A deep dive into the implications of the 20% Deduction Under the 2018 Tax Reform Act, for ICs and employers.
Working with Independent Contractors is complicated to begin with. Add in new legislation and shifting regulations and things get even more complex. So we pulled in an expert, employment attorney and workforce expert Denis Kenny to give you the scoop on what you need to know about ICs and Tax Reform. Whether you’re a contractor or an employer, you can skip the stress of the unknown, and get the info you need to build a plan that works for you and your goals.
Setting the Stage: Quick Background and Summary
Last December, President Trump signed into law the Tax Cuts and Jobs Act, coined the “Tax Reform Act.” A provision, the Internal Revenue Code Section 199A, provides a 20% deduction for workers being classified as independent contractors, whether by choice or by edict of hiring companies.
This deduction is for "pass-through income" earned by:
- Sole proprietors
- Owners of partnerships
- Owners of S-corporations, and
- Other pass through entities – on the ever-evolving and growing trend of workers classified as independent contractors (whether by choice or by edict of hiring companies)
Pass-through income is business income that is immediately “passed through” to the personal tax return for the tax filer.
The pass-through enables two main things for IC tax filers:
- They can avoid corporate income tax
- Their overall taxable income is reduced. Specifically, the new deduction allows non-employees, most notably, independent contractors (ICs) in certain types of businesses with earnings in a specified income range, to write off 20% of that income before calculating their taxes (the “20% Deduction”).
Keep reading to understand the five main implications of Tax Reform for Independent Contractors and their employers.
1. Effective Date and Duration
The 20% Deduction became effective January 1, 2018. It may be used on 2018 tax year returns filed in 2019.
Absent amendment to the Tax Reform Act, the 20% Deduction will expire December 31, 2025.
2. Income Range Limitations
Only non-employees who make less than $157,500 individually or $315,000 filing jointly, will be eligible for the full 20% Deduction. Guaranteed payments to partners and wages paid to S-corporation employees are not considered income eligible for the 20% Deduction (defined as “qualified business income”).
3. IC Classification Implications
How does the 20% Deduction implicate employment law?
The answer lies within the world of independent contractor compliance.
Companies already have many incentives to save costs by classifying workers as independent contractors rather than employees.
Notable cost savings include:
- Healthcare insurance premiums
- 401k matching contributions
- Workers’ compensation premiums
- Wage and hour protections (overtime, meal and rest breaks, paid sick leave) and payroll taxes (unemployment insurance)
- Federal Insurance Contribution Act (FICA) contributions for social security and Medicare, among other employment-related benefits and expenses.
Employers may be inclined to highlight the new deduction as an added “benefit” to convince workers that they would be better off being classified as ICs, along with other business deductions and write-offs (such as home/office expenses, travel and entertainment expenses, equipment, etc.). And, at first glance, there may be some truth to that statement.
In fact many workers may themselves see the value of being an IC instead of an employee when they become aware of the deduction.
Example: W2 vs. 1099, How Does This Really Impact Take-Home Income?
→ Worker’s Point of View
Take a worker given the choice of being hired as a W2 employee or as an IC when the worker is confident he or she could make $50,000 a year doing that service (e.g. driving for a shuttle or ride sharing company, delivering food or merchandise to homes and businesses, installing and repairing cable television or audio visual equipment, etc.).
Under the 20% Deduction, if that worker is classified and paid as an IC and call himself or herself a “sole proprietor,” he or she would be eligible to take a tax deduction of about 20% and pay taxes on only $40,000. The tax savings may incentivize and lure many more workers to seriously consider accepting their next “job” or gig as an independent contractor.
→ Employer’s Point of View
And of course, that added incentive of IC classification for workers may provide advantages to hiring companies who are inclined to watch the “bottom line” of reducing wages and payroll costs. Workers retained as ICs may be less likely to complain about their non-employment status given the tax advantage of the 20% Deduction.
But none of these implications of the 20% Deduction on IC classification change the applicable legal framework:
- The hiring company, not the worker, has the burden of proving the validity of IC classification.
- And that burden of proof is significant and based upon a highly fact-intensive and nuanced IC/W2 employee classification assessment. This is still full of uncertainty and attendant liability and damages exposure.
4. The Key Takeaways
Impact on Workers
The 20% Deduction will likely increase the incentive for business-savvy workers to push for IC classification or, at the very least, to be more open to it. But hiring companies should be very careful touting the benefits of the deduction as a way of convincing or encouraging workers to forgo employment in favor of IC engagement.
Risks for Employers
Hiring companies must make no mistake--there is no substitute to ensuring viable IC classification at the outset of every hiring decision. The need to maintain solid compliance is still as strong as ever.
- A worker’s choice of IC tax status is not a defense to IC misclassification against the hiring company. Those workers who choose IC classification may just as easily decide they would prefer the benefits of employment status the next day, week, month or even years later.
- All it may take is a disgruntled worker filing a wage claim for overtime, a Form SS8 with the IRS for “anonymous” IC/W2 employee classification assessment (which is a “red flag” for workplace audits), or a claim for state unemployment benefits.
- Likewise, a worker suffering an on-the-job injury resulting in a report to a state workers’ compensation agency may also cause the IC misclassification analysis to come into play.
5. Long-Term Implications for ICs and Businesses
It’s important to address the viewpoint that a more conservative administration and Department of Labor may make IC misclassification enforcement seem less risky. Indeed, the President’s fiscal year 2019 budget proposal earmarks $2.5 billion, a 21% reduction for Department of Labor funding.
- Reduced resources could impact Department of Labor enforcement.
- On the other hand, the budget proposal remains in its early stages so the final budget could result in materially different amounts and initiatives.
Moreover, making decisions that raise serious legal risk based on views about political trends seems to only tempt fate. Misclassifying workers as ICs remains one of the lowest hanging fruits for federal and state agencies seeking to generate revenue for depleted coffers. Further, while political motivations may vary, individual state enforcement policies and court decisions will not be impacted by federal budget cuts and policies.
So, IC inquiries and enforcement could just as easily increase rather than decrease depending on how badly state and federal enforcement agencies are straddled with budget cuts and depleted tax revenue.
Recognizing IC misclassification risk and the attendant need for a strong IC compliance program must remain prominent fixtures of any business considering the retention of ICs.