W-2 Converted to 1099 Reasonable Salary

By Jason Watson, CPA
Posted Thursday, November 2, 2023

So, you are bumping along and one day your employer decides to convert you from a W-2 employee to a 1099 contractor. Fired on Friday. Same duties on Monday. Aside from this being a load-shedding sham that the IRS and most states believe to be an end-around, several large businesses continue to reduce their workforce in favor of contractors.

You say, no problem, and eventually create an LLC taxed as an S corporation. Now what? Do you peg your salary to the same salary you had before? Hardly. Labor burden rates for businesses can vary from 1.4 to 2.0. What does this mean? This means if a business is paying you a $100,000 salary, your actual cost to the business might be as high as $200,000. Why?

Health insurance, dental insurance, paid time off, vacation, sick pay, holiday pay, payroll taxes, workers’ compensation insurance, disability, group life insurance, office rent (smaller workforce smaller office footprint), overhead, etc. Yeah… read that again. There are a ton of direct costs that gets tacked on to you as an employee. Don’t forget profits too. No wonder the business just converted you from W-2 to 1099. Mo’ money! Just not for you.

How does this factor in the reasonable salary conversation? Let’s say your business’s labor burden rate is 1.8 which is not far off most big, fat corporations. This would suggest that a $100,000 salary costs the business $180,000. If you are paid $100,000 as a contractor (which would be a crummy deal), then your relative salary could be $55,000. You shouldn’t get penalized if you run a leaner operation than your former employer.

What about the risk of this new arrangement? As a shareholder in an S corporation, you are assuming a ton of risk- equity risk, industry risk, small business risk and business-specific risk. If we perform a business valuation where the business has a singular client, the risk of the future economic benefit (income stream) is huge.

As mentioned elsewhere, as risk increases, we as the investor demand a higher rate of return, or as the shareholder, increased distributions. Makes sense, right?

Mini recap- labor burden rate plus increased risk of singular client can suggest a lower salary than the old W-2 job. And… being converted is not a bad deal- business car, your own 401k, various other deductions that were mostly unavailable to you, business casual means PJs, etc.