1099 to W2 conversion: what salary to offer when you convert a contractor to an employee

To decide what salary to offer a contractor you are converting to a W-2 employee, price the role at market as a salaried job first and make the offer from that band. Do not convert the contractor rate. Multiplying an hourly billing rate by 2,080 produces a number that is usually far too high, because the rate was never pure compensation. It was funding self-employment tax, health coverage, unpaid time off, equipment and every unbillable hour.

The classification decision itself is a separate question, and it should already be settled before you get here. If you are still working out whether a worker has to be an employee at all, start with 1099 vs W2 classification, which covers the DOL, IRS and state ABC tests. This article assumes you have made that call and now have to put a number on the offer.

Why the contractor rate is the wrong starting point

The instinct is understandable. You know exactly what this person costs today, so you reach for that number. The trouble is that a billing rate and a salary are different units, and the conversion breaks in two places at once.

The first break is hours. Nobody bills 2,080 hours a year. Contractors lose time to unpaid holidays and sick days, to invoicing and bookkeeping, to finding the next engagement, and to gaps between projects. Somewhere between 1,500 and 1,700 billable hours is a realistic year for a solo contractor working steadily. Using 2,080 overstates their actual revenue by roughly a quarter before you have accounted for anything else.

The second break is what the rate had to cover. A self-employed person pays self-employment tax at 15.3 percent, which the IRS splits into 12.4 percent for Social Security up to the annual wage base and 2.9 percent for Medicare on everything. An employee pays half of the equivalent, because you pay the other half. The contractor was also buying their own health insurance, funding their own retirement with no match, absorbing their own software and equipment, and taking every day off unpaid.

A worked example: what a $75 an hour contractor is really earning

Take a contractor billing $75 an hour. The figures below are an illustration with stated assumptions, not a formula, but the shape holds for most conversions.

• The naive number: $75 times 2,080 hours equals $156,000. This is the figure that derails conversations.
• Actual billings: at 1,600 billable hours, $75 an hour is $120,000 of business revenue.
• Business overhead: assume $6,000 for software, equipment, liability insurance and an accountant. Net earnings of about $114,000.
• The extra tax an employee would not pay: self-employment tax applies to 92.35 percent of net earnings, or roughly $105,300 here. The half an employer would otherwise carry is 7.65 percent of that, about $8,050.
• Health coverage: assume $7,200 a year for an individual plan they were buying themselves.

Strip those out and the contractor's employee-equivalent position is roughly $98,000 to $99,000, before you credit the paid time off, retirement match and disability coverage an employee gets and a contractor does not. So the honest W-2 comparison to a $75 hourly rate is a salary somewhere near $95,000 to $100,000 plus benefits. Not $156,000.

Now check your own side of the ledger

Run the same arithmetic from your seat and the result tends to surprise people in the other direction. On a $98,000 salary you pay the employer half of FICA at 7.65 percent, about $7,500. Add federal and state unemployment taxes, which are small per employee but real, and a benefits contribution in the region of $12,000 for an individual on a decent plan. The fully loaded cost of the employee lands close to $118,000.

You were paying that contractor $120,000. The total barely moved. What changed is who carries the overhead, who absorbs the slow weeks, and who is exposed if the classification was wrong in the first place. That framing is worth having ready, because the conversion is often pitched internally as a cost increase when it is mostly a cost transfer.

The operational change is real even when the money is not. Their invoices stop arriving in accounts payable and their pay starts running through payroll on a fixed cycle, with withholding, a pay stub and whatever notice rules your state applies to pay changes.

The sequence that actually works

The reason to do the contractor arithmetic second rather than first is that it is an explanation, not a pricing method. If you anchor the offer to what one person happened to be billing, you import their negotiating history into your pay structure, and you will not be able to explain the result to anyone else in the same job. Price the job, then explain the number.

1. Benchmark the role, not the person. Establish what the job pays in the market the employee actually works in. Our guide to market pricing a job covers matching the role to survey data by scope rather than by title.

2. Build the band around it. A single point estimate gives you nowhere to put someone. A minimum, midpoint and maximum tells you whether this hire lands at 90 or 110 percent of midpoint and what that implies for everyone already in the band. See salary bands for how to set the spread.

3. Check the band minimum against the exempt floor. If you intend the role to be salaried exempt, the salary has to clear the applicable threshold, which is higher than the federal $684 a week in six states. The current figures are on exempt salary threshold by state.

4. Decide exempt or non exempt on the duties. Clearing the salary floor is necessary and not sufficient. A converted contractor is often a specialist individual contributor whose work does not match any of the duties definitions, which makes them non exempt and means their hours have to be tracked from day one. Work through exempt vs non exempt before you set the schedule.

5. Handle the posting and notice duties. If you advertise the newly created role publicly, several states require a good faith range in the listing, and that range should come from the band rather than be invented for the ad. See job posting salary ranges.

How to run the conversation

Lead with the arithmetic, not with the offer. Most contractors have genuinely never costed their own benefits or counted their unbillable hours, so the gap between $156,000 and $98,000 feels like a pay cut until they see where the difference went. Walk through billable hours first, then the 7.65 percent of self-employment tax they stop carrying, then the health premium they stop paying, then the paid time off they start accruing.

Be straight about what they lose too. They give up rate flexibility, the ability to take other clients, and some autonomy over how the work gets done. Pretending otherwise damages your credibility on the parts of the conversation that matter more.

One practical warning: do not bridge the gap with a side arrangement that keeps part of the relationship on a 1099. Paying the same person a W-2 for their job and a 1099 for additional hours of that same job is one of the clearest misclassification patterns there is, and it typically creates an unpaid overtime problem at the same time.

How do you convert a contractor rate to a salary?

You do not. Benchmark the role as a salaried job in the market where the person works, build a band around that figure, and make the offer from the band. The contractor rate is useful afterwards, to explain the offer, because it was covering self-employment tax, health coverage, unpaid time off and unbillable hours that the salary no longer has to.

Does converting a contractor to an employee cost more?

Usually less than employers expect. Once you add the employer half of FICA at 7.65 percent, unemployment taxes and a benefits contribution to the new salary, the fully loaded cost often lands close to what the contractor was already billing. What changes is not the total, it is who carries the overhead and who carries the risk.

Should a converted contractor be exempt or non exempt?

Decide it on the duties, not on the fact that they are now salaried. Many converted contractors are individual contributors doing specialist work that does not match the executive, administrative or professional definitions, which makes them non exempt. The salary also has to clear the exempt threshold in that state before exempt is even on the table.

This article is general information about published tax and wage rules, not legal or tax advice. The dollar figures in the worked example are illustrative assumptions, not published rates, and benefit costs vary widely. Confirm your own position with the relevant agency or with counsel before reclassifying anyone.