Financial Consult: What’s the big deal about having employee status?

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Last month we discussed the nuances of being an independent contractor (IC). While IC status does have its advantages, there are numerous advantages to taking the traditional route of becoming an employee.

Last month we discussed the nuances of being an independent contractor (IC). While IC status does have its advantages, there are numerous advantages to taking the traditional route of becoming an employee.

Tax Issues
As you probably know, an IC receives a 1099 form whereas an employee receives a W-2 form to file with federal and state income tax returns. The key difference is the amount of taxes that are withheld. An employee’s monthly paycheck equals net income after taxes are withheld while an IC’s paycheck is gross income with no taxes withheld. ICs, therefore, must pay quarterly estimated taxes while employees generally do not. Several problems arise from the payment of estimated taxes. First, most physicians probably won’t be able to accurately predict their yearly income, especially if there is any incentive based compensation. Second, even if you know your exact gross income, it’s difficult to estimate deductions and therefore taxable income. In other words paying estimated taxes involves a lot of guesswork. That would be fine if the IRS wasn’t so picky. If you don’t pay estimated taxes equal to an amount within 10% of actual taxes due, or 110% of previous year’s taxes (assuming income greater than $150,000), then you subject yourself to underpayment penalties. On the flip side, being an employee does not necessarily eliminate estimated taxes. It lessens the chances, but if you have other sources of taxable income, such as taxable dividends or capital gains, you might find yourself in this boat. And if you do find yourself paying estimated taxes, take solace in the fact that the quarterly schedule gives you a chance to earn a bit of extra interest over a three month period.

Unlike ICs, which are responsible for paying the full amount of Social Security taxes on their income, an employee splits the payment of Social Security taxes (or FICA taxes) with the employer. So, on the first $102,000 of 2008 income, instead of paying the full 15.3% Social Security tax, both you and your employer pay 7.65%. On amounts above $102,000 you and your employer each pay 1.45%. However, unlike an IC you are not allowed to deduct any part of the Social Security tax from your income tax return. While the difference may seem large, ICs are generally compensated more than employees.

One potential drawback to employee status is the limited business expense deductions. ICs can directly deduct a large amount of business deductions on Schedule C, but employees can typically deduct only unreimbursed employee business expenses which exceed 2% of their income. The good news is that employers usually reimburse employees for large business expenses (such as CME) or pay certain large business related expenses (such as malpractice insurance) as benefits, so effectively there is not much of a difference between an IC and an employee from a tax perspective. Also, there may always be an unintentional tendency for ICs to deduct certain expenses which are not allowed, thus opening up the risk of IRS audits.

Perhaps the greatest advantage of being an employee is the plethora of pretax benefits. Common employee benefits include retirement plan contributions, short and long term disability insurance, health insurance, group life insurance, CME allowance, and malpractice insurance. While ICs have maximum flexibility of benefits, often the task of choosing the type and amount of benefits is time-confusing and frustrating. Most employee groups have a dedicated human resources department or official who can shop around for the best deals. One way employees can now compete with ICs in terms of benefit flexibility is the use of cafeteria plans, which allow employees to choose among a menu of supplemental benefit options, including additional life insurance or medical reimbursements among others. Also, since group policies have easier eligibility requirements (medical exams usually are not required), you may qualify for certain types insurance (such as life insurance) on a group basis but may not qualify on an individual basis. Some insurance (health insurance for example) may also be cheaper than individual insurance.

Employees can fund retirement through employer sponsored retirement plans, the most common being a 401 (k) plan. Just like an IC, it is possible for contributions into this plan to equal $ 46,000 in 2008. However, in a 401k plan, the employee can only contribute a maximum of $15,500. In order to fund the 2008 maximum, the employer must contribute the difference (profit sharing). Most employer sponsored retirement plans offer a limited number of mutual fund and investment choices. While this setup avoids the confusion of selecting from a vast sea of mutual funds in IC retirement plans, most options I have seen have high fees and poor diversification (although some plans are self-directed to provide investment flexibility). Also, most employee retirement plans will have a vesting schedule, which means that you won’t actually fully own your employer contributions for several years (up to six). If you switch jobs, you will forfeit a certain percentage of your employer contributions (as much as 80%!). IC retirement plans don’t have this nuisance.

Group short term disability benefits are generally available to employees but not to individuals. A short term disability is covered up to one year, at which point long term disability benefits kick in. Remember that unlike an IC, who pays the disability premium, if the employer pays your disability insurance premium, then benefits are taxable to you. For those physicians considering switching into an employee group practice, if you already have an individual long term disability policy, you can potentially have more total disability benefits once you become an employee due to now owning two policies (individual and group).

Life insurance is typically provided as term insurance and is a multiple of salary. Be aware, however, that if the employer pays premiums for life insurance for a benefit amount greater than $50,000 then those premiums will actually be taxable to you. Also, usually the amount of group life insurance protection is inadequate for most physicians and so you will have to supplement with an individual policy anyway.

Ultimately the most important decision to make is how well you fit in with a particular group. Given two equally desirable groups, which is better: IC or employee? If you want maximum flexibility in tax deductions, retirement plans, and choice of benefits, IC is the way to go. If you want more structure, more tangible and affordable benefits, and less administrative headaches, employee status is right for you.

Acknowledgments: Thanks to the physicians and staff of EmergiNet and Northside Emergency Associates, particularly Michael Bourland, MD and Robert Higgins, MD

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