Becoming Your Own Boss (BYOB, 5.3)

In the first series, Becoming Your Own Boss (BYOB, 1.x) "Introduction, Today's Employment Picture", 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 second series, Becoming Your Own Boss (BYOB, 2.x) "Examining Your Situation", you answered some key questions to figure out if starting as an independent contractor was a good idea for you. In the third series, Becoming Your Own Boss (BYOB, 3.x) "Preparing for Business", you examined the numerous topics (from taxes and insurance to your need for equipment and an office) that need to be considered before you take the step to establishing an independent contracting business. In the fourth series, Becoming Your Own Boss (BYOB, 4.x) "Establishing Your Business" you learned the many requirements involved in operating a business from the business name and structure to the business forms you will need once you establish your business.

In this article you learn some of the methods of diversifying your client base and why this is important to your business survival.

Diversifying Your Client Base

A diversified client base is important for two reasons: 1) to reduce the risk of less than adequate income, and 2) to reduce the risk of tax problems.

Risk Of Lower Income: Of the two, the risk of income reduction is the more significant problem because it is the more difficult to guard against, particularly during the early stages of your business. If you have only one client, or one client who supplies a large majority of your work, that client exerts an inordinate amount of control over your livelihood. If that client suddenly cancels a contract, or reduces the magnitude of the task, or notifies you that there will be no follow-on contract, you have a problem. This is a particularly difficult problem because, if you work alone (as many contractors do, particularly at the beginning), you have rather limited resources to cope with a demanding client who likes your work and insists on using all of your time. You have little time for marketing and, even if you secure another contract, you have little time to do the work. There is also the danger that your discipline might falter. If you are working full time on a contract, it is very easy to fall into the "comfort trap" and simply forget to continue marketing efforts.

Remember that definition of reality from BYOB, 2.x:

"If you're selling, you're not working.
If you're working, you're not selling.
Both are required."

The key sentence here is: "Both are required."

Obviously, if you have several clients and one client reduces your contract volume, there is less risk for you because you still have other contracts or potential contracts. All is not lost however. There are methods for coping with a reduction in business with your principal client. Here are three:

First, there is your capability to work more than 40 hours in a week. It might reduce your other activities, and it might affect your home life, but it is often necessary. It is probably a wise move, at least during your early business life, to allocate 60 hours per week for work. You might not need it, but allocate it anyway. Then, if one client requires fulltime effort, there is still time for marketing and for doing work for other clients. If you find extra contracts and you do work more than 40 hours per week, the extra income can be used to pay debt down, or put into your contingency fund, or whatever. For most of us, it is not difficult to find use for extra income.

Second, there is the possibility of joint ventures and subcontracting. If you are offered or know of an available contract, but also know that you cannot possibly complete it alone, perhaps there is another contractor who could work with you on it. Perhaps the other contractor is also working full time, but is in the same situation as you are. A joint venture in such case would require that you submit separate invoices. A disadvantage in this is that you are effectively sharing your client with another. If this is not desirable or practical, perhaps you can subcontract part or even all of the new work to another contractor. To be sure, subcontracting has its dangers, particularly its tax dangers. (More on the tax problems in the next section.) However, with careful selection of the contractor, and careful attention to contract details, these problems are surmountable.

The desired end result is that the work be accomplished in acceptable fashion so that you end up with some profit, a satisfied client, and, most importantly, your reputation intact.

Third, there is the possibility of hiring an employee. This option is covered third because it is the least attractive. There are many problems associated with employees. There are also many expenses. Hiring an employee is not a step to be taken lightly, and it removes one of the more desirable factors of independent contracting - being responsible for only yourself. If you select this option, work out the details very carefully with your accountant and your attorney so that nothing falls through the cracks. Also, do not forget the fact that, if your principal client has lots of work, that client will probably overload your employee too as soon as the word gets out, and you'll be back at square one.

Risk Of Tax Problems: The second reason for a diversified client base, risk of tax problems, is extremely important, but it is somewhat less significant because it is somewhat easier to implement safeguards. Because the language of Section 1706 of the tax code is confusing to many people, and because of aggressive enforcement practices by the Internal Revenue Service, many companies are hesitant about doing business with independent contractors. In enforcement action, the principal risk is to the client, not the contractor, so the client's reluctance is at least understandable.

In summary of the problem, the perception by many companies is that, if you, the contractor, are not properly prepared for business regarding Section 1706, the IRS might determine that you are an employee of the client, and demand payment of all withholding taxes that would have been applicable since the beginning of the relationship, plus large penalties. This perception is mostly in error, but it exists nonetheless, and you must deal with it.

To preclude problems, any contracts that you negotiate with your clients should take into account the IRS definition of a contractor vs an employee. In practice, IRS uses a semiformal test, often referred to as the "20 questions", to determine employee status on a case-by-case basis. If you wish to obtain a ruling from IRS on a specific instance, the test is available in its official form from the Internal Revenue Service as IRS Form SS8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. To obtain a written ruling, write the answers to the questions on the form, then submit the form to the IRS. Again, in practice, it seems that you need not comply with every one to "pass" the test, but more complete compliance will offer higher confidence to the client. The book Tax and Business Handbook for Consultants and Clients, by Jonathan D. Wallace, contains an excellent treatment of the issue of Section 1706 of the tax code. Also, there is the article How to Avoid Getting Caught in the IRS Crackdown by R. Roth and A. Beibl in the May, 1991 issue of the Journal of Accountancy.

Obviously, if you elect to offer work to subcontractors, you place yourself in the position of client to those subcontractors. Because you, as a contractor, are doing work for your client, your business relationship with your client is similar to that between a client and a temporary agency (job shop), and you fall exactly under the requirements of Section 1706. Thus, you must take extreme care in such relationships. As a matter of course, you must make certain that you can answer the IRS questions properly to "pass" the test. However, it is even more important that you make certain that your subcontractor(s) can also "pass" the test because, in this relationship, you are at risk as the potential employer.

The next article in this series (BYOB, 5.4) addresses the topic of bidding for services plus the companion topic of performing services.

To read the rest of the series click here