[Important Note to Readers, 1/15/18: This post is dated May 2017, before the final tax plan was passed, and the final version is slightly different than described in this post. For a revised 2018 analysis based on the final tax bill, click here.]
President Trump’s tax plan, released last week, is great news for independent contractors. Contractors may be able to cut their tax rates by half (or more) by creating an entity, instead of contracting as an individual. Indirectly, this would help companies who use contractors as well. Here’s why:
Benefit to Individuals:
For individuals, the proposal would reduce personal tax rates modestly. An individual being paid as an independent contractor will likely see a reduction in marginal tax rates, but the range is likely to remain somewhere between 25% and 35%, depending on income level.
For individuals being paid through their homemade entities, however, the proposal could result in substantial savings. Currently, pass-through entities like LLCs pay taxes at the rate of the individual. The sole owner of an LLC would pay taxes on the LLC’s profits at the individual’s personal income tax rate, likely between 25% and 35%.
Under the proposal, however, pass-through entities such as LLCs and partnerships would instead be taxed on pass-through business income at 15%. That’s a sizable savings compared to 25-35%. [Note 9/29/17: Latest proposal would tax entities at 20%, not 15%, but there’s still a long way to go before any of this becomes law. And it may never become law. For now, it’s just a proposal.]
If this proposal passes, individual independent contractors will have a strong financial incentive to incorporate. Creating an LLC is relatively inexpensive. If it leads to a much lower tax rate, incorporating is going to be worth the small investment for most individual contractors.
Independent contractors would then enter into agreements on behalf of their entity (such as Todd Lebowitz, LLC) instead of as an individual (Todd Lebowitz, human with back problems). The Independent Contractor Agreement would then be a business-to-business agreement, rather than business-to-individual.
Benefit to Companies:
The shift to business-to-business agreements also helps protect the companies who retain independent contractors.
Companies who contract with businesses, instead of with individuals, are in a better position to defend against a challenge that the contractors are misclassified and should really be employees — the ever-present Independent Contractor vs. Employee battle.
By contracting with the individual’s entity, the company is in a better position to demonstrate that the arrangement is a business-to-business transaction, not an employment arrangement disguised as an independent contractor agreement.
Remember, most of the tests for determining Who Is My Employee? are multi-factor balancing tests. (Read more here, here, and here.) The fact that the contractor is in business for himself or herself is a factor that weighs heavily toward legitimate independent contractor status.
Independent contractor status is further enhanced if the contractor truly operates that entity as its own business, such as by having business cards, a website, invoices, letterhead, and other customers, all through the business’s name instead of the individual’s name.
For now, Trumps’ tax proposal is just a proposal, and the path through Congress is a long and winding road that leads to your door, will never disappear, I’ve seen that road before, it always leads me here, leads me to your door.
Sorry, got distracted there. We’ll see what happens, but the idea of taxing pass-through entities at a lower rate than the individual owner of the entity is an idea that (if passed) should change how most independent contractors do business.
A secondary effect of that change would be to improve companies’ defenses against claims that independent contractor relationships are really employment in disguise.
Don’t leave me standing here, lead me to your door.
© 2017 Todd Lebowitz, posted on WhoIsMyEmployee.com, Exploring Issues of Independent Contractor Misclassification and Joint Employment. All rights reserved.