Employee or Contract Labor

With the economy being in turmoil, a lot of people are turning to contract labor jobs. That’s where the company doesn’t hire you as a regular employee, even though you work for it. You won’t receive a W2 at tax time, but you will receive a form 1099MISC and you will be expected to pay tax on that.

Contract labor is good for employers who are a little gun shy over hiring. It’s also good for employees who may need to work to put food on the table, but don’t want to commit to a job that they wouldn’t ordinarily take.

If you’re thinking about accepting a contract labor type job, here’s a few things you should know. First, when you receive a form 1099MISC, the IRS treats that as self employment income. That means, at tax time you’re going to have to file a Schedule C along with your 1040 long form. You will be required to pay your own Social Security and Medicare taxes, in addition to paying what your employer would normally have withheld.

Let’s use an example: Heather and Melanie are both high school seniors looking for summer jobs. Heather gets a job at McDonald’s making $10 an hour. Melanie gets a contract labor position also making $10 an hour. They both work 20 hours a week. Since this is the only income the girls will make all year, we’re not even going to look at regular income tax (they won’t owe any) we’re just going to look at their take home pay and self employment taxes.

Since Heather works as an employee, McDonad’s is required to withhold her Social Security and Medicare taxes (FICA). Heather makes $200 a week, but she’ll only take home $184.70 because McDonald’s will hold back $15.30 to pay her FICA. What most people don’t realize is that in addition to the money McDonald’s holds out of Heather’s paycheck, McDonald’s also pays an additional $15.30 towards Heather’s FICA. At the end of 12 weeks, Heather will have $2,216.40 that she was paid by McDonald’s. She will owe no income tax at the end of the year.

Now let’s look at Melanie. As a contract laborer, Melanie has no FICA withheld from her pay. For one week, she gets a check for $200. At the end of 12 weeks, she’ll have been paid $2,400. The difference here is that Melanie will have a tax bill of $339 that she’ll owe at tax time. After paying her taxes, Melanie will only have cleared $2,061.

[Geek alert: if you checked my math, you’d say. “but 2400 times 15.3% is $367” -and yes, you’re right. The first $433.13 of self employment income isn’t taxed so the actual equation is income x .9235 x .153.]

In our example here, it’s better to be hired as an employee because the company pays half of your payroll taxes. But that doesn’t mean that you should not take that contract labor job. For one thing, you may be able to write off some of your job expenses, which would reduce your self-employment taxes. Or, you might negotiate a higher hourly wage rate. An increase of 7.65% would basically cover the additional tax paid by the employer. Knowledge is power. Knowing how you’ll be taxed and how much you’ll be taxed let’s you make smart decisions.