Pay Less Tax When You’re Incorporated

For IT contractors currently working as sole-proprietors, meaning the client pays you directly without withholding payroll tax, and they cut you a 1099 at the end of the year, the self-employment (SE) taxes can be staggering. What can you do to pay less in SE tax? Read on…

One of the most important decisions you will ever make as an IT contractor is what business structure to use. Most contractors start out working under their own name or a fictitious business name under a sole-proprietorship. You really don’t need to do anything special to have this designation. If someone pays you for a service without withholding taxes and/or issues a 1099 in your name, you are a sole-proprietor. In your 1040 Tax Filing, you’ll file a Schedule C for this business.

If you’re the type that shrieks at having to handle the administrative functions of your business, wait until you find out what you’re missing. Most incorporated contractors avoid paying the most of the self-employment tax you’ll pay every April.

While you won’t be able to completely avoid self-employment tax, at least not after the first year of operation, you will pay much less than someone earning the same amount but operating as a sole-proprietor. Self-employment tax (SE tax) is a social security and Medicare tax for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from paychecks of regular employees. SE tax is computed using Schedule SE of tax Form 1040.

The self-employment tax rate of 15.3% is made up of 12.4% for social security (old-age, survivors, and disability insurance, or OASD) and 2.9% for Medicare (hospital insurance). The first $102,000 of your combined wages, tips, and net earnings are subject to the 12.4% social security part of SE tax. For any amount earned over $102,000, you do not pay this 12.4% part of the SE tax. All of your wages, tips, and net earnings are subject to the 2.9% Medicare part of SE tax. This portion of the self-employment tax is unlimited in that it applies to the total amount you earn.

As an example (highly simplified for our discussion), suppose that in 2008 your net profit as reported on Schedule C is 98,000. Your self-employment tax on that amount would be $13,847.

Compare that with someone who is incorporated and pays him/her self a salary of $35,000. Paying yourself a salary out of your corporation is key here. The remaining $63,000 would be treated as other income or investment income and is not subject to social security and Medicare tax, the two taxes comprising our SE tax. By the time their corporation pays for half of the SS (known as FICA for businesses) and Medicare tax and they pay the rest, the amount of social security and Medicare taxes paid would be $5,355. Your net savings would be a whopping $8,492.

So, now that your eyes are almost bulging out of their sockets, the next question you have to address is what business structure or entity to use? Without going into the differences between corporations and LLC’s, the best option is to form a corporation and file for Subchapter S status which allows all profits and losses to flow through to you. Otherwise, you’ll be subject to double taxation, or paying taxes at the corporate and personal level.

To get your corporation set up, go to MyCorporation.com. They are an Intuit company, the same people that make TurboTax. For business and incorporation services, they are the best, fastest, and cheapest in the business. Click here http://www.mycorporation.com/?kbid=4347 to get your corporation set up. Please remember to use our links because we do receive an affiliate fee, and this helps pay our bills.

What Do I Look Like, an IT Consultant?

It’s interesting to see the prevalent lack of understanding for the difference between the role of a contractor and  consultant. We will now dispel any confusion with a simple distinction. The only real difference is that a contractor “does” things such as directing, carrying out, or implementing a solution, while a consultant provides advice. There is no other significant differentiating factor between the two – not financially, nor hierarchically.

So, if you were brought in to advise an IT Director on the architectural design for a rebuild or renewal of their web applications, you are a consultant. Conversely, if you were hired on to develop or implement a web application, you are a contractor. Finally, your work may involve a mix of the two where you are both providing advice and carrying out the work. No, you won’t be called a consultractor or contrasultant. But, in this case, it doesn’t matter whether you are a consultant or contractor. Just make sure you have the clients’ best interests in mind so there is no conflict of interest.

Recruiter: An IT Contractor’s Mortal Enemy

Any job search conducted on one of the large job sites these days is sure to turn up job postings made by employment agencies. For many common IT job searches, the jobs posted by agencies far outnumber the jobs posted by the clients themselves. Employment agencies can provide value in this chain by saving clients the cost of sourcing and screening contractors. But, are those savings to the client worth a 30% fee, on every hour worked by the contractor, paid to the agency?

The popular belief is that the client, and not the IT contractor, is paying for the agency’s fees (usually ranging from 15% to 50%). However, this is not really accurate. In many cases, the contractor bears half of the burden to pay the agency it’s placement fees. A contractor can also be denied work, for a rate that would otherwise be affordable for a client, but turns out to be too expensive after the agency adds on it’s fee.

Let’s consider an example of a common placement to see the problem. Raking Half International, our fictitious agency, contracts with a technology firm to locate a software developer. The client has no concrete hourly figure but is shopping around for the right mix between cost and contractor capability. Raking Half then proceeds to search its database as well as online resume databases for suitable contractors, pre-screens them, and then submits a short list of suitable resumes to the hiring manager at the client.

One of the contractors, John, is being considered by the client, but the client is not willing to pay more than $65 per hour for John. At the same time, John wants $65 per hour for this job. Raking Half may then lobby the client to pay $75/hr and persuade John to accept $55/hr. If Raking Half’s efforts work, the client and John both lose a combined total of $20/hr. We must now ask, are the few hours that Raking Half put into this transaction worth between $20,000 and $40,000 (if John works between 6 and 12 months)?

In a second example, assume that the client is looking for a bill rate not to exceed $80 per hour. Raking Half then proceeds to do its sourcing magic and provides the client with three contractors. One of the more qualified, Frank, is willing to work for $75 per hour. If the client is not willing to budge, and Frank won’t accept less than his rate, the agency can’t make the fee they’re looking for and Frank is still out of a job. In many cases, the client is then sold a less qualified contractor that earns an hourly rate low enough for Raking Half to earn their fee. This artificial buffer that the employment agency creates prevents both clients and job seekers from extracting maximum benefit in the job market.

Though there are agencies out there that do add value to the equation, most tend to be of the “used car salesman” variety doing little more than searching the Monster resume database, short listing contractors based on resume key words, availability, and rate, making sure the contractors are breathing, and then ushering them to the hiring manager for interviewing. Keep in mind that most of the cost and effort in hiring a contractor goes into phone and in-person interviews that are conducted by the client hiring manager. The least, or more clerical, effort and cost goes into sourcing and pre-screening contractors. For most agencies, whatever little real value they add to this equation is not worth more than a few hundred dollars. They certainly should not be earning thousands of dollars over the course of a project.

The moral of this story is to find your own clients without the aid of an employment agency. If you must work though an employment agency, you should ask for their bill rate (the amount they are going to charge the client for your work). You are entitled to this information and if the agency doesn’t want to disclose it, they’re probably charging an excessive fee compared to what you’re being paid. Find another agency. Most importantly, learn to negotiate a reasonable rate for your work and don’t budge. Let the agency or the client figure out how to afford your rate.