Many people are used to working as employees in so-called "permanent" jobs, and are new to contracting. Here's how contract firms work - these are also called "job shops", "brokers", "agencies", or even "consulting firms", although most of them are really not true consulting firms, and some act more like temporary labor agencies. Some of these kinds of companies also have recruiters that do "permanent job" placements, but that's not relevant here, except that some will offer a "contract to hire" or "temp to perm" arrangement as well. This also describes our similarities and differences. It applies mostly to technical service contract work such as computer consulting and engineering but probably also applies somewhat to all kinds of freelancing.
Some of these firms (especially the real consulting firms and companies whose revenue isn't primarily obtained by farming out their people's labor to clients), typically the largest and richest ones or the ones that charge the most, hire "permanent" staff and pay them salaries and benefits and are responsible to keep finding projects for them to work on. If you finish a project and don't have another one right away you can take some vacation time or training or whatever, but even with these situations you don't usually get as much paid "bench" time as they say; after a few weeks if they can't find you another project they'll usually lay you off anyway. In either case, they typically bill your services out at a much higher rate than they pay you in salary and benefits. You might get the equivalent of 30-40% of the bill rate.
The other way most contract firms work, especially the ones often referred to as "brokers", is to hire a temporary employee just for a specific contract or project. They pay you hourly, usually a little higher rate, and usually little or no benefits, and they might let you buy some benefits out of your own earnings. Once you finish the contract, you're laid off unless they just happen to find you another one; most contractors find their next contract from a different firm entirely. Contractors that prefer to work this way do it because they like the better variety of work and the higher rates, and they don't believe in unlimited paid bench time anyway. They manage their money so that they have some savings to tide them over between contracts, they enjoy some vacation time and take some time out to take classes to upgrade their skills. They enjoy a degree of independence, and might work 9-11 months out of each year depending on the market for their skills and mostly on their own preferences. They usually get 50-70% of the billing rate, depending on which broker they work with and the specific arrangements. Most contract firms work both ways.
The temporary contract employee model above still has some disadvantages. Unless you accept whatever benefits you might be able to buy from your current broker on a pretax basis, you have only very limited opportunities to deduct your expenses, yet you're already taking much of the risk of an entrepreneur in that you have to earn your keep, and you're ultimately responsible to find your own work even though the broker helps with that. This also makes it difficult to build a permanent and stable set of benefits and job history for credit purposes. These are some of the reasons that many people prefer to work as Independent Contractors (IC's), either self-employed or incorporated. You take more risk but you can write off your expenses much more easily. You also have more responsibilities in paying various taxes, but because of this (the broker no longer has to pay payroll taxes and worker's compensation insurance on you), you should be able to get 70-80% of the billing rate in a typical deal where the broker still finds you a contract. Taking the extra payroll taxes into account, you come out about the same, though, except for the expense deductions you get.
Unfortunately, the brokers usually don't like this because it gives you even more independence, and the brokers often like to feel like they're controlling their people. Since you're in business for yourself, it also poses the potential opportunity for you to contract directly with clients, so brokers see you as competition, as a threat, rather than as a valuable free-lance consultant that can subcontract to them to help with their projects. In fact, if you could find the client contracts yourself (even though clients don't usually like to deal with individual consultants directly), or if you could find a separate marketing broker that would just find contracts for you for a percentage and then get out of the way, like an agent, a lot of the traditional employer-type brokers would no longer be needed.
For these reasons, around 1986, a powerful group of large brokers conned Congress into passing Section 1706, which makes the tax laws discriminate against the technical occupations such as computer programming that the brokers wanted to control. It causes extra tax problems for IC's in these fields, so this makes it easier for the brokers to force you to be their employee rather than letting you subcontract to them. If you're out of work and run out of savings and the only brokers that have the contracts you can work all insist on making you their employee, you don't have much choice, especially since these same brokers have used 1706 to con the clients into thinking that clients are more likely to get into trouble with the IRS if they let you contract directly with them, which is the exact opposite of the truth. Armed with 1706, brokers are often able to keep consultants from becoming successful businesses, even if incorporated, unless you can develop your marketing skills to the point that you can sell your services directly to clients, and even then you have to overcome their distrust of one-person businesses (even if incorporated). Many legitimate IC's were put out of business by 1706, which is exactly its real purpose, so that the big "consulting firms" would have less competition from the mostly better independent consultants.
That is why I organized my consulting firm in such a way as to overcome these limitations. I've had to struggle with these same problems for years, even though I incorporated and even had the IRS itself as a client, so I developed a modular structure that makes it easy for us to have several consultants, like a regular consulting firm, yet still give the consultants most of the same IC tax benefits (and even more) and independence. This gives you the best of both worlds, working in a group that can overcome these limitations because we have multiple contractors and clients plus the usual insurance, plus the advantages you would have as an IC. You also get about the same equivalent rate through us or better. And since you'll be part of our firm, not a subcontractor to us, we do not add to the number of parties in the deal, so 1706 does not apply to us. Yet, by working through us, you actually strengthen (or even establish) your IC status rather than jeopardize it as you would by working for other firms. We have effectively repealed 1706, as far as our people are concerned.
This has worked well in practice, because we've gotten much of our business over the years by subcontracting to brokers who tell all their other contractors "W-2 only". They recognize that we meet their criteria (or excuses), so they'll do business with us. This is our best benefit of all - our ability to make it possible for contractors to effectively work as an IC even on contracts normally available only on W-2. By joining us and maintaining your status with us, you also avoid flipping between IC and W-2 status, which can damage your IC status, and through us you show a permanent, stable company for credit records and also benefits so you don't have to change insurance, retirement plans, etc. every time you change contracts.