site.
I'm in a scenario similar to #1 on the W2 vs. 1099 vs. C2C post page. I wanted to see the attachment but the file comes up not found.

Can you email it to me?

Thanks,
John Bealor

Missing Attachment

Sorry about that. Upgraded the content management software & had a little glitch with that. I think it's sorted now. Please let me know if you continue to have trouble downloading the attachment.

L:)

Great information but my head is still spinning!

Thank you so much for this information - clearest that I have found so far. But I am still in over my head! I do a bit of consulting (I am in academia full time) and this year I formed a professional services corporation in Illinois mainly for liability reasons. At the time, a colleague advised me to form an S corporation. I am not clear on whether that will benefit me at this time or not. I was paid for 3 cases this year totaling about $6000 (I have 1099s for 2 of the cases). I just finally opened a business bank account (I also had twins this year so this has all been on the far back burner - but now it's tax time!).

I purchased the Home and Business turbo tax and have worked my taxes out without the S-Corporation - it looks like I would be paying about 15% that route.

Is it in my interest to file the paperwork you talk about above (form 2253) for the S-corporation and then create the K1 - would I just pay myself that full amount since it's not that much money? I would then need to do payroll taxes on the $6000?

I'm sorry but I am still not clear on all this. Thanks for any assistance.

S Corp or C Corp

I'm not clear if you've filed the paperwork to be an S-Corp in 2007. If not, then you have no choice but to report the income on the Schedule C and pay income & SE tax on it.

If you formed a corporation in 2007 then you need to file a corporate tax return & you'll need TurboTax for Business to prepare the correct return (which was due on 3/15).

If you formed the corporation & didn't make the S election, you can file Form 1120S and send in the Form 2553 S Election with the return (although special handling is required & I'm not sure how filing late will affect that).

Otherwise you must file Form 1120 (also due 3/15), and if you have distributed any of the $6000 to yourself you will have to have to pay dividend tax on that (plus 35% flat tax on the income of the corp).

If you did not file the paperwork to be a corporation or if the payments were made to you personally & not the corp (ie the 1099s have your SSN on them) then you can go ahead & file on the Schedule C, although I would work on either running your consulting through the Corp or dissolving it. No sense in having it hang around if you're not using it.

L:)

Question about Scenario 1

In Scenario 1, I am confused on how you determined the W-2 saved only $4000 for retirement and how the 1099 and corp-to-corp put $44,000 toward retirement.

When paid on a w-2 you can

When paid on a w-2 you can only save for retirement via IRA, which limits your contributions to $4,000. When you are self-employed you can contribute to a SEP (self employed plan) and the contribution limit is much higher (in the $40k+ range) and the tax benefits obviously better.

Consulting & More: C-Corp, S-Corp, and LLC - Several Questions

Hi Linda,

This is a fantastic site and service you provide. Thank you for providing your valuable time and energy to educate all of us.

I have many questions throughout this post, and they're all interrelated. You'll probably need to take a couple of passes at it before responding, to get a good feel for where I'm coming from. I apologize in advance for the amount of detail in here.

I'm a California resident, recently unemployed from a company where I was involved in high-end software manufacturing, sales, and services (basically an ISV). I contributed in many ways, including engineering, product management, and sales (account executive). My customers included banks, telcos, and other large organizations. I'm preparing to form a company (C-Corp, S-Corp, or LLC), which will be used for providing professional services consulting to some of my customers (initially), but also for technology sales (hardware and software) eventually (at least that's my plan). I have other ideas for income as well, but I'm not sure how many different types of income producing activities I can operate under a single business entity (perhaps each with a different DBA, all tied to the same company). That's another question, if you want to tackle it.

Back to my original line of thought - There's no question that I'll form a company, since operating as a W-2 or 1099 isn't appropriate (or desired) for my purposes. I'll be dealing with multiple clients (hopefully), and I want each client to be able to deal with me as a business entity (for contractual and payment purposes), rather than dealing with me as an individual.

I do care about how the business structure I choose effects my ability to deduct health premiums and other benefit costs, since we'll be making some decisions about that over the next couple of weeks. I'm married with 2 children. My wife is a W-2 employee with health benefits, including an FSA which we've used over the years to cover out-of-pocket medical expenses (co-pays, etc). I had the option of an FSA at my employer, but never used it since we used my wife's. My kids have been covered with me under my previous employer's health plan (which is still in effect through Feb 29). So we're trying to decide whether to have my wife cover all of us as part of her PPO (which would take her monthly premium from $1 to $500+ month), or if I should get a high-deductible PPO ($2500/person) for the kids and I (about $300/month), and then I could write off the premium via the entity I select for my business. I still need to understand how an HRA works, as well as an HSA. If we end up putting all of us on my wife's plan (there's a decent chance of that), then this becomes less of an issue (at least in the beginning).

I'm still evaluating all the entities, C-Corp, S-Corp, and LLC. By the way, I've also read your post, "Consultants: What about LLCs", at http://www.biztaxtalk.com/node/12, but I don't think it answers my LLC related questions that follow.

If I remember correctly, a C-Corp can accumulate earnings without tax consequences to shareholders, correct?

Can an S-Corp also accumulate earnings without tax consequences? Meaning, can the earnings be retained without having to distribute to the S-Corp shareholders?

What about an LLC? Whether single member or multi-member, what are the options for how income is handled (wages vs. distribution), and any tax implications:

        Forced distribution? Must an LLC distribute any net income to members, or can a portion accumulate without negative tax consequences?

        SE tax and other taxes

                Are all members subject to SE tax on their share of net income, regardless of member type - individual, corp., trust, another LLC, etc? I'm assuming only an individual (i.e. "natural") member must pay SE tax on their share of distributed net income. What about a C-Corp member? What tax must a C-Corp member pay on its share of the LLC net income? What about an S-Corp member? A trust?

        Are LLC members taxed on their share of net income regardless of whether it's actually distributed to them?

        What if I choose to be an LLC taxed as an S-Corp?

                It seems like I can have the benefits of an S-Corp (e.g. net income split between wages and non-SE taxed dividends), without the corporation formalities - although the formalities don't seem like they'd be that bad for a closely held corp.

                I'm under the impression that S-Corps get special scrutiny these days by the IRS? Haven't they become a bit of a lightning rod since the compliance audits from a couple of years ago?

                If I do form an LLC taxed as an S-Corp, are their any substantial benefits over simply forming a straight S-Corp? Does the LLC still have the ability to have any sort of member (individual, corp, other LLC, trust, etc)? I'm guessing that an LLC can only elect S-Corp taxation if all members of the LLC meet the regular (staight) S-Corp shareholder requirements (less than 100 members, individuals, certain types of trusts, etc) - is that correct?

                If I form an LLC taxed as an S-Corp (meaning all members meet traditional S-Corp shareholder requirements), can I distribute dividends to the members any way I choose, per the LLC operating agreement? That may be one interesting advantage to having an LLC taxed as an S-Corp. I'm assuming a straight S-Corp must distribute according to each shareholder's percentage of stock ownership.

        What else jumps out? I'm probably missing something else.

Also, I think you've stated that a C-Corp gets to avoid SE tax, but I don't see how that's true if the corp. has to pay 1/2 of the employee's SS and Medicare, and then the employee (i.e. me) has to pay the other half via withholdings. I think I'm missing something there.

I'm guessing that for either C-Corp and S-Corp, I decide how much salary to pay the Consultant (i.e. Me), and whatever that is, it gets taxed SS and Medicare (the corp. pays 1/2 that tax, and I pay half that tax via withholdings), along with Fed and State tax, and then whatever isn't part of wages is either distributed to me personally (for S-Corp), or accumulated (for C-Corp). But I though you wrote than an S-Corp can also accumulate earnings, without mandatory distribution - is that right? I think I asked that one already - sorry, my head is spinning.

Speaking of salary, I need to get clarity on that, particularly with respect to what will happen in the early stages of the company. Keep in mind that in the beginning, I won't be able to draw any sort of regular salary (as CEO, CFO, Secretary, and Consultant), since I won't receive any payments for a while (terms are typically Net 30 to Net 60 for these large clients). Assuming I capitalize the business from savings (say, $10K - $20K to start), I can't afford to start paying myself a salary from that capital with no income coming into the company, otherwise it'll be gone in a flash, and then my business will have no capital for ongoing expenses, such as equipment, office supplies, business insurance, rent (e.g. a fractional or "virtual" office space location), health insurance premiums, legal fees, accounting fees, and so on. I'm trying to understand how I can capitalize the business, use that capital for initial capital expenditures, and keep enough money in the company until I have some reasonably steady (or semi-steady) income - without getting the IRS upset at me.

You've stating many times that a person organized as a C-Corp performing consulting is considered a PSC, and therefore subject to a flat 35% tax on all net income. I've read some posts that say to qualify as a PSC, at least 95% of the stock of the C-Corp must be owned by employee-owners performing the services, as you outlined in your C-Corp vs. S-Corp posting at http://www.biztaxtalk.com/node/11. However, IRS pub 542 (http://www.irs.gov/publications/p542) defines a PSC as follows:

Personal service corporations. A corporation is a personal service corporation if it meets all of the following requirements.

1. Its principal activity during the testing period is performing personal services (defined later). Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:

1. The last day of its tax year, or
2. The last day of the calendar year in which its tax year begins.

2. Its employee-owners substantially perform the services in (1). This requirement is met if more than 20% of the corporation's compensation cost for its activities of performing personal services during the testing period is for personal services performed by employee-owners.

3. Its employee-owners own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.

Personal services. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

Employee-owners. A person is an employee-owner of a personal service corporation if both of the following apply.

1. He or she is an employee of the corporation or performs personal services for, or on behalf of, the corporation (even if he or she is an independent contractor for other purposes) on any day of the testing period.

2. He or she owns any stock in the corporation at any time during the testing period.

The above info in pub 542 semms to indicate only slightly more than 10% of the corporation's stock need be owned by employee-owners to qualify for PSC status, instead of 95%. I'm guessing that the regulations changed since you wrote the "C-Corp vs. S-Corp" article in 2006. Or is IRS pub 542 leaving something important out?

One of the things I'm considering is whether it makes sense to have my wife (and potentially other family and maybe some friends) be shareholders (if I choose a C-Corp or S-corp) or members (if I choose an LLC), in order to avoid single-member anything. I get the impression from reading many web posts and books that having more than one corporate shareholder (or LLC member) affords much better liability protection, particularly for charging orders (e.g. against an LLC member). I certainly don't plan on doing anything fraudulent or unethical, but our society is incredibly litigious, so I'm trying to make sure I prepare properly - which means I'll need to look into some liability insurance, both for the business entity, as well as individually. I'm under the impression it's also possible to create a trust and have it be a member of the LLC (or a corporate shareholder), to establish multi-member status. Do you have any experience with that? Do you know what type of trust (e.g. Grantor vs. Irrevocable) would be allowed to establish multi-member status? I don't want to implement something, only to have it disallowed by the IRS or the state when it comes under scrutiny. I simply want to do whatever is legal and ethical, without rocking the boat too much (a little is ok).

If I'm able to establish either a multi-shareholder corp or multi-member LLC, how does that affect taxation? I'm under the impression that a multi-member LLC has more flexibility in how net income is distributed (and therefore taxed). If I remember correctly, an LLC can distribute net income to members any way it chooses (per the operating agreement), and not necessarily with respect to the ownership percentage of the respective members of the LLC. Is that correct? That seems to be one vary different aspect of LLCs verses any other business entity - the flexibility of the distribution model, as well as the flexibility in terms of the membership (other LLCs, Corps, individuals, etc).

If I have a multi-shareholder corp, I'm assuming any distribution of net income or accumulated earnings must be distributed exactly according to the stock ownership percentage of each member, assuming it's a single class of stock. I suppose if I have different classes of stock, preferred stock would receive a higher distribution than common stock - is that correct? But I think only a C-Corp can have multiple classes of stock, is that correct?

What if I have a Net Operating Loss? I believe a C-Corp can only write-down ordinary losses against ordinary income, and capital losses against capital gains. What about an S-Corp, or an LLC? If I end up losing big time on my business venture, what's the best way for me to account for the losses? Likewise, if the business venture doesn't look like it's going to pan out and I liquidate, I'll need to go back to being a W-2 employee and will want to take the losses in the most favorable way allowed on our personal tax return. I don't like thinking about that, but I have to plan for that as a possibility. I suppose if I use a C-Corp or S-Corp I could go with sec 1244 stock, so that I can offset any of our W-2 income with the stock (captial) loss counting as an ordinary loss against our W-2 income. If I go that route, do I need to do anything special when forming a corporation, in terms of documenting the stock as sec 1244?

I've been running on and on Linda. I hope I haven't overwhelmed you with all of my questions. I have a lot to consider, and I'm trying to make sure I clearly understand the pros and cons of each business entity, and the net effects of each.

Thanks in advance for any time you're able to give my rather large post.

Best regards,

Mike

Decisions... Decisions....

Hi Mike,

Wow, that's quite a post. Let me see if I can tackle most of this.

Tax Consequences to Shareholders


Yes, a C Corp accumulates retained earnings without tax consequences to shareholder. No, the current year's taxable income always flows to the shareholder's personal income tax return regardless of whether the income is distributed to shareholders.

For an single or multi-member LLC with default tax treatment, the income is taxed as the personal level as well, so again LLC members will report the taxable income of the LLC on their personal income tax return (regardless of distribution). In addition, that income will be subject to the 15.3% Self Employment tax. If the members are corporations, then it's reported on the corporation's return. No, they won't pay SE tax (but when that C corporation distributes the earnings as dividends, those will be subject to the 15% dividend tax rate).

LLC Taxed as S-Corp

Yes, if you form a LLC and opt to have it taxed as an S Corp, it must meet the S Corp shareholder requirements. The LLC is easier to form and less formal. Yes, you can change the ownership distribution more easily with an LLC. I'm not sure how that will be viewed by the IRS. My thinking is that it may raise eyebrows but could easily be explained if it comes up.

I'm not sure S-Corps are a lightning rod. I think it's more S-Corps that give distributions in lieu of salaries in an attempt to avoid payroll taxes that are more scrutinized.

Personal Service Corporation

Publication 542, Corporations is from February 2006. The 2007 Form 1120 Instructions state that corporations in which substantially all of the corporation's activities involve the performance of services and 95% of the corporation's stock are held directly, or indirectly, by employee-owners are Personal Service Corporations. Regarding the exact percentage the code only states "substantially". There have been some private letter ruling that indicate if a non-employee owned >5% of the company that could be enough to eliminate the PSC standing. This is where the 95% comes from in the instructions. However, that non-employee could not be your wife, child, or other close family member. That would be indirect control & you'd be back where you started from.

If you give a shares to unrelated friends who do not work for your company you could eliminate the 35% PSC flat tax.

You certainly would not want to do this if you form an S-corp. First because once you make the S election the whole PSC issue goes away (by definition an S-Corp is never a PSC). Second because you will be sloughing off your taxable income or loss onto your friends. They probably wont be for very long if they're paying your income taxes for you. :) You might be tempted to say that you would pay out all your income in wages, but then there's not much advantage to being taxed as a corporation at that point.

Regarding the legal advantages & disadvantage of a greater or lesser number of shareholder, that is more a legal question and outside my bailiwick. :)

Liquidation

I think Sect 1244 will only help you to the extent you purchase stock. Usually what happens is people purchase the stock for as little as possible and then loan or invest additional cash as required. The additional contributions are not eligible for 1244 treatment.

As far as what you need to do to issue 1244 stock. In looking at Code Section 1.1244(e)-1 it looks like you need to so state in your corporate records that the stock are eligible for 1244 treatment.

I think that covers most of the big issues. Let me know if there is anything else.

L:)

Re: Decisions...Decisions...

Hi Linda,

I thought I had responded several weeks ago, but apparently not. Maybe I never pressed the 'Post Comment' button. I've also been side-tracked applying for individual health insurance as a result of my recent unemployment. Applying for individual health insurance is a nightmare!

First, thanks for your response. That's very useful info.

One of the areas you didn't touch on was salary. In the beginning, I won't be able to afford to pay myself a salary. It'll probably take several months before I can take a draw, so I'll be living off of savings for a while. When I do have some income, the amount I pay myself will always be dependent on the income for the company. My point being I can't see paying myself any sort of consistent "salary" - I suspect it will be different for each pay period, with some periods of no salary (particularly in the beginning).

Are there any problems with the "salary" varying like that?

Does your answer change if the company is an LLC instead of an S-Corp?

Also, I understand that if I have myself and my wife set up as employees (either via an S-Corp or LLC), then I can apply for group health insurance, correct? What if my wife is working for another company as well? How does that affect all of this?

One final question - for asset protection purposes, I'm thinking of setting up a multi entity scenario, where my wife and I are members of a Delaware LLC, and then the Delaware LLC is the sole stockholder of a California C-Corp. I would be the sole director and hold multiple offices in the C-Corp, and I would perform the consulting services under the C-Corp, but I would not be an "owner" of the C-Corp (and hence not an employee-owner), since the sole owner of shares of the C-Corp is the LLC. What are the tax implications of that scenario? I'm assuming I don't need to worry about a PSC, due to the LLC being the sole owner, correct? What other tax implications are there, if any? How do answes to my questions about salary (at the beginning of this post) change if I use this multi-entity structure?

Thanks again Linda!

Mike

how to pay 1 employee

I have a small company and I have 1 employee that works about 40 hours a week. she does have some things I expect her to do, but she has no set time to come in, or to leave, or to take her breaks, or in what order to do what thing. except to answer the phone when it rings.
Can she be considered a 1099 wage earner instead of a w-2 wage earner?

Keep It Simple

On the salary front, obviously if you have insufficient or inconsistent cash you can't pay yourself on a regular basis. Remember the test is "reasonable". If you opt not to take a salary in the beginning or when cash it tight that's pretty reasonable.

On the S-Corp/LLC question. An single-member LLC will be taxed as a sole-proprietor & a multi-member LLC a partnership unless you make election to be taxed otherwise. That does change the scenario somewhat. For example, a sole-proprietor can not take advantage of an HRA.

In CA, insurance companies CAN NOT sell a group policy when there is only family in the policy. Regulatory requirements state they sell you an individual policy. Most people will take their individual COBRA policy and use the HRA to have the company pay the premiums & out of pocket expenses.

I don't see how the asset protection scheme is going to help you? First off you'll have CA & DE LLC returns and fees to pay each year and the CA corp minimum tax. The DE LLC doing business in CA must register with the Sectary of State and pay the $800 minimum LLC fee. It seems to me you could get some pretty good insurance for less than the $800 in extra taxes.

You can assume you'll get out the PSC as the ownership rules apply to direct and indirect ownership.

Plus even if you could get away with this plan. When you want to take money out of the C-Corp beyond salary,you would be paying the dividend tax.

Keep it simple. It's complicated enough for most small businesses to keep the record keeping and taxes straight for one entity. Why add the additional layer of confusion & indirection. The IRS is on to that and the rules just don't allow you to take advantage of it.

L:)

Corp to Corp as Non-Profit and Tax-Exempt Non-Profit

If you consider incorporation, don't forget there are some benefits to going as a non-profit corporation (NPC), and even more benefits for going as a tax-exempt non-profit. I always have to remind people that non-profit does not mean non-revenue. I'd like to see the NPC (Taxed and Tax-exempt) in your tax comparison table above.

Roy

Tax Exempt Status

Hi Roy,

I didn't include 501(c)(3) treatment because most people considering the W2-1099-CorpToCorp questions don't qualify for tax-exempt status.

In order to be a Tax-Exempt organization it must meet the following criteria:

  • Serve some type of common good
  • Not be a for-profit entity
  • Not have net earnings that benefit the members of the organization
  • Not exert political influence

Most people are trying to make a profit, otherwise they'd be volunteering. :)

Plus 501(c)(3) organizations must pay taxes on their Unrelated Business Income, which is pretty similar to corporate tax rates.

Also, there is a $300 filing fee for gaining tax-exempt status by the IRS and tax returns are available to the public.

I would not be comfortable advising businesses to apply for tax-exempt status.

L:)

Tax Exempt Status

Linda,

I am wondering about the following you wrote earlier:

"Most people are trying to make a profit, otherwise they'd be volunteering. :)"

You forgot about employee salaries. Not everyone is volunteering. :-) The last I read the President of United Way makes a hefty six figure salary. Where can I "volunteer" for this job?

In the end, the theoretical net result is supposed to be Revenue-Expenses=0. So, if you make enough money and pay your executives very, very well, you can get to zero. This seems like a nice way for some to write off legitimate business expenses while paying yourself and your employees on a W2. It may not work for everyone, but it seems like an option for some.

Take Care,

Rich

Profit Motive

Hi Rich,

If you're just going to take enough salary to bring the net income to $0, then your tax liability is $0 and you could be taxed as a regular corporation. I don't see the advantage.

In order to be granted tax-exempt status your entity must have societal benefit. While certainly some workers will receive salaries, the raison de etre for the organization is to help others, not make a profit.

I would be uncomfortable suggesting to others that they could hide behind the tax-exempt status in order to avoid/evade income taxes. (Plus I'd be subject to stiff penalties & censure.)

L:)

Profit Motive

Linda,

I was writing many people can assert his or her business has societal benefit. It could be an open source project, ministry, medical software or a variety of other "businesses." I was just pointing out while the "entity" may not make a profit, the officers can be paid very, very, very well.

Take Care,

Rich

Multiple contracts

Hi thanks for the wonderful writing.
If a sole-consultant-in-an-S-Corp gets a contract through S-Corp in first half of year with one company, and in the 2nd half of year with another company, and if these two client companies are in different states, then I guess the S-Corp has to pay taxes to both states? Does the S-Corp need to incorporate/register in both the states and file corporation yearly fees in both the states?

Does the state of the client depend on where their headquarters is or where the work is done by the contractor? What if the contractor telecommutes from a different state?

MultiState Income

Usually it's based on where the work is done. Say I'm in California doing work for someone Maryland. All the work is done in California and I have no nexus or business presence in Maryland. In this case I just have a California Corporation and report all income to California.

The telecommuter point is a definitely a gray area. You might find my Taxes for Telecommuter helpful.
The article referenced goes into more detail. In fact it matters which states you're telecommuting to. In New York, the telecommuting must be "necessary" for you to slip the NY tax net. In some other states, it need be for the employer's convenience.

I hope this helps a little.
L:)

Being Paid By Corp-To-Corp

Hi Linda, very great article. I was recently hired to do sales at a web firm and I am interested in taking payment through a small Nevada C Corporation versus W2.

I like the flexibility of a C Corporation the best and want to use it to acquire my assets. I have a very low living expense and was wondering what I would have to do to make this legitimate.

I trade Equities and Forex online at night time and run a small bulk candy operation which earns near 1200-1500 a month. Right now I am doing this all as an Individual and want to do this through Corporation to take advantage of the Tax Code and Limited Liability a Corporation offers...

What step would I have to do making this legitimate. The operations of the business will be selling web advertising products, currency trading, and bulk candy/gum ball machines.

If I filed the Nevada Articles of Incorporation, setup the Registered Agent in Nevada, then filed Foreign Corporation papers with my home state of Florida and turned all the the booking over to a book keeper or an accountant would I be on the right path. I can mentally envision how it would work and the process I would have to do.

Also, what expenses could I write off as being an employee of the corporation?

Could I write off Health Membership, Gas, Accounting Fees, Home Office, and Cell Phone? I am also going to school for Book Keeping.

From my current understanding, any expense that contributes towards building the business is a deduction. My ultimate goal is to have 85-90% of the income invested in the business till I can build $50,000 a year in Residual Income. So say I bought an additional candy dispenser to grow the business. Would that be considered a deductible expense? I do apologize for the lengthy message, I am 19 and this is some what confusing stuff to me.

Thank you, and this article has really helped me out!

Hi Bryan Frankly I've never

Hi Bryan

Frankly I've never understood the whole Nevada Corp thing. You still need to register with Florida and pay any Florida corporate taxes, so why not just setup a Florida corporation?

The expenses you list are more likely to be deductible by the corporation rather than you personally. As you envision the process, keep in mind that you & the corporation are two separate entities. The more you can do this the less you will have trouble with the two becoming intertwined.

Health Club dues & memberships are not deductible at all. The home office will also not be an option once you incorporate. However, you can have the corporation reimburse you for the cost of using part of your home (excluding depreciation, mortgage interest & property tax; the last two are deductible on your Schedule A). Gas & other auto expenses are only deductible to the extent the can be attributed to business use. Check out IRS Publication 463, Travel, Entertainment, Gift & Car Expenses for more information on car expenses. It's rarely as deductible as people think. :)

It sounds like the candy dispenser could be fixed asset. It would be deductible in the year purchased if it meets the Section 179 qualifying equipment requirements. Used equipment never qualifies for Section 179.

The bookkeeping classes could be deductible but you should check out IRS Publication 970, Tax Benefits for Education. There could be other options for paying for your education.

I think the bookkeeping classes will be really helpful to you. Many small business owners just don't understand what all those numbers can tell them about their business.:)

Kudos for you entrepreneurial spirit & good luck!!

L:)

Legal Offshore Corp-to-Corp

What, if any, are legitimate ways to beat the w-2, 1099 US(?)-corp-to-US(?)-corp options discussed here, tax reduction wise, by, for example, forming an offshore company in a district with no/low applicable taxation, paying a US citizen, the owner of the offshore company, a salary or contract, buying his house, car, etc. Can you please discuss of direct me to comprehensive but to-the-point material (from my perspective) on such options?

Thanks a million! :)

Dream On

Hi Gary,

If you are a US citizen, you must report all your income, world-wide, and pay US income taxes on your taxable income, even if some it goes through the Cayman Islands. Unless your income is coming from Mars you're out of luck. :) (And I'd bet that even income from Mars would be subject to tax, too!)

You might be interested in these stories of people convicted for abusive tax schemes that led to serious jail time and fines in the hundreds of thousands of dollars.

L:)

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