For years, being an independent contractor meant paying more taxes, but with the 2017 tax reform changes the classification of independent contractor may be a much better choice.
Before your clients take the plunge into self-employment status or switch employees to independent contractors, here are some key points to help your clients understand their classification decisions, resulting tax effects and what happens if they make the wrong classification.
Defining the Classifications
Each year, the IRS updates Publication 15A, Employer’s Supplemental Tax Guide, with a section entitled “Who Are Employees?” A worker’s status is determined based on the degree of control in three categories:
- Behavioral Control – Facts that show whether the business has a right to direct and control how the worker does the tasks for which the worker is hired. If the business is telling you what to do, when to do it and how to do it, you are probably an employee.
- Financial Control – Facts that show whether the business has a right to control the business aspects of the worker’s job. If you are not experiencing the same business pressures an owner would feel, you are probably not running your own business and are, in reality, an employee.
- Type of Relationship – Facts that show the parties’ type of relationship. Independent contractors are free to work wherever and for whomever. If someone is dictating these facets to you, then you are probably an employee.
Impact of Tax Reform
The TCJA includes a new 20 percent pass-through deduction, available for pass-through business owners such as S-Corporations, LLCs and partnerships, but is also available to independent contractors. The pass-through deduction is calculated as the lessor of:
- 20 percent of qualified business income, net of business expenses; or
- 20 percent of the difference between taxable income (prior to the pass-through deduction) and any capital gains
However, there are some income limitations. If your client has more than $157,500 filing individual or $315,000 married filing jointly in total taxable income, prior to the pass-through deduction, they will be subject to one or more income limitations, including the wage and property limit, and the service businesses limit.
Let’s take a look at an example of an employee and an independent contractor both making and equal amount of pay and how the 20 percent pass-through deduction can save the independent contractor thousands of dollars in taxes. Then, let’s assume there is a W-2 employee receiving a $100,000 salary and an independent contractor receiving income of $107,650. (Gross up contractor’s pay: $100,000 x 7.65 percent Social Security tax = $7,650; $100,000 + $7,650 = $107,650.)
As you can see from this example below, working as an independent contractor will save the worker $3,955 in after-tax income.
However, before helping clients make any switches, keep in mind there are consequences to making an incorrect classification. Making an incorrect classification of independent contractor when workers are employees can cause the worker to be held responsible for all back federal and state payroll taxes, unemployment taxes, and employment benefits.
To best assure a favorable outcome in the event of tax scrutiny, encourage clients to:
- Have written contracts or arrangements with independent contractors
- Have an attorney review all documents
- If need be, request assistance from the IRS in determining status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
Guiding your clients through tax reform is good for you and good for them; it positions you as a trusted advisor and could lower their tax liability!
January Colandrea, CPA, is a Tax Content Analyst working at Intuit ProConnect for ProSeries in San Diego, CA. Prior to joining Intuit in September 2016, January worked as a senior tax analyst in public accounting and worked in private industry specializing in international taxation.