Figuring Equivalent Billing Rates: W-2 vs. Corp-to-Corp
I often see questions posted asking what is the equivalent corp-to-corp rate for a given hourly rate paid to an employee. I think a better question is what rate will the market bear. But be that as it may, there are several issues you need to consider if you're trying to come up with an equivalent for a starting point.
The most important point is usually what benefits do you have as an employee that you will have to make for when you switch to a corporation.
If you are transitioning from an employee of a large corporation to owning your own business you might be surprised by the employee benefits you probably take for granted. For example as an employee you probably get around 10 days off per year for holidays. You also probably get two weeks PTO for sick days and vacation. Both of those are out when you go to work for yourself. You'll only get paid for the hours you can actually bill your clients. On the other hand, you will get paid for each hour you actually work, where as if you're getting a salary you just get a lump sum no matter how much overtime you work.
You probably aren't currently getting a pension, but your company may have a 401(k) plan with employer matching. If you strike out on your own you'll be the only one making contributions.
It's also surprising the various insurance plans that cover employees. You probably get pretty good health & dental insurances policies. Maybe a life insurance policy, maybe up to $50,000 benefit and if you're really lucky your company offers long-term disability and/or long-term care policies.
Your company may also reimburse your costs for professional organizations, subscriptions, books and education.
It's amazing how quickly these benefits can add up. And you get them all tax-free.
There are other expenses you may not have as an employee. You may need to purchase computer equipment and software that you never needed before. You'll need to fork over the cash for those things too. And to further complicate things, it's only deductible to the extent it's used in your business. So if you use that new computer to play games, it's deductibility is limited.
And then there's all the time you're going to spend keeping track of your time, billing, payroll, accounting, tax preparation, etc. That's time you're not going to be spending with your kids, or mountain biking, or whatever. Even if you hire someone to do the heavy lifting, you're still going to be involved and making the decisions which takes time.
There are also a lot of deductions people like to throw out as deductible expenses that really aren't. My personal favorite is deducting your business clothes as "uniforms." Forget that one. You can only deduct uniforms that can't be worn outside work. The IRS is pretty sticky on this one. If you're a waiter and you have to wear black pants & a white shirt, it's not deductible as a uniform because those clothes can be worn outside work. Even a shirt with a logo embroidered on it is not deductible. Oh, and no deducting the dry cleaning either, unless it's while you're traveling away from home.
Another one is the home office deduction. First off, you must use your office regularly and exclusively for your business. Most people can't get past this one requirement. Also, the home office is a red flag for IRS audits and it totally complicates things when you sell your house.
Oh, and health club dues, that's a good one too. It used to be that employers offered this benefit and some still do, but it is no longer tax deductible.
It's almost impossible to come up with an exact equivalent rate for W-2 and Corp-to-Corp. But let's look that the following example:
Let's say you are single, live in California and make a salary of $120,000. In addition, you have a 401(k) plan that contribute the maximum $15,000 to and get 3% employer matching. You get health and dental plan with a $100 per month premium that's paid with pre-tax dollars. And your employer has a section 125 plan that you contribute $1000 to annually. You also get reimbursed expenses for your professional organization dues and select publications plus you usually take a class every year to keep your professional skills sharp. These expense are typically $1500 per year. And you get the usual 10 days PTO for vacation & sick days, plus the 10 federal holidays. You work in a fairly busy office so your typical work week is 45 hours. Let's use 2006 tax rates and other limits.
So given these assumptions, plus a few more about estimated costs of insurance premiums, etc., your $120,000 salary costs an employer about $136,000. Given that you actually work 2610 hours (45 hours * 48 weeks) per year, that's an hourly rate of $47 to you but $52.10 from the employer's perspective. Although most employers tend to calculate it on a standard work year of 2080 hours which would give the employer a rate of $65.38.
Now, if you charge only $47 per hour you're never going to make any money. In fact you'll be losing money especially if you need a take home salary similar to what you made as an employee. If you can drop your salary to $96,000 your company will still lose about $6,000 because of the additional expenses you have as a corporation, like the computer, taxes, and other expenses. I'm also assuming you're not making the maximum Individual 401(k) contribution just the same 3% matching you would have received as an employee.
In order to maintain your current salary of $120,000 and max out the 401(k) contributions you'd need to charge closer to $78.50/hour to have a marginally profitable S-Corp. Your take home pay the same as it would be as an employee but you could fund $44,000 to your 401(k) each year. This does allow you to put much more away for your retirement than you could as an employee.
Also, this assumes you're working pretty much all year with only about 2 weeks either on vacation or between contracts. If there's a slump in the economy, you could go months without any income.
So you can see, there's really no easy way to figure out what is an equivalent W-2 billing rate when you shift to a corporation mostly because you're trying to compare apples to oranges. I'm not sure how helpful it is even try to determine this but its a question I see alot. You're better off trying to figure out what you need to charge to make your business profitable. If you can't charge that you might be better off remaining a W-2 employee.