What are the differences between being an Independent Contractor with income reported on a 1099 versus an employee with income reported on a W-2? Read on to find out.
What, if any, are the benefits and drawbacks of being an independent contractor?
Independent contractors will have to pay more in Federal Insurance Contributions Act (FICA) taxes but can deduct business expenses without the 2% of Adjusted Gross Income (AGI) limitation imposed on W-2 employees. Additionally, they will have to purchase their own health and disability insurances as they cannot participate in the employer’s group benefits. Finally, employees are limited by the IRS and business when contributing to pre-tax savings vehicles such as a 401(k), whereas independent contractors have fewer limitations allowing for better fund investment options and potentially larger pre-tax contributions thus pulling back their taxable incomes back.
The determination of whether a worker is an employee or independent contractor is elucidated by applying a multi-factor approach to determine if the employee is economically dependent on the business, including the control the worker has, permanency of employment and the specialization of work the individual brings to the business. This brief assumes this determination has been made and focuses instead on the differences, drawbacks, and benefits of being an independent contractor.
There are three major categories of differences between independent contractors and employees outlined below. The categories are: taxes, insurance, and retirement plans.
There are two key differences between independent contractors and employees in the area of taxes. The first difference is what independent contractors are required to pay in Social Security and Medicare tax under FICA. The second regards the ability to deduct business expenses as an independent contractor. The first is a drawback to the independent contractor and the second is a benefit.
The first difference between employees and independent contractors is how much they pay in FICA taxes. When you are an employee, your employer is required to withhold your portion of Social Security and Medicare tax (FICA taxes). Under FICA, 12.4% (2017 rate) of earned income up to an annual limit ($127,200 for 2017) must be paid into Social Security, and an additional 2.9% (on all earnings) must be paid into Medicare. As an employee, you are only responsible for one-half of these Social Security and Medicare taxes. Your employer pays the other one-half of these taxes.
As an independent contractor, the contracting business may be required to give you Form 1099-MISC to report what it has paid to you. Independent contractors are responsible for paying their own income tax and may be required to make estimated tax payments throughout the year. Also, in contrast to employees, independent contractors must pay for both the employer’s portion and the employee’s portion of the Social Security and Medicare taxes. In other words, the employee pays 7.65% in FICA taxes (using 2017 rates) on his first $127,200 of earned income and then 1.45% on income above that. In contrast, the independent contractor must pay 15.3% in FICA taxes on his first $127,200 of earned income and then 2.9% on all income above that.
For example, consider $200,000 of earned income for 2017. An employee would pay $15,300 in FICA taxes on the first $127,200 (7.65% of $127,200) and then $1,055.60 (1.45% of 72,800) on the remaining $72,800 ($200,000 – $127,200). This is a total of $16,355.60 in FICA taxes as an employee. An independent contractor, on the other hand, would pay $19,431.00 (15.3% of $127,200) in FICA taxes on the first $127,200 and then $2,111.20 (2.9% of 72,800) on the remaining $72,800. This is a total of $21,542.20 in FICA taxes for the independent contractor. This is $5,186.6 more than the employee will pay.
There is a strategy that many accountants and attorneys employ to mitigate this FICA tax. Instead of the 1099 income coming directly to the independent contractor, the income goes to a business entity (Limited Liability Company (LLC), Professional Corporation (PC), etc…) that is owned by the independent contractor. Then the independent contractor will take a W-2 salary from their own business entity. The IRS requires this salary be “reasonable.” The contractor will only pay the FICA taxes on the salary that comes from the business entity. Any money left in the company after the salary can be distributed to the contractor as a K-1 distribution and does not result in any FICA tax. Please contact your tax advisor for more information on this strategy.
As an aside, the Affordable Care Act contains a provision that institutes an additional 0.9% Medicare tax on higher income earners over certain thresholds beginning in 2013. The threshold is $200,000 ($250,000 for married taxpayers who file jointly). This 0.9% tax is the same whether you are an independent contractor or an employee.
The second difference between employees and independent contractors is in their ability to deduct business expenses on their taxes. Employees may deduct unreimbursed business expenses on Schedule A of their income tax returns, but only if they itemize deductions and only if their unreimbursed business expenses exceed two percent of the their AGI. In contrast, independent contractors may deduct all qualifying business expenses on Schedule C of their tax returns and receive a dollar for dollar deduction for these expenses from the very first dollar.
Consider the example of $200,000 earned income. An employee would have to spend $4,001 in business expenses to get a $1 deduction. In contrast, every dollar that the independent contractor spends in qualifying business expenses is deductible.
Employees are often protected from liability for acts done within the scope of employment by an insurance policy held by the employer or are otherwise indemnified by the employer. An independent contractor must purchase his own liability insurance. Given the size of the business, employers often offer their employees discounted life, health, and disability insurance as a part of a group plan of benefits offered by the employer. An independent contractor will be required to purchase his own life, health, and disability insurance, which may be more expensive since the independent contractor is not part of a larger group.
Employers are required to pay unemployment (FUTA) taxes on their employees’ wages and maintain worker’s compensation coverage for their employees. Independent contractors are not provided these benefits and will not be entitled to unemployment compensation during periods of unemployment or compensation for disabilities incurred while performing their contracted duties.
Employers often offer employees a retirement benefits package that includes a fully or partially funded retirement plan or 401(k) plan. Often, employers will match employee contributions up to a certain level of elective deferrals. Access to the plan offered by the employer may limit an employee’s ability to utilize other potential retirement savings and investment plans. Independent contractors must set up and fully fund their own retirement accounts.
The benefit for employees is that they can potentially get an employer match, but employees are limited to thresholds such as $18,000 (in 2017) per year for 401(k) and 457(b) contributions. Furthermore, they are limited to the employer’s plan provisions including vesting schedules, eligibility requirements, and limited investment options. It is not unheard of for some solo or small physician practices to have a 1-2 year waiting period before the employee can contribute at all. Or worse yet, the solo or small practice does not offer a pre-tax savings option at all.
In contrast, an independent contractor can implement any or a combination of several types of retirement plans including an individual 401(k), SEP (Simplified Employee Pension), Defined Benefit Pension Plan, and Money Purchase Plan. Not only are there no limitations from the employer (vesting, fund options, etc…), but the IRS also allows the employee to put more money away pre-tax in these plans. For example, the employee can put away up to $54,000 pre-tax in their SEP in addition to $18,000 in their Individual 401 (k).
Although independent contractors will pay more in FICA taxes and be required to procure their own health and disability benefits, they do not have to meet a 2% threshold in order to take their first dollar of business expenses as a deduction and they can potentially put more money away in their pre-tax savings plan thus pulling back their taxable income.
This article has been provided for informational purposes only and is not intended to be, nor should it be considered legal advice. Consult an appropriate legal professional regarding current laws and application to your particular situation. You should not make any decisions about any legal matter without first consulting with an attorney. This article is not intended to create, and receipt does not constitute an attorney-client relationship.
IRS Circular 230 Notice
To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this memorandum was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.
Randall (Randy) Larson is the Larson Law Firm’s founding member, practicing in the areas of estate planning, business law and asset protection for doctors and dentists. He earned his law degree at Washington University in St. Louis, Missouri, where he was a member of the Global Studies Law Review. Randy also earned his Master of Laws Degree (LL.M.) in Taxation from Washington University. Randy is a frequent speaker to doctor organizations and residency programs around the country, presenting about financial education and other advanced planning topics for physicians.