Becoming Your Own Boss (BYOB, 3.3)

In the first and second articles of this series (BYOB, 1.0 and 1.1) you learned some of the facts related to the current employment picture and examined some of the choices that were available to you. In the third, fourth, and fifth articles of this series (BYOB, 2.0, 2.1, and 2.2) you answered some key question to find if starting as an independent contractor was a good idea for you.

This set of articles (BYOB, 3.x) covers a number of topics that will make it more likely that you will succeed as an independent contractor. The last article covered the office needs of your business as an independent contractor. This article goes into detail on obtaining and using the equipment you might need as an independent contractor. If you are to be an independent contractor, particularly in the professional career fields addressed in this series of articles, you will need some office equipment to start, and you will acquire more as you become established. To start, your equipment will probably include at least some of the following: computer(s), test equipment, printer(s), scanner, copier, tape recorder, desk, file cabinets, and tables. Getting started is probably not going to be cheap. What to do?

Converting Your Personal Equipment To Business Use

You probably already have an office area set up at home that includes some of the items (such as a computer, desk, tables, and so on) that you will need as an independent contractor. There is no problem with converting this equipment to business use as long as you keep as you keep the following precautions in mind:

1. If you intend to write off the equipment value on your taxes, it must be used solely in your business. If it is used partially for personal reasons (for instance, using a computer for kid's games or your spouse's hobbies), you may deduct only that portion that is used for business.

2. The value that you assign to the equipment must be the "then current value" of the equipment at the time of its conversion. This value is probably only a fraction of the price that you paid for it originally, and also a fraction of the price of replacement equipment.

3. If you later decide to return this equipment to personal use, you must recover (on your tax form) any residual equipment value for the business.

When starting out, you will be most concerned with cash flow and not overextending yourself. As the above precautions indicate, the tax implications of using your personal equipment will usually make it more advisable to buy new equipment at the first opportunity. Go ahead and use your personal equipment until then, but don't make a tax conversion unless you are willing to accept the tax implications that go along with it. Your tax specialist can guide you through the process if you decide to make the conversion on your tax returns.

Using Your Client's Equipment

Dependent upon the circumstances of a contract, some clients might offer equipment for your use. This option, at first thought, seems attractive, but it is undesirable for the following two main reasons:

1. From a practical standpoint, if you use the client's equipment for your first contract, you might be tempted to delay procuring your own. In such a case, you will not be prepared for the end of the contract because you will not be set up to perform for another client.

2 The second reason however, is more important because it might have an adverse impact on your tax situation. (For more information, see "Tax Consequences" later in this article.)

Buying/Leasing Equipment

The lease/buy decision is relatively clear-cut and uncomplicated. Unless you are really cash poor (which makes your launch into independent contracting risky), leasing is not very attractive from a purely economic standpoint. The following points and counter-points apply to the lease/buy decision:

Lease (1) - In almost every advertisement or sales pitch for leasing, the first advantage listed is that you need not tie up large amounts of possibly scarce capital in your equipment - capital that could otherwise be used for operations or for your contingency fund. In many instances (at least according to the advertising) you need pay only two months of lease payment (equivalent to the first and last) at the start of the lease.

Buy (1) - If you are a good credit risk, you will be able to obtain ordinary purchase financing with a minimum down payment, usually little more than two months of lease payments, and thus will not be forced to tie up large amounts of capital anyway.

Lease (2) - The advertisements suggest that the per-month cost to lease equipment of a certain value is less than the loan cost for the same amount. Upon closer examination, you will find that this is based upon a significant residual value at the lease conclusion. Such values are very difficult to recover on computers and other office equipment, so the monthly lease payments are not necessarily favorable.

Buy (2) - The overall costs of borrowing to purchase equipment are measurably lower than are the overall costs for most leases, particularly if you qualify for favorable rates. (Remember the question in the BYOB 2.x set about being on good terms with your banker?)

Lease (3) - It is often quicker and less difficult to arrange for an equipment lease than it is to arrange for a loan covering the same equipment.

Buy (3) - The terms for borrowing are usually less restrictive than the terms on a lease. For example, early payoff of a loan will ordinarily result in a rebate of some of the loan interest, but the lease fees (equivalent to interest) are seldom rebated if the lease is paid off early.

Lease (4) - You do not own leased equipment unless you elect to buy it at the end of the lease term.

Buy (4) - With a loan, you own the equipment and the bank holds a lien against it. This difference makes repossession slightly more difficult and sale or replacement of the equipment somewhat easier than it is with a lease.

If you are newly structured as a company, or newly incorporated, you will almost certainly not be able to borrow as a company to purchase equipment or to lease equipment.

As a new enterprise, you will be required to offer a personal guarantee for any financing done in the company name, whether it be straight borrowing or leasing.

Do not make the mistake of thinking that the bank or any other financial entity will treat your new company as something special, deserving of a new line of credit. At the start, you will be regarded as an individual in spite of any corporations, holding companies, or other legal fictions you create. The credit line that you hold as a company will be the same as the one that you had as an individual.

Tax Consequences

There are basically two aspects to the tax consequences pertaining to equipment: 1) the buy versus lease decision, and 2) the factors involved in the Internal Revenue Service employee determination.

With recent changes to the tax rules, tax advantages of leasing equipment are largely illusory. In addition, you, as the lessee, will almost certainly be responsible for any direct property tax on the leased equipment. In some states, this is called "personal property tax"; in others, it is called "business equipment tax". Whatever it is called, in most instances, this alone will more than offset any advertised tax advantages of leasing. The net effect of the taxes, when considered with the fact that the effective cost of the money is usually higher in a lease than in a financed purchase, virtually rules out leasing.

With other recent changes to the tax rules, using the client's equipment is inadvisable except under unusual and very carefully controlled conditions. Because one of the marks the Internal Revenue Service uses for determining contractor status pertains to ownership of the equipment on which the work is performed, using the client's equipment is permissible only as an adjunct to your own equipment. If you cannot accomplish most of the work on your own equipment, consider it almost mandatory to do at least some of the work on it. If you do decide to use the client's equipment on which to perform the work, do so only for short-term contracts and have your own equipment available for similar work.

NOTE: Throughout the life of your business, no matter how busy you are, it will be necessary (for your success) to continue to search for other contracts. For tax purposes, it will be necessary to keep appropriate records to document that search. If you use the client's equipment, the search and attendant records are especially important. Take extra precautions in such instances.

Changes on your tax return attract the attention of the Internal Revenue Service. Because your change to contractor status is an important and immediately visible change, it is very risky to add another attention getter. Using the client's equipment for a long-term contract is just such an attention getter; that is, not having and using your own equipment, for which you invested money, for which you are claiming depreciation, and for which there are the ordinary income and expenses associated with a legitimate business.

Using the client's equipment (except in very narrowly defined circumstances) can result in close scrutiny by the IRS, if not in an outright determination that you are an employee of the client. Either result can have unfortunate tax consequences for the client. If you are determined by the IRS to be an employee, the consequences for the client are severe indeed. And rest assured, if the consequences are difficult for your client, that client will not long remain your client.

Although it is not associated with tax considerations, there is one more point that we must make while we are on this subject.

If you cause a client difficulty with the IRS, that client will probably never again engage the services of an independent contractor, but will instead seek the required help from a larger job shop or service organization.

Thus, if you cause difficulty for a client, you cause difficulty not only for yourself, but for all other independent contractors in the business.

The next article in this series (BYOB, 3.4) addresses the important topic of insurance (of several different kinds) for independent contractors.

To read the rest of the series click here