Senior System Analyst wants to become a consultant

A LinkedIn user wonders about converting from a full-time employee to a independent contractor and is not sure about the billing rate he should use. He also wants to know about taxes and insurance. Here is my response:

My rule of thumb is that your starting hourly rate is your annual salary divided by 1,000. For example, if your annual salary is $80,000 then your hourly consulting rate would be $80 per hour to be equivalent. The big catch are the middlemen and they may bill you out at a rate they set and then pay you 50% to 90% of the proceeds. Note that many companies try to pay you less as a contractor than the equivalent employee would make. You shouldn't let yourself get suckered into this. However, you may have to take a pay cut to get established.

You will need to figure the taxes, insurance, etc. yourself or with your accountant. If you can't do this, you should not go out on your own. Many contractors are covered by their spouse's insurance because health insurance by itself can run $750 to $1,000 per month. But consider that, beginning in 2014, you may need to either provide your own insurance through your company or pay a penalty under the Affordable Care Act.

You should definitely line up an accountant before you go out on your own, not after. The accountant (I recommend a certified public accountant [CPA]) will help you decide the form of your business (C corporation, S corporation, LLC, etc.). Note that many companies will not contract with you unless you are a corporation or LLC this will help protect them from an IRS determination that you are an employee. The important thing is to this part correctly up front and not to wait until April 14 to think about this.

One of the requirements to be an independent contractor is that you pay yourself a salary and file all of the various employment tax returns required. In Ohio, you must keep track of your pay by municipality and file city and possibly school district tax returns for every city that you work in. Currently, I am filing in four cities and one Indiana county. My rule of thumb for your salary is about 50% of net billings.

With any client, you should offer to provide your own computer, typically a laptop. Having your own tools separates the independent contractors from the employees. The client may prefer you use their computer but at least you made the offer. Many times, I set up a separate virtual machine on my laptop for a client with their settings and policies.

Finally, get a copy of the "20 factors" and read them. The technical term for this is IRS Revenue Ruling 87-41 but this has been updated since then and it's not clear that the IRS even uses them in that form. The point here is that if your client is requiring you to be at work at a specific time and leave at a specific time, you may be considered an employee and not a contractor.

You may think that I'm trying to dissuade you from going out on your own. Au contraire. Although many contractors in the computer business have left due to the recession, some contractors have more job security than the people on staff. I was at a company once and heard that the staff was being cut by 10%. I went to my contact and said I felt bad that I was being kept on while others were being let go. He said, "You don't understand. They're paid out of the expense budget and you're paid out of the capital budget. There's a big difference." As it turned out, none of the IT people were laid off after all.

Let me know (through comments or direct email) if you have any questions.