Your title might be “consultant,” “contractor,” “freelancer,” or “senior analyst,” but in the eyes of the law, there are only two worker categories that apply to professional consultants: employee (either temporary or full-time) and independent contractor.
For most professional independent consultants, it is preferable to work as an independent contractor, where a statement of work governs the agreement for services and you are paid on a 1099 tax basis. Being paid on a business-to-business basis is usually more profitable for the consultant. That said, a client may ask you to be paid through a staffing agency, or a staffing agency may recruit you directly, and you will be paid like a temporary employee on a W-2 tax basis. In that case, you gain a few conveniences but may lose the work-life flexibility that attracted you to consulting, and you may be less profitable. (Watch this two minute video to find out why, "Friends Don’t Let Friends W-2"™)
Business owners can deduct expenses that employees can’t, and they can participate in more favorable retirement plans. In some situations, you will pay significantly more taxes on the same income when paid on a W-2 basis than you would if you were paid on a 1099 basis.
You take on the risk (and rewards) of the business enterprise. You fund your own marketing, equipment, and office space. You define what products or services you deliver and how they are priced. Finally, you may pay other people to act on your behalf in doing day-to-day work, either as employees or sub-contractors – and you must pay them even if the business loses money. (The IRS calls this financial control.) When you’re an independent contractor, clients don’t withhold taxes, don’t pay health insurance or unemployment insurance premiums, and don’t cover you under their worker’s compensation policies.
Sometimes it is easy to recognize a business-to-business relationship. If a licensed general contractor adds a wing to a company building, neither the company, the contractor, nor the IRS would mistake that contractor as an employee of the company. An independent consultant, by contrast, may appear to perform the same kind of work as an employee in the same corporation. This puts the corporation at risk of an employment audit by a government agency, and at risk that non-employee workers will file a lawsuit demanding employee benefits.
Should a government agency or court determine that de facto employees have been improperly classified as independent contractors, the corporation may owe fines and penalties; be ordered to pay back taxes not budgeted into the worker’s rate; have to compensate the worker for benefits; have bad publicity or all of those things. This is why corporations are hesitant about hiring independent contractors.
The following table summarize the primary distinctions between independent contractors and employees.
|Independent Contractor (IC)||Employee|
|Who||IC is a business entity; client company is its customer. Statement of work codifies responsibilities between the entities, and of each entity towards the public, as well as the ownership of any inventions and copyrights created during the engagement||Employee is the agent of the company; the company assumes responsibility for the employee’s activities while under its direction and ownership of inventions and copyrights created during the engagement|
|What||IC delivers services documented in a statement of work||Employee fulfills duties of role defined in a job description|
|When||IC sets own working hours or hours set forth in the statement of work. Work may be priced by project or deliverable, without specific account for how hours are spent||Employee adheres to schedule imposed by the employer. Employee’s base salary is calculated by time, whether an hourly wage or a biweekly, bimonthly, or monthly payroll.|
|Where||IC determines where to work within the constraints of the contract: from a home office, at the client site, at an end customer site||Employee is told where to work. Reports to a job site, sits at an assigned workstation, gets permission to telecommute, or is assigned to end customer job sites|
|Why||IC delivers packaged or customized services to||Employee fulfills a role within the company’s hierarchy|
|How||IC determines the work methods and may contribute value through proprietary templates or processes; maintains own equipment and supplies||Employee gets trained on and adheres to employer’s processes and procedures; employer provides equipment and supplies|
When looking to determine if someone has been improperly classified as an independent contractor, courts and government agencies look at three factors:
Because these factors are intertwined and the final judgement is subjective, corporations get nervous about classifying their workers. That is the pain point to which staffing agencies market. They tell employers that they are the solution to compliance worries.
When they market to consultants, staffing agencies emphasize the benefits of being an employee. If you work on a W-2 basis (whether through a staffing firm or directly through an employer), you receive a regular paycheck. You don’t have to file quarterly estimated income taxes; the staffing agency withholds your taxes from your paycheck. You may have access to a group medical and dental insurance plans. Your city or state may mandate paid sick leave. Staffing agencies also help find work opportunities for you, although they are often more tactical and less strategic.
What the staffing agencies don’t say is that the bulk of their profit comes out of your pocket: the client company pays high fees to staffing firms that could otherwise go towards a higher pay rate for the consultant. In addition, the staffing agency business model originates from their roots in providing hourly temporary staff such as clerks and bookkeepers. As a result, you may have to “punch the timeclock” for a 40-hour workweek and you may be perceived by your colleagues as a temp, not a strategic advisor.
If you are going to be self-employed, be smart about it. Project yourself as a business and ask (insist) to be paid on a business-to-business basis. This will enable you to take business owner tax deductions and lower your taxable income. It will also allow you to set up a self-employed retirement plan and is the ticket to lower taxes and healthier retirement savings. "Friends Don't Let Friends W-2"™ - and neither should you. Independent contractor status is worth fighting for!