Congratulations, You Are an Entrepreneur!

Rutt Gonad, a client, came to the office with a question about his employment as a ditch digger. His employer, Legree Construction, offered him a pay increase from minimum wage at $7.25 per hour to $8.00, if Rutt would agree to be an independent contractor, instead of an employee. If he agreed, Rutt would not have taxes taken out of his pay and he would receive a Form 1099 at the end of the year, instead of a Form W-2. Rutt wanted to know what the difference would be and whether it would be in his best interests to become an independent contractor.

An employee, even if the employee is “under contract” and receives no benefits, receives a paycheck from which taxes are withheld and at the end of the year he receives a W-2 reflecting wages and withheld amounts. An employer pays 5.2% Social Security tax and 1.45% Medicare tax on the employee’s wages. The employee pays the same amount. A self-employed person, however, has to pay both the employer’s share and the employee’s share of these taxes. Legally, the self-employed person, or independent contractor, is obligated to pay 13.3% on his or her wages, up to $106,800 per year. The self-employed person also must make quarterly payments on federal and state income tax obligations.

Rutt’s hourly wage of $7.25 is currently reduced by $0.48 for Social Security and Medicare and $0.60 for state and local income tax withholding. By taking the “deal,” Rutt would get $8.00 per hour in hand, but would have to pay $1.06 Social Security and Medicare taxes and make quarterly payment to the IRS for income tax. The employer saves the 6.65% employer portion of the payroll taxes on Rutt’s $7.25 per hour, $0.48, and avoids some of the payroll headaches of tax withholding. Being an independent contractor would only put more money in Rutt’s pocket if he does not pay his taxes. This makes him liable for prosecution for tax evasion, if caught. It also means that he is not contributing to Social Security, so his benefits would be reduced when he reaches retirement age.

Legree Construction is clearly a scofflaw company. Rutt goes to work at a specified time and uses company equipment to dig ditches. He is under the direction of a Legree Construction foreperson and is required to follow defined work rules to perform tasks as assigned. Rutt is now an employee and his circumstances would be unlikely to change if he became an “independent contractor.” For Legree Construction to call Rutt an independent contractor is contrary to tax law and regulation.

To be an independent contractor, Rutt would have to be paid by the job and be given considerable freedom in deciding how the job would be done. If Legree Construction assigned Rutt the task of digging a trench six feet deep and three feet wide from mile marker 100 to mile marker 101 on a certain highway, and gave him a deadline to complete the trench using his own equipment, Rutt could be an independent contractor.

At Rutt’s pay grade, there would be no advantage to being an independent contractor as opposed to an employee unless the pay for an independent contractor is much higher than the pay for an employee. However, there are some situations where it would make sense, particularly if the independent contractor formed a corporation or taxable limited liability company to perform the services.

If Lucretia Smith is a nursing assistant in a long-term care facility earning minimum wage, a 15 or 20% increase would not make it economically beneficial to form a corporation and have the corporation act as the independent contractor. However, if Pandora Mora is a nursing home administrator making $150,000 per year, it might be advantageous for her to form a C corporation, Pandora, Inc., or a taxable limited liability company, to contract with the facility for her services.

By acting as her own employer through a corporation, Pandora can reduce her employment taxes. If Pandora, Inc. receives $150,000 per year for Pandora’s services, but only pays her $50,000 per year, this would reduce the employment taxes by over 50%. If the other $100,000 is received by Pandora as corporate profits, she would not pay employment taxes on those receipts. This is not all peaches and cream because there would be corporate income tax on the profits, although there are a lot of deductions for such employee benefits as medical expenses, health and long-term care insurance, and pension funding. It becomes a very complicated trade-off.

If Pandora set up an S corporation or a limited liability company taxed as a sole proprietorship or partnership, there might be some savings on self-employment taxes. The profits after paying salary would not be subject to self-employment tax, but the medical expenses and various insurance premiums would not be deductible.

A low-wage worker is always better off as an employee than as an “independent contractor,” unless the worker is willing to duck income taxes and risk severe penalties, up to and including prosecution. If a low-wage worker is called an independent contractor, he or she probably is really an employee and is being taken advantage of by the employer. There may be tax benefits or other benefits to working as an independent contractor or under a corporate shell for higher-wage workers, but it is a complex set of factors that must be weighed and balanced.


John B. Payne, Attorney
Garrison LawHouse, PC
Dearborn, Michigan 313.563.4900
Pittsburgh, Pennsylvania 800.220.7200
©2012 John B. Payne, Attorney

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