Switching to Contract Work From Full-Time Status Can Result in a Tax Break

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Here’s a nice little brain-teaser for tax preparers: How much can you help clients who are taxpayers save on taxes by converting them from employees to contractors or sole proprietors?

On the other hand, how big a headache will this be for their employers?

Courtesy of the new tax law, employees can change their status if their taxable income is less than $157,500 for singles or $315,000 for joint filers, according to Steven Rosenthal, senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute, an attorney and former legislation counsel with the Joint Committee on Taxation. His advice was posted on the Tax Policy Center’s website.

“In effect, Congress flipped traditional tax-planning upside down:  in this instance, many moderate-income workers may be able to exploit a tax break that higher-income workers cannot,” Rosenthal writes.  “And by shifting their status from employee to contractor, workers potentially can reduce their taxes by thousands of dollars.”

That comes to mind Form 1099, though we have to wonder whether almost $160,000 actually is considered moderate income.

Well, according to Rosenthal, here’s how this could work. The new law creates a 20 percent individual income tax deduction for income from pass-through businesses, such as sole proprietors and partnerships, he writes. Thus, that reduces the income tax rate for a sole proprietor more than for an employee with the same income.

Legislators denied the deduction to high-income owners of service businesses, such as law firms, but allowed it for lower-income service business owners and owners of other types of businesses.

Naturally, the key obstacle here — which Rosenthal doesn’t really get into — is how easily someone can convert their job status, if at all. Not all employers may allow employees to charge independently for their services, he notes.

Converting a job status will take some negotiating, and employees should consider the loss of job security (if that ever really exists), organizational support, and retirement and health benefits.

But if it works to employees’ benefit, the switch can mean tax savings and deductions for business expenses. Sole proprietors use Schedule C of Form 1040 and that allows a wide range of deductions, including the business use of a vehicle and use of a home office, Rosenthal states.

Here’s an example that he offers. A married couple, in which each spouse earns $100,000 in salary, opts to have one of them become a consultant for the same total pay. That pay includes the employer’s share of payroll taxes, which is 7.65 percent — making the consultant’s new self-employment income $107,650. The couple could save more than $5,000 a year by negotiating the new work deal, Rosenthal notes.

Presumably, legislators knew that “more tax planning could shift down the income scale from the new preferential tax treatment for income from pass-through entities, but may have assumed the tax savings would be too small to pursue,” Rosenthal states.

About Terry Sheridan

Terry Sheridan

Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.

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Jan 29th 2018 17:02

This is such a gray area and a wee bit dangerous to imply that employees can just become contractors.

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Jan 30th 2018 23:14

The whole issue of "firing" yourself as an employee and "rehiring" yourself as a consultant/independent contractor sounds nice in theory but is a landmine in practice. It just isn't that simple. Among the various tests to determine employee status (the main one being control) are time (do you spend 40 hours a week working for one entity? You're probably an employee) and percentage of total income (does, say, 80% of your total income come from one source? You're probably an employee of that entity). The whole concept of "independent" contractors is no one entity makes up a significant portion of your income and you perform services for many different businesses.

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