1099-vs-w2

When freelancers discuss payment, they often mention 1099 or
W2. On the surface, these describe the tax relationship between
you and the other party. As it turns out, however, the path you choose
determines much more. Read on to learn the pros and cons of each.

This article concerns freelancers who wish to be paid (read: all of us).
Payment comes in two flavors: 1099 or W2. These are tax
status labels, and they respectively discern between You, Inc the
business and You, Individual the person.

1099, also known as Corp-to-Corp, describes a situation in which You, Inc
does business directly with another company. That company cuts checks to
You, Inc; from that money, a (smaller) check is cut to You, Individual.
Depending on your company’s status –corporation versus a sole
proprietorship — you will have different tax liabilities. (Note that 1099
is called “Corp-to-Corp” regardless of whether the companies involved are
true corporations.)

W2, by comparison, is a little closer to salaried work: You, Individual
receives a check from which all proper taxes, social security, and so forth
have been removed. The second(smaller) number on the pay stub is 100%
spendable by You, Individual because Uncle Sam has already taken his cuts.
You may recognize W2 as the name of the form you attach to your tax filings
in April. Note that going W2 doesn’t necessarily make you an employee of
the other company: W2 freelancing still means it’s up to you to cover the
cost of insurance and such.

You will almost always work 1099 status when you have a direct-to-client
gig. Then again, it’s fairly rare for a client (especially the larger,
more established shops) to do direct business with a small firm such as
You, Inc. It’s a hassle for them to file papers to setup a new freelancer
on their books.

This is where the middlemen come in: these firms establish a direct
relationship with the client and saddle business burdens such as insurance.
In turn, the middlemen reach out to You, Inc to provide the actual
services. (They earn their money by taking a skim off your rate.) It’s
sort of a win-win situation: You, Inc gets work at a client (though not a
direct gig), and the client gets the top-notch services of many small firms
while having only a handful of preferred vendors on their books.

It’s these middlemen who offer the choice between 1099 and W2. There are
benefits to either situation, though people tend to religiously fall into
one camp or the other. We offer some pros and cons of each to help you
make an informed decision.

Going W2 is typically a low(er)-risk situation than 1099 because:

• the contracts are simpler. Almost any contract signed by You,
  Individual will be shorter and more straightforward than that signed by
  You, Inc. They are typically noncompete forms, which translate to, “don’t
  steal our client.” Such contracts are short and have no room to negotiate,
  which means you pay less money to A Ttorney
  to review. (It’s not that you don’t love your attorney, but…)

• taxes are handled for you. There’s little tax liability here
  (approximately 0%). So long as you were honest in the forms you filed with
  the middlemen, Uncle Sam can’t chase you down for tax errors in your
  paychecks. There’s also the simplicity of not having to pay quarterly taxes
  (as corporations do): What You’re Paid Is What You Get.

• you don’t have to carry business insurance. The larger clients
  often require hefty business insurance, to the point that it may be out of
  your pay scale (or at least, not worth your time) to acquire it.

• you can probably negotiate regular paychecks. The W2 work I’ve done
  has been on a “floating” basis: the middlemen had a cash reserve from which
  they paid me every two weeks. By comparison, 1099 work means you get paid
  whenever the client gets around to it. Most places pay regularly and on
  time; others put paying their freelancers at the bottom of the priority
  list. In turn, going 1099 often means having to have a larger cash reserve
  to handle situations in which you don’t see a paycheck for 2-3 months after
  you’ve submitted an invoice.

• you have less to lose if the deal goes sour. If the gig falls
  through at the last minute, you’ve spent nothing on insurance and next to
  nothing on contract review. (Read: “when the gig falls through”;
  it will happen eventually, if it hasn’t happened already.) All of those
  savings are passed on to the middlemen. This is especially helpful if the
  gig is so short that the pay would never cover the setup costs.

That said, going 1099 — either with the middlemen or those rare
direct-to-client gigs — has its benefits:

• your company itself earns money. Companies are treated (somewhat)
  as living entities: they can apply for loans, make purchases, and so on.
  Similar to individuals, a company’s income affects its ability to do such
  things. If you have setup You, Inc but only do W2 work as You, Individual,
  your company shows zero income and thus zero chance of getting a loan.

• you get more control over your income. You, Inc and You, Individual
  are separate entities. As such, You, Inc has no obligation to pay You,
  Individual all of the money from each 1099 check.

  Say, for example, You, Inc earns enough money that it can pay You,
  Individual $150,000 over the course of a year. That sounds quite nice for
  You, Individual until you realize that a lot of the money will be lost in
  taxes. Instead, You, Inc could pay You, Individual a more modest salary of
  $90,000 and save the remaining $60,000 for bench-time pay. This has the
  added benefit of putting You, Individual in a lower tax bracket and thus
  less of the money will be paid to Uncle Sam.

  -and before you ask, my understanding is that this practice is 100% legal.
  A company doles out pay as it sees fit. (See your accountant for details.)

• you’re (somewhat) protected by the corporate veil. There’s a slim
  chance you’ll ever be sued, especially if your contracts are tight enough.
  That said, when lawsuits happen, it’s a little tougher for a client or
  middleman to attack You, Individual so long as You, Inc signed the
  contract. In turn, this means the risk is shouldered by You, Inc.

  Don’t get cocky, though: there are still cases in which a suit can be
  brought against You, Individual. This is known as piercing the
  corporate veil and when it happens, you’re in hot water.

• 
  you incur fewer out-of-pocket expenses. Whether it’s something small
  (transit) or a big-ticket item (health care), You, Individual can quickly
  eat through a lot of cash if you pay for these out of your W2′d paycheck.
  Consult your accountant for details, but many such expenses can be
  (legally) handled by You, Inc as long as they are incurred in the line of
  duty. In turn, You, Inc can (legally) file some of these as business
  expenses, such that they are effectively tax-free.

  We’ll cover accounting in another article. Needless to say, your
  accountant can save you a lot of money.

• you get (a little) more privacy. In this day and age, companies are
  asking for far more information than they need when you apply for a job.
  (True story: some companies want to check your credit history and even your
  driving records, even when the job doesn’t call for you to handle sensitive
  data.) Going 1099 offers you more leverage in this fight, because you can
  (rightfully) contest such invasions of privacy: “you’re hiring my company,
  not any particular individual.”

  You won’t always win these fights, but this is certainly a case in which
  every victory counts.

When a middleman firm offers you the choice between W2 and 1099, know the
difference between the two. W2 is a great way to get started because it
usually requires less startup capital and incurs less risk than going 1099.
Long-term, though, the contract professionals I know prefer the power and
control of 1099.