Billing rate arithmetic: Salaried vs hourly equivalencies

 11 min read

Employers are often highly misguided regarding how to determine fair hourly rates for contractors.  With individual clients to whom one acts as a consultant, negotiations are based on supply and demand, and defined as a fixed-scope, flat-fee arrangement (with the consultant doing the math for herself to ensure that the implicit hourly rate for the anticipated hours of work is above their break-even threshold).  However, when employers bring in an individual contractor as a commitment-avoidance measure, they are often seriously mistaken about how to calculate a pay rate.

Usually, people can all agree on what a person’s approximate market value is in terms of annual salary.  Controversy only arises when doing the arithmetic to convert an annual salary to an hourly equivalent.

In this calculator, the default values reflect an example annual salary of $100k, actual tax rates for a person earning at that level, and reasonable assumptions about business expense deductions, productivity, health insurance costs, and vacation days.

Explore the calculator with the link below — use your own inputs!

Wage format effect on contractor billing rates
 
Gross annual income
Gross hourly pay (amount specified in contract)
Taxes paid by employer
FICA
Taxes paid by worker
FICA rate payable
FICA effective rate, after applicable biz expense deductions
Effective income tax rate (tax paid / total income), after applicable biz expense deductions, FICA payment deductions, self-employed health insurance
Additional hassles
Net hourly pay
Benefits
Vacation and holiday pay
Health insurance
(Retirement savings and other benefits ignored)
Productivity
Net annual take-home
Employee
Contractor
Service Provider
W2 full-time salaried
Undocumented
W2 hourly
1099 - Schedule C
1099 - Schedule A
Corp-to-corp (single shareholder)
$
$ 88696
$ 118816
$ 123922
$ 99582
$ 104338
$ 48
$ 58
$ 78
$ 81
$ 68
$ 86
 
%7.7
%0.0
%7.7
%0.0
%0.0
%0.0
 
%7.7
%0.0
%7.7
%15.3
%0.0
%15.3
%7.7
%0.0
%7.7
%13.8
%0.0
%15.3
%20.0
%0.0
%17.7
%14.6
%15.0
%16.7
n/a
n/a
n/a
quarterly estimated tax pmts
n/a
incorporation, bank acct setup, monthly payroll tax, unempl. tax, possible state-specific taxes
$ 34.78
$ 58.17
$ 58.17
$ 58.17
$ 58.17
$ 58.17
 
%0
%)10(
%)10(
%)10(
%)10(
%)10(
$ -
$) 350(
$) 350(
$) 350(
$) 350(
$) 350(
 
%100
%70
%70
%70
%70
%70
$ 72350
$ 72350
$ 72350
$ 72350
$ 72350
$ 72350
 
Assumptions:
Worker's aggregate tax rate (from prior year returns)   % (federal "total tax" on form 1040 line 61 + state "total tax" / federal "taxable income" on form 1040 line 44)
Worker's effective tax rate (from prior year returns)   % (federal "total tax" on form 1040 line 61 + state "total tax" / federal "total income" on form 1040 line 22)
Does the worker itemize deductions? (check box if yes)      
Business expense deductions (% of gross receipts)   % (it is common to have deductible expenses equivalent to 5 - 20% of gross receipts)
Productivity (avg % of 40-hr work week billable)   % (One unpaid lunch hour per day alone brings productivity down to 88%; one hour per day of unbillable admin work brings it down to 75%; one week of unbillable sales work after each completed project 4x per year brings it down to 67%. However, increase this if you want to mentally account for some of your nonconsensual downtown as valuable time off, or if you are comfortable planning to work additional billable hours evenings and weekends to offset the unbillable time (note in that case you are no longer making an apples-to-apples comparison of equivalent pay rates across salaried and contract jobs.))
Monthly group health insurance premium $   (assumes employer pays full amount in W2 salaried scenario, and that worker can get insurance at equivalent rate in other scenarios)
Annual vacation days   20    
Annual paid holidays   10    
FICA tax rate   15.3%    

 

Now, let’s see how hourly rate equivalencies vary, depending on the business context.

Example #1:  A temporary staffing firm offers you hourly work for a 3-month project.  Hours will be consistently 40 hours per week throughout, with a clear, contractual scope in place.  Pay is typically W2 hourly with this type of placement firm.

You are worth $100k in the market as a full-time employee.  Because this could turn into a contract-to-hire situation, your rate should at least be equal to the mathematical equivalent of $100k.  Productivity is fairly high, at 80%.  Business expense deductions are very minimal because you’re working in their office.  Risk premium is minimal because it’s a long-term, stable project.  Ask for $75 per hour as a floor rate, which would make you indifferent between hourly and converting to full-time salaried at $100k.

Example #2:  A random business contact offers you a one-off, two-week project while you’re between jobs.  He’s going to pay you with a personal check, as this is a random gig for both of you.

Given your $100k market worth, you would hope to get $50 per hour from him. Productivity and lifestyle are less of a consideration because it’s a short-term project, and you were in between gigs anyway.  If he surprises you by instead issuing a 1099, know that you can file a Schedule A because this is your only contractor gig this year…and ask him to be fair and gross the pay up to $60.

Example #3:  Your main gig is being an independent consultant, and you do projects for various clients, ranging from a few weeks to a few months on an on-going basis.  Clients pay you with a 1099.

The fair rate equivalent to your $100k full-time salaried fallback alternative is $80 per hour.  Productivity loss and risk premium are substantial, given that you have to scramble to find your next client after each project, and that project workflow is volatile and controlled by your clients’ waxing and waning appetites.  For part-time, short-term work where someone only wants your expertise advising them a few hours here and there, ask for $100 per hour.  If you consistently earn less than $80, you’d be (financially at least) better off reverting to a full-time salaried job. 

Ultimately, you should explore this model with your unique assumptions — and then layer in your values and subjective preferences.  Come up with a firm understanding of your real indifference points.  When someone asks you off-the-cuff what your rate is, you can speak confidently on the topic…and back it up with a simple arithmetic explanation, if they are taken aback by the number.  

As a starting point for your exploration, here are suggested 1099 indifference points for workers with other market values:

$125,000 –> $110/hour
$175,000 –> $150/hour
$250,000 –> $220/hour

Assumptions built into this model:

  • Unemployment insurance tax (applicable to corp-to-corp setup) is negligible and not included
  • Retirement contribution effects — which can be substantial if the worker has a very high savings rate — are not included.
  • Corp-to-corp setup here assumes all corporate net taxable income is paid out as “wages” to the single shareholder, rather than “distributions” (which avoid FICA tax, and thus slightly lower the overall tax burden for the corp-to-corp setup). Overall premise of model is that total income is less than around $150k (b/c after that, FICA calcs change and deduction caps being to apply), and that income is derived from business consulting. Given requirement to pay shareholder “reasonable” wages, it’s unlikley that at this level there would be much in distributions.
  • Model does not contemplate any other benefits for the W2 salaried case, though there are often numerous other financially significant benefits and perks.  These would serve to make hourly rate break-evens even higher.

Observations about the model’s calculations:

  • Tax rates are based on worker’s prior year return, implying that the contractor setup is a new one going forward, compared to W2 salaried work in the past. If that’s not the case, the model’s calculated pay rates may be too low (because of possible double-counting of prior year biz expense deductions plus biz expense deductions assumed in model), but relative pay rates across scenarios will be approximately correct.
  • The “aggregate tax rate” is used in a ratio with “effective tax rate” to estimate default deductions of worker and incorporate those into all scenarios.
  • The best way to calculate arithmetic equivalencies for your particular tax situation is to just fill out sample tax forms for all your relevant cases.
  • Your personal inifference points across pay structures (i.e., beyond arithmetic equivalency) will vary due to individual utility of: flexibility, predictability, job security, hassle factor.
  • If you can generate deductible expenses over about 25% of income (highly unlikely), you wind up with equal tax burden in w2 salaried and 1099 cases; then its all about productivity, vacation, and health insurance (and retirement)
  • People focus on the nitty-gritty tax calculations, but in comparing salaried vs hourly work, the real variation in value of different pay structures comes from assumptions about productivity, vacation, health insurance, and retirement savings.

 

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