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Two partners started a business, and it's grown pretty big (comparatively).

Now they've asked me to be the CTO, and I've determined it's a good position for me to take. I'll be getting 90% of my current salary, and 5% equity in the company.

The question has come up, would I rather be an employee or a contractor? There's no real difference between the two, as far as we're concerned, because either way I'm going to work half from home, half from the office, but I'm concerned about taxes at the end of the year -- I've heard it both ways, that consulting will cost me way more (because I pay double the social security tax) or that as a consultant, I'll save a ton of money by being able to write things off. I'm signing a 6 month contract with these guys either way, so job security isn't really an issue.

Which is closer to the truth? Will I make more as a consultant or an employee? I understand it depends on my specific circumstances, but what factors are involved?

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4 Answers 4

up vote 7 down vote accepted

Your comment to James is telling and can help us lead you in the right direction:

My work and lifestyle will be the same either way, as I said.
This is all about how it goes "on the books."
   [emphasis mine]

As an independent consultant myself, when I hear something like "the work will be the same either way", I think: "Here thar be dragons!". Let me explain:

If you go the independent contractor route, then you better act like one. The IRS (and the CRA, for Canadians) doesn't take lightly to people claiming to be independent contractors when they operate in fact like employees.

Since you're not going to be behaving any different whether you are an employee or a contractor, (and assuming you'll be acting more like an employee, i.e. exclusive, etc.), then the IRS may later make a determination that you are in fact an employee, even if you choose to go "on the books" as an independent contractor.

If that happens, then you may find yourself retroactively denied many tax benefits you'd have claimed; and owe penalties and interest too. Furthermore, your employer may be liable for additional withholding taxes, benefits, etc. after such a finding.

So for those reasons, you should consider being an employee. You will avoid the potential headache I outlined above, as well as the additional paperwork etc. of being a contractor.

If on the other hand you had said you wanted to maintain some flexibility to moonlight with other clients, build your own product on the side, choose what projects you work on (or don't), maybe hire subcontractors, etc. then I'd have supported the independent contractor idea. But, just on the basis of the tax characteristics only I'd say forget about it.

On the financial side, I can tell you that I wouldn't have become a consultant if not for the ability to make more money in gross terms (i.e. before tax and expenses.) That is: your top line revenues ought to be higher in order to be able to offset many of the additional expenses you'd incur as an independent. IMHO, the tax benefits alone wouldn't make up for the difference.

One final thing to look at is Form SS-8 mentioned at the IRS link below. If you're not sure what status to choose, the IRS can actually help you. But be prepared to wait... and wait... :-/

Additional Resources:

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1  
Awesome. This is exactly what I was looking for, but we're going against your advice :) As it stands, we've decided that per our situation, contractor makes more sense. I'm getting paid a lump monthly sum, I'm providing my own tools and resources, and I'm working out of my home office [from which I also work on other projects for other clients]. The third link you posted raises the best points; specifically, I've got personal interest in this project (the equity means that I have something to gain/lose depending on my work's performance), and I'm covering my travel expenses. Contractor it is! –  linkedlinked Feb 5 '10 at 23:33
    
You're welcome. I'm glad it was helpful. Yes, it sounds like the conditions of your work could support being independent. Just to give you peace of mind, though, you may want to consult a tax pro and see if there's anything else you could do up front to solidify the case for being an independent contractor. –  Chris W. Rea Feb 5 '10 at 23:57
1  
Remember that nutcase who crashed a small plane into the IRS building? He was making a statement about IRS section 176, among other things. –  fennec Mar 10 '10 at 17:10
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Sadly, yes. Section 1706. See my question at taxqueries.com/questions/1338/… –  Chris W. Rea Mar 10 '10 at 23:16
    
Oops. The source I looked up to verify the number really quick had it wrong. :( –  fennec Mar 11 '10 at 0:38

To be honest I don't know how any of this work in the US so my answer will be of very limited value to yourself, I suspect, but when it comes to the UK if you're going to get the same pay gross either way than being independent makes very little sense.

Running your own business is hassle, is generally more risky (although possibly not in your case) and costs money.

Some of the most obvious costs are the added NI, probably the need for an accountant, at around £1200 p/a for basic accountancy service, you are obliged by law to have liability insurance and you probably want professional indemnity insurance, this will be around £600 p/a minmum, and so on and so forth.

On top of that, oficially anyway, as a contractor, you really shouldn't be getting any benefits from the client, and so health insurance, company car, even parking are all meant to be arranged by, and paid by, your company, and can't (or rather - shouldn't) be charged to the client.

So - I would say - if you're seriously thinking about setting up a consultancy company, and this client is first of many - set up a company, but take into account the sums you need to earn. If you're really thinking about employment - be an employee.

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Great info, thanks! I won't mark this correct, as I'm still hoping for a US-specific answer, but you get an upvote :) –  linkedlinked Feb 5 '10 at 21:25

Linkedlinked,

You might want to seriously take another look at the links that Chris provided you. Specifically the ones on the IRS website:

http://www.irs.gov/businesses/small/article/0,,id=99921,00.html

From the IRS website:

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

Perhaps more importantly... pay attention to what happens if you're WRONG:

Consequences of Treating an Employee as an Independent Contractor
If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker (the relief provisions, discussed below, will not apply). See Internal Revenue Code section 3509 for more information.

I would STRONGLY recommend that you and your partners give your accountant a call and discuss the matter. They will be able to help you make the right decision.

One of biggest mistakes businesses make in this are is to classify their employees as independent contractors. The IRS (who happens to be hungry for money right now) comes in and says, "Nooooooooo... those are employees."

...and the COMPANY gets to pay the employment taxes. I actually have person experience with this as I worked for a company this happened to. Every contractor was re-classified as an employee except for two (myself and one other). The key reason in that case was that none of the other contractors had any other clients.

While I understand that you have other clients, I would still recommend talking to your accountant for an hour or so... just to be 100% sure.

Sincerely,
Andrew Smith
TaxQueries.com

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+1 especially for "The key reason in that case was that none of the other contractors had any other clients." I make a point myself of taking on additional work from time to time, even when one good client could have otherwise kept me busy. –  Chris W. Rea Feb 6 '10 at 4:01
    
+1 Welcome TaxQueries.com! –  Zephyr Feb 6 '10 at 4:01

I think it really depends on what work/lifestyle you are looking for. I'm sure your more than capable of going down either route, but you should weigh up the pros and cons of each

A consultant would be great, you'd be your own boss and you have overall say on how your business/career plans out, but be prepared to put in a hell of a lot of work to get it off the ground. Long hours, little time for social/family etc. But in the long run it'll pay off

Employee, no worries about running your company, just turn up and perform your duties. You'll get the whole benefit package: healthcare/pension etc. You can probably go on expense paid training courses etc

It depends, do you want to just be an employee working "for the man" or do you want to be "the man"?

I wish you luck in whatever you do! :D

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This isn't really an answer to my question at all. My work and lifestyle will be the same either way, as I said. This is all about how it goes "on the books." –  linkedlinked Feb 5 '10 at 21:26

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