W2 vs. 1099 - which is better? $100K scenario
A question I often get asked as a CPA is: Should I be an employee (“W2”) or self employed / independent contractor (“1099”)? A common, big round number thrown out there is if the worker is earning $100,000 annually.
Most people do not get the option of deciding. If you are working for a company that controls how and when you work (a typical “9-to-5”), you will automatically be categorized as an employee and receive a W2 at the end of the year.
Many individuals who already have a W2 job decide to start a side business in which they are an independent contractor or sole proprietor.
Additionally, some employers cut corners (willfully or out of ignorance) by misclassifying their employees as contractors (because it saves them money), but this opens them up to lawsuits and penalties for denying their workers’ rights and privileges entitled to employees.
Employment laws aside, let’s focus on the tax implications of both options.
The most important things to consider are:
· Employment Tax (also referred to as “payroll tax”)
· Business expenses (“write off’s”)
· Entity Structure (Sole prop vs. LLC vs. S-Corporation)
Employment (Payroll) Tax
Some background: The Federal Insurance Contributions Act (FICA) was established back in 1935 to act as a safety net for elderly retirees who were living in poverty. NOTE: although related, payroll taxes and income taxes are separate.
As a W2 employee, you will see 7.65% of payroll taxes being withheld from your check every pay period:
· 6.2% toward Social Security
· 1.45% toward Medicare
Therefore, a single individual who is earns $100,000 will receive the net of $92,350, after $7,650 (FICA) is withheld.
This is only HALF of the payroll taxes, since you are splitting the cost with your employer, who also pays 7.65% on every dollar they pay to you. (Social Security phases out for those earnings more than $168,600 for Year 2024). Therefore,
· The employer pays $107,650 ($100,000 + $7,650 FICA) out of pocket
· The employee receives $92,350 ($100,000 - $7,650 FICA)
· The IRS receives a whopping $15,300 (12.4% Social Security and 2.9% Medicare)
Payroll taxes account for more than a third of all IRS revenues (over $2.1 TRILLION annually). Alternatively, income tax accounts for $2.6 TRILLION and Corporate tax for only $467 BILLION.
Both W2 employees and 1099 independent contractors pay payroll taxes. W2 employees pay half of their payroll taxes, while the 1099 independent Contractors pay 100% of FICA, since these contractors are acting as both an employer AND an employee (i.e. “Self-Employed”)
A worker earning $100,000 filing Single in a zero-tax state (such as Florida) will be affected as follows:
As a W2 employee, take home pay will be $78,084
· Payroll tax of $7,650 (with the employer paying an additional $7,650)
· Income tax of $14,266
for a total tax liability of $21,916, (for an effective tax rate of 21.9%)
For a 1099 independent contractor, take home pay will be $76,642 (assuming zero expenses)
· Payroll tax of $14,129
· Income tax of $9,228
For a total tax liability of $23,357 (for an effective tax rate of 23.4%)
On its face, it appears that the W2 earner gets to keep more money in their pocket.
Additionally, the W2 employee does not have to worry about making tax payments because their employer already withholds taxes from their paycheck. So, if your expenses are minimal and you hate the idea of tracking your expenses, running a business, or paying estimated taxes, W2 is the better option.
Write Offs
However, if the 1099 independent contractor has expenses of at least $4,340, they will pay lower taxes than the W2 employee, who does NOT get the benefit of writing off things like:
· Home Office (rent, supplies, utilities, & equipment like computer / telephone)
· Auto expenses (including depreciation, insurance, repairs, lease payments & mileage)
· Business Travel & Meals
· Advertising / Marketing
· Outside Labor
· Legal & Professional
Independent contractors in most industries will be able to utilize write-offs to easily cover $4,340 of expenses, thereby making the 1099 a more attractive option.
Entity Structure
Many independent contractors open a limited liability company (LLC) either prior to or shortly after starting a business. The first step of opening an LLC, Articles of Organization must be filed with the state in which is conducting business.
NOTE: An LLC is not in itself a tax classification, but a flexible vehicle which can be treated in one of several ways:
· Single Member LLC
· Multi-Member LLC
· Converted to an S-Corporation
By default, an LLC with one owner is a Single Member LLC, which is considered a “disregarded entity” in the eyes of the IRS. This means that the LLC will not offer any tax savings, and the owner will still have to pay Self Employment taxes on the net income. Yuck.
The business activity of a SMLLC is reported on Schedule C of the business owner’s personal tax return, which is the same place to report all self-employed income on an individual return.
If there is more than one member, the LLC will automatically be considered a Multi-Member LLC (MMLLC), similar to a partnership. An MMLLC needs to file a separate tax return (Form 1065 "Partnership") with the IRS.
Every member of the MMLLC receives a K-1 from the LLC which reports the net income or loss for each member. For this reason, MMLLC’s are referred to a “pass-through” entity.
Either one or more members of the MMLLC will need to pay self employment tax on the net income, depending on their involvement (either passive or active). Since they are flexible, it is advisable to hold real estate and other investments in LLCs.
Generally, LLC’s do NOT save money on taxes. But, if there is an LLC in place, this gives the taxpayer the option to either proactively or retroactively convert the LLC to an S-Corporation which WILL save money on taxes- specifically payroll taxes!
S-Corporation – best of both worlds
An S-Corporation is formed by filing Articles of Incorporation with the state and obtaining an EIN from IRS, or by converting an existing LLC to an S-Corporation.
An owner of an S Corp needs to file a separate tax return (Form 1120S) each year with the IRS. The owner(s) of the S-Corp (referred to as “shareholders”) receive a K-1 reflecting the net income from the business (similar to the MMLLC, this a “pass-through” entity). However, unlike MMLLC’s, only individuals can be shareholders of an S-Corp, and the S-Corp structure is far more rigid than LLC’s.
On the plus side, the S-Corp benefits from a lower intrinsic tax rate (by avoiding self employment taxes) AND by being able to capture business expenses available to S-Corps.
Because the S-Corp allows the owners to avoid self employment tax, there is a requirement from the IRS to pay a “reasonable salary” to the officer(s) of the business. This requirement ultimately results in the payment of some payroll taxes, but only on the portion that is paid out via W2. Even after paying a reasonable salary to the officer, the S-Corp structure still results in a lower tax rate than both the straight W2 earner and the sole proprietorship.
For our $100,000 net income example:
For an S-Corp with zero officer salary, take home pay is $85,734.
· Payroll tax of ZERO
· Income tax of $14,266
This represents tax savings of $9,092 over a sole proprietorship / SMLLC
For an S-Corp with officer salary of $35,000, take home pay is $80,973
· Payroll tax of $5,355 (half of this is a deducted from the business income)
· Income tax of $13,672
This represents tax savings of $4,331 over a sole proprietorship / SMLLC
Once you factor in the write-offs and the tax savings available to an S-Corp, any business that earns at least $50,000 in net income would benefit from the S-Corp structure. See below for a chart for effective tax rates for the various scenarios listed above.
If you have any questions about your situation, please reach out and schedule an appointment with a tax expert today!
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