As a consultant or contractor, you can sometimes be faced with the decision when taking a new contract of whether to go 1099 or W-2.  Essentially, the question is in what manner will you be paid by your client.  Having faced that decision a few times myself, I will fill you in on my thoughts and how I try to compare the pay rates of both.  First off, definitions of both:

W-2: Usually the client has a head hunter, broker or other third-party service that will act as the intermediary between you and them.  You will receive wages from the broker with the requisites taxes withheld, so you are essentially an employee of the broker.  The broker in-turn invoices the client for your services (with a markup).  Some brokers will provide you with medical and dental insurance options, life insurance, Section 125 flexible spending and even a 401(k) plans.

1099 (Self-Employed Sole Proprietor):  A sole proprietorship is an unincorporated business that is owned by one individual.  You submit an invoice to the client or broker and are paid without any taxes withheld.  You will receive a 1099-MISC each January from your client indicating the payments made to you for the previous calendar year (hence the term “going 1099″).  Please be aware that the IRS might still consider you an employee and disallow your independent contractor status, even though you are paid via 1099.  See IRS Publication 1779: Independent Contractor or Employee?  If this were to happen, the company you work for would owe back payroll taxes, so some companies prefer W-2 to avoid this situation.

Now for the pros/cons of each:

W-2:

• Don’t need to submit invoices (no bookkeeping)
• Employer pays their portion of taxes, and they withhold your portion of the taxes
• Employer may pay part of health insurance
• Limits on the deduction of unreimbursed business expenses (amount over 2% of your adjusted gross income) and health insurance premiums (amounts over 7.5% of your adjusted gross income)

1099:

• Need to submit invoices (more bookkeeping)
• Most contracts specify “30-day net”, meaning the client has 30 days to pay you after they receive your invoice.  That means you need to have enough money in the bank to go at least 30 days without getting paid!
• With W-2 you are pretty much guaranteed to get paid by the client.  With 1099, you could have issues collecting payment
• You must pay self-employment taxes (social security and Medicare tax).  This is what is usually paid by the employer when you are W-2.  THIS IS THE BIGGEST DIFFERENCE BETWEEN 1099 AND W-2: You have to pay 7.65% in extra taxes!
• Need to be diligent and save money each paycheck so you can pay quarterly taxes (estimated taxes each April 15th, June 15th, September 15th, and January 15th)
• Can deduct more business expenses, like a home-office deduction (see IRS Publication 587, Business Use of Your Home) and full cost of health insurance premiums on the front of your 1040 (but these expenses don’t reduce your self-employment taxes).  See IRS Publication 535, Business Expenses for all the details on what’s deductible and what’s not
• You can defer more current income into retirement plans than you can with W-2, thereby reducing your income taxes (see IRS Publication 560, Retirement Plans for Small Businesses).
• Unlimited liability for the owner
• Be aware that there could be a BIG difference between paying for medical insurance via W-2 thru a broker and paying on your own via 1099.  The broker would likely be paying for a portion of the medical insurance, where going 1099 you would pay for all of it.  Insurance costs are crazy and a self-employed heath plan with a high deductible will cost you at least $500/month for a family plan (and were talking a $7500 individual deductible with no maternity coverage, no pre-existing condition coverage, and a required health background check…insane)

So how do you compare the rates for 1099 and W-2?

Since you have to pay self-employment taxes with 1099, what would be the equivalent pay rate for 1099 be compared to W-2?  Let’s break out some math, using 2011 IRS rules.  As an employee, for each pay check you pay 5.65% in taxes (4.2% FICA, 1.45% Medicare).  Your employer pays 7.65% in taxes (6.2% FICA, 1.45% Medicare).  But if you are self-employed (1099), you have to pay BOTH the employee and the employer taxes, which is 13.3% (10.4% FICA, 2.9% Medicare).  This is called the self-employment tax.  In essence, you are paying an extra 7.65%.  However, you only have to pay FICA on the first $106,800 of your earnings.  Anything over that and you only have to pay medicare.

So let’s see how much more you have to pay as a 1099.  Let’s assume you are a very well paid consultant making $200k/year.  You will be paying an extra 6.2% FICA on the first $106,800, which totals $6621.  You will also be paying an extra 1.45% Medicare for the full $200k, which is $2900.  So adding $6621 and $2900 gives the total amount of extra taxes you will be paying: $9521.  Assume you will work 2000 hours in a year, and that results in $4.76/hr.  So your 1099 rate would need to be $4.76/hr higher than a W-2 rate to equal out.

But there are a few other things to consider.  You need to compare the cost of medical insurance via W-2 thru a broker and on your own via 1099, unless you are covered thru your spouse.  If not, let’s assume you would pay $375 W-2 and $500 1099 for similar insurance (taken from my experience).  That means you would need to make an additional $0.75/hr to make up the difference.  Added to the $4.76/hr and you are up to $5.51/hr more for 1099 over W-2.  At the expense on confusing you more, the other thing to think about is that you can deduct half of your self-employment tax in figuring out your adjusted gross income come tax time.  You can also deduct the full cost of health insurance.  Assuming you are in the 35% tax bracket, without repeating all the calculations, that equates to a tax savings of $5,046/year, or $2.52/hr.

So in the end, if you subtract the $2.52/hr from $4.76/hr, you are left with $2.24/hr as the amount you need added to the W-2 rate to equal a 1099 rate in this example.  Hopefully this will give you some guidance to substitute your own numbers and accurately compare the two when faced with your own decision to go 1099 or W-2.

Hope this helps.  In a future post I will compare 1099 and W-2 to two other options: corp-to-corp and a salary for a permanent position.

More Info:

Consultants: W-2, 1099 or Corp-to-Corp?