W-2 Converted to 1099

By Jason Watson, CPA
Posted Monday, October 23, 2023

One of the biggest pushes into the S Corp world is when your employer decides to convert you from W-2 to 1099. You are fired on Friday and brought back on Monday as a contractor. Now what?

To refresh your memory, when you are paid a W-2 salary your employer pays for half of the Social Security and Medicare taxes associated with your income. Conversely when you are paid as a 1099 contractor, you pay both halves of the Social Security and Medicare tax.

Another nice feature of being paid a W-2 salary is the built-in budgeting since your taxes are taken out before the direct deposit into your checking account. On the other hand, 1099 income is raw- just a big ol’ fat check ready to spend.

Businesses like to have contractors versus employees since it cuts down on cost and offers more flexibility. Some businesses can easily exceed a factor of 1.5 for a fully burdened labor rate. For example, if you are being paid a $100,000 salary, the cost to the employer could be $150,000 after you factor in payroll taxes, 401k contributions, pension funding, health insurance, vacations and sick pay, office resources, etc. This would be a factor of 1.5.

Another benefit of deploying contractors is when a business needs to shrink, it simply ends the contract or reduces it dramatically without much hoopla. If Northrop Grumman laid off 10,000 workers there would be congressional hearings. If they cancel 10,000 contracts with sub-contractors, no one pays any attention to it.

Some employers, such as Verizon, have recently gotten in trouble by converting too many W-2 employees into 1099 contractors. The IRS and several states see it as an end-around. Many one-person S corporations are probably disguised W-2 employees so this is a sensitive subject.

Regardless, when entertaining being converted from W-2 to 1099, consider the fully burdened labor rate of your employer. If you were making $100,000, you really need to make at least $130,000 or more to come out ahead. You win, they win.

Don’t forget that as a 1099 contractor you now can rifle a bunch of expenses through your business that were otherwise limited or not allowed. Wait! What? Let’s take mileage as an example. If you are paid as a W-2 employee, you cannot deduct mileage expenses since 2017. But if you are paid as a contractor, your business can either own the car and deduct actual expenses, deduct mileage (Schedule c) or reimburse you for mileage (S Corp). Not just one option, baby, but a 3-pack of ‘em.

Being converted from a W-2 employee to a contractor is risky since the connective tissue is reduced dramatically, but generally it is a good thing since it puts you in a better tax position (and you might actually make more money). However, don’t leak that out during negotiations.

Lastly, create an LLC and tax it as an S corporation, or at least consider it. In another chapter we’ll review some of the reasons an S Corp election is not good. In yet another chapter, we take the W-2 Converted to 1099 one step further when considering a reasonable shareholder salary.