Sunday, October 22, 2006

S-Corps for Software Contracters

Do you prefer 1099 or corp-corp?

Ever been asked that by a recruiter or HR? Did you freeze like a deer in the headlights?

If so, it's probably because you've spent your entire career up until now in Full-Time, 'Permanent' positions, and you're about to do your first real independent contract. In many situations going 1099 is the least costly and least complicated route to take. But, if a client ever insists that you do "corp-to-corp" (as happened to me last year), you'll need to incorporate and take on a few added responsibilities and expenses.

If you ever find yourself needing to do corp-to-corp, this guide will give you a real leg-up on the process. Before I start though, I need to lay out some disclaimers, which I assume you will keep in mind at every point as you read this article:

  1. I am neither a lawyer nor accountant. I am not giving professional advice, only sharing information from my personal experience. I provide no assurance that it is accurate or complete. Before you replicate anything from my experience you should get input from a qualified lawyer and a qualified accountant and consider their advice primary. I am not liable for any legal or financial woes you incur from following or failing to follow this.

  2. My company is in Illinois and is incorporate in that state. I did no research to find how tax & corporate law works in other states. Your accountant and lawyer will have to advise you on the peculiarities of your state.

That being said, let's get started.

The Gory Truth, All At Once

Here is an executive summary of incorporating and running a corporation, at lightspeed. The usual choice for an individual is the S-Corp. The idea is you are setting up a corporation in which you are the sole employee. The legal process of drawing up Article of Incorporation must be undertaken; your lawyer can do it, or you can do it yourself on the web. You're going to put yourself on payroll. You're going to do all the deductions, and file and pay them yourself to the Fed and your State. Some of these deductions have to be matched by the company, which means you pay them twice. You also pay the state and the fed unemployment insurance. The filing and payment of all these various taxes happen on different timescales: some are monthly, some are quarterly, and one of them is yearly. Plus, big corporate clients will require you take out insurance as well.

Why Incorporate

You heard right: double the usual medicare & Social Security, state and federal unemployment, fees for filing articles of incorporation, and business insurance. So why take this on, then? Because an employer may require corp-to-corp: it's how they keep their nose clean with the IRS. The IRS comes down pretty hard on tax-evading companies who try to hide part-time employees by calling them "contracters". Companies know that this all costs you extra money, so your hourly rate is adjusted appropriately.

Or you may want to be an S-corp because you expect your business to grow (i.e. hire employees), or perhaps the legal formality of the corp. status raises your standing in the profession. S-corp is not the only choice; an LLC (Limited Liability Corporation) is also a possibility that meets the Corp-to-corp requirements. LLC's are usually for when you have one or more partners in addition to yourself, so if incorporation is really just for you to run a company of one, S-corp is the obvious choice.

Articles of Incorporation

It is not strictly necessary to engage a lawyer. You can actually incorporate online with sites like I think there are several good reasons, however, for choosing a lawyer. Your lawyer will have the best advice for your state, and he/she will be available to answer your questions. A website that serves a national clientele can't answer questions about your state. Unless you are comfortable with legalese, plowing your way through all the documents will be a major distraction. The cost of a lawyer and the online costs are pretty much the same. It cost me $600 to incorporate.

The process itself not a big deal, really. With a lawyer you'll take care of the whole thing with one phone call, a few days wait, and one in-person meeting. The lawyer asks you a few questions, you sign a few forms, you get a stack of papers, and your 9-digit FEIN (Federal Employment Insurance Number).

Your FEIN becomes the key to everything. It shows your client that you're incorporated; it sets you up for paying taxes; it allows you to create an account with a bank in your company's name. Pay close attention to that last one: if you bill your client for two weeks, and he writes the check to XYZ Corp, the bank ain't gonna let you cash it on your personal account. Get your FEIN and your company bank account in order before you start billing.

Creating Your Payroll

Running a payroll is more records-keeping than anything else. You do not need to buy some Quicken product or engage a professional to handle payroll; you want to roll up your sleeves, handle this yourself, and know exactly what is going on with your money. First make a template for a pay stub. Keep it simple, just copy a paystub from one of your recent W2 employers, including deductions for Medicare, Social Security, Federal taxes, and State taxes. Distinguish between gross and net pay. You can do all those Year-to-Date columns on the gross pay and deductions too.

Pick a frequency of pay. What makes sense here? First of all keep in mind that your invoicing (billing) to your client is completely decoupled from your salary, and there's no need or benefit to keeping them in lock step. I chose bi-weekly just so I could recreate the amount of cashflow I had at my last W2 position. Whether you do bi-weekly or something else, it would be wise to stick to it and pay yourself on every pay period; otherwise, having payroll tax filings that change wildly from month-to-month doesn't look like you're really running a business.

Pick your salary. All your taxes combined are going to run about 36% of your gross, so for sure don't pay yourself more than that. But you should still probably pay yourself less than the remaining 64% because you'll have other business expenses (which I'll covere later). One self-employed computer contractor I know said to me "I pay myself like a secretary." Why not pay yourself cheap? The money that stays in the company account is still yours anyway. You can give yourself a quarterly bonus to make up for shortfalls. (And yes, all the taxes apply to bonuses as well.) The key advice is, be conservative on this from the start, and you won't find yourself in a panic later.

Your employee taxes

Here are the figures for calculating the various taxes that I used in 2006 (in my state of Illinois) for each pay stub. Social Security is 6.2% of gross; Medicare 1.45% of gross; Federal tax is (25% of gross) - $336.55; State tax is (3% of (gross - $1000)) + $30. Where do these figures come from?

  • Federal tax figures: The IRS website, gives you the "Tables for Percentage Method of Withholding" (see links below) and apply them to your frequency of pay. These tables cover circumstances such as being single or married and number of exemptions.

  • State tax figures: The calculation process is similiar, and possibly more simple. In Illinois, once your gross for the pay period is over $1000 you follow one simple formula. See the links at the end for the location of Illinois tables.

  • SS & Medicare: These figures rarely change; the two rates of 6.2% and 1.45% have been constant since at least 1997.

Those "other" taxes

Now as a business you have to duplicate those Medicare and Social Security taxes for each employee (i.e. you) and pay them AGAIN as the "company contribution". Your W2 employers have been doing all along for you, and now you're doing it for your own company.

Next there is unemployment insurance. I don't mean a policy that you take out from State Farm; I mean a mandatory tax you pay to the govenment. In case you didn't know this, your most recent employer is the one footing the bill if you go on unemployment. If you work for ABC Corp for a year, then lose your job and go on unemployment and get a few hundred dollars in benefits from the state every two weeks, that is ABC Corp who is paying for the lion's share of that through their unemployment insurance contributions. And your corporation will have to make those contributions now. Just think of it, taking money out of your own gross pay to pay yourself if you go on unemployment! (Seriously though, you might want to talk to your local Department of Employment Security before you try that one.)

There are both State and Federal unemployment taxes to pay, but the Federal one is negligable...a fixed amount in the area of $60 for the whole year. In Illinois, the rate is 4.2% and figured quarterly, on a maximum of $11,000. So let's say you gross $8000 one quarter, your State unemployment tax is 4.2% of $8000. If you gross over $11,000, say $12,500, you only pay 4.2% on $11,000.

So What Should My Hourly Rate Be?

Very good question! Perhaps learning about all these extra costs has made you you run away screaming from the idea of doing corp-to-corp. Don't. These are all known expenses of running a business. Work them into your hourly. If a company has you doing corp-to-corp then you've let them off the hook for medicare, social security and unemployment insurance, and they know full well that you're shouldering it in their place. Plus that company is not paying medical insurance or retirements benefits costs for you either. So don't be shy about upping your hourly. But how much is reasonable?

Perhaps you know your market value in terms of a yearly salary in a normal W2 job. What is the reasonable mathematical equivalent for a corp-to-corp? That will be useful in establishing a baseline. Perhaps there are reasons for a contract to pay you much more than that; maybe it is a short contract with huge demands and a high penalty for failure, and located 1000 miles away. But that's for you to figure out. For now, we'll just talk about an hourly that leaves you just as well off as if you had a W2 at your current market value.

Imagine a hypothetical worker named Sue earning $80k gross on a W2. (We're going to leave medical and retirement benefits out of the picture, now but more on that later.) That works to about $38.47/hour. Sue's net is coming to about $59.5k/year because her Medicare, SS, State & Federal taxes come to about $20.5k/year. Now, let's transform that into a corp-to-corp position. The company portion of medicare & SS, and the state and federal unemployment taxes will come to an additional $8.9k/year and Sue's net annual salary has gone down to $38.6k/year. So her $38.47/hour puts Sue way below what she was earning on a W2. Boost her hourly up to $53.45, though, and then Sue hits that net target of $59.5k/year.

But now Sue wants medical coverage, which, say, costs her $1000 a month. At her last W2 she had a nice medical plan that she paid $200 a month toward, so the value of what she is sacrificing by going corp-to-corp is $800 a month. Translate to an hourly for a year's worth of coverage, and that's $4.62/hour. On a W2, medical coverage is pre-tax, but Sue will have to pay tax on an extra $4.62/hour of income, so it should be bumped up to $6.28/hour. Sue is now asking her client for a rate of $59.73/hour.

Now Sue is still out customary W2 benefits like Retirement Plan, Life Insurance, Disability Insurance, paid vacation, and who knows whatever perks her client offers their full-timers, like Health Club membership. And she's got her business expenses, like indemnification insurance, keeping her laptop and home network in good condition, printer toner cartridges, and so on. Sue might feel justified in adding $3-5 more to her rate. But I would advise Sue against sharing these calculations with the client up front. Clients do not feel they are responsible for every aspect of your financial safety net and company operations; what they would say is, "hey, you're a contractor, those are your issues." Instead, Sue keeps the information in reserve. If they balk at her rate of, say, $62/hour, she can just refer to all those other things in passing: "I haven't even mentioned all the other expenses I am shouldering like business costs and insurance, so I think my rate is fair."

Filing and Paying Taxes

Okay now. Decoupling the money your company makes from the salary you pay yourself is a real trip, right? It gets better still when it comes to filing and paying taxes.

Looking at the paystub from your last W2 employer, you might get the feeling that paying taxes is all sort of automatic and done for each paycheck. Not at all. "Payroll taxes" include Federal & state withholdings and both the employee and employer Medicare & Social Security contributions. The State portion covers only the state withholdings; everything else is considered the Federal portion. You file these figures once a quarter, but pay them once a month. If you fall behind on either (I think the grace period is about 15 days), you'll be penalized and have to file separate forms to cover the penalty...nothing crippling, but unpleasant still. The fact that you pay earlier than you tell them how much you owe them, and then can be penalized for getting it wrong, underscores how important it is to keep extremely clear payroll records.

At the time of this writing, Federal filing can only be done with a paper & snail-mail process. Go to the IRS website and download Federal Form 941. You'll notice that it does not distinguish between the employee and employer contributions for SS & medicare; you lump them together. You'll see that you can also send your payment along with this form, but you have the option to handle the payment online, which I'll cover in a moment.

State tax withholdings can be filed in Illinois via the Illinois TaxNet system. (Hopefully your state has a similar system.)

Payment of payroll taxes is once per month. When your W2 employer takes deductions for tax, medicare, SS, etc., they're actually banking that money until payroll tax time at the end of the month. Both state and federal can be paid online. The federal portions (tax, medicare and SS) can be paid with the EFTS system (see links below) and Illinois state tax can be paid with Illinois TaxNet.

Now for unemployment insurance. In Illinois, you both file and pay state taxes quarterly, using Illinois TaxNet. For Federal, you also file and pay together on EFTS, and only once, at the end of the year. And remember, it's a very small amount (0.8% of gross earnings).

Summary of Times and Activities

Here's quick summary of everything that happens over time at various points:

  1. Invoices are submitted to your client, frequency of your choosing.

  2. Client auto-deposits or mails you a check written to your company bank account.

  3. You generate a paystub for yourself every two weeks indicating the gross earnings, the tax withholdings, and the net amount. You write a company check to yourself (your personal name) for the net amount and deposit it into your personal account.

  4. At the end of each month (with 15 days grace) you pay state and federal payroll taxes for the amounts you withheld in salary to yourself during that month.
  5. At the end of each quarter (March 31, June 30, September 30, and December 31, with 15 days grace for each), you file the state and federal payroll taxes deducted during that period. You also file, and pay, state unemployment tax at each of these quarter ends.

  6. At the end of the year, you file and pay federal unemployment tax.

Why Incorporate, More Reasons

  • With an S-corp you've got all the apparatus for growing into a larger company. Your payroll mechanism scales to multiple employees with no necessary changes.

  • You come to understand how companies work, and your role vis-a-vis clients and the middlemen that separate you.

  • If you go back to W2 employment at some future time, when you get your paystubs, you can go over the figures to see if their withholdings are correct, because you know how they're supposed to be calculated.

  • Using your company as a formality for keeping track of job-related expenses. Need a technical book, or a new wireless router, or some paper clips? Charge it to the company card, then write it off. Incorporation gives you some added authenticity in the eyes of the IRS.

Spreadsheet Tips

My major advice here is to develop a passion for keeping very exact records, and get handy with MS-Excel if you aren't already. Whatever flavor of spreadsheet you use, here are some ideas for you to get started.

  • In one worksheet, I maintain one row for each pay period, with formulae for converting each gross pay to each of the withholdings in separate columns. I copy this row to another worksheet that uses those fields to generate a paystub.

  • Divide the pay period rows into four separate groups corresponding to the quarter of the year. Your state unemployment insurance payments are computed according to quarter.

  • Use another part of your worksheet to keep tracks of each of the categories of tax payments that you make. Label them according to the month and quarter they were for. The steady bi-weekly, monthly and quarterly paperwork, filings and payments become a blur after a while, so keep good records. The 15th day of the month into a new quarter can be a panicky day if you're unsure of your filings and payments.

  • Use another part of your worksheet to show what taxes are currently owed by comparing the payroll rows with the Tax Payments Made records. And finally you can calculate the financial state of your company: money in the bank after you've made payroll, minus the taxes not yet paid.

Other Tips

  • For each transaction relating to salary, keep together copies of the pay stub, check, cancelled check and bank statement line item. Staple them all together and file them away. Do the same for each transaction relating to invoicing and client payment. You'll have so much order in your records, you'll be wanting to dare the IRS to audit you.

  • Keep track of your expenditures using your company card or checks for things other than salary. Now here is a case where I recommend using something like Quicken instead of rolling your own Excel spreadsheet. Don't go overboard and invest in QuickBooks or anything, although Quicken "Premier Home and Business" is worth the extra few bucks.

  • It's inevitable that your personal and business bank accounts will intermingle on occasion. Here's two things that happen to me a few times a year: I buy groceries with the company card because I forgot the personal card at home. Or, I absent-mindedly use my personal card to buy a piece of networking hardware that I want to be a business expense. I de-mingle these as they occur, and keep a paper trail. I have a separate forms that I use for payment back to the company, or payment from the company, and I copy the check, cancelled check, and bank statement line item for each one, as I do with other expenses.


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