Employers: Be cautious of the new tax law’s incentive For independent contractors

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Posted on 01/09/2018 at 10:00 AM by The Newsroom

The new Federal tax legislation, effective January 1, 2018, brought many changes. The IRS has not yet issued regulations interpreting the statutes, so the many details of the new law are still in flux. However, one thing is clear: the tax rates of C-corporations and pass-through entities, such as S-corporations, LLCs, and partnerships, have changed significantly. Specifically, the new tax law will reduce the tax rates of most C-corporations and provides a twenty-percent business income deduction for pass-through entities that meet certain criteria. Not only do these rate changes have businesses rethinking their business structures, but they have employees contemplating the benefits of incorporating themselves and acting as independent contractors to take advantage of the twenty-percent business income tax deduction. 

For example, let’s say you are single and earn $100,000 a year working as an accountant (employee) for an accounting firm. Based on the new tax rates, you would pay $18,289.50 in Federal income taxes.  However, you could reduce your Federal income tax liability if you were to incorporate yourself as an S-corporation and perform services as an independent contractor, with the accounting firm hiring your S-corporation to perform accounting services.  As an independent contractor, you would be able to receive reasonable wage from the S-corporation ($40,000) and take an S-corporation distribution ($60,000). Under the new law, you get a twenty-percent deduction on the S-corporation distribution. Thus, incorporating as an S-corporation and performing services as an independent contractor would result in a Federal income tax liability of $15,409.50, a savings of nearly $3,000 versus performing services as an employee.

Impact of Employee Classification on Tax Liability


Employee (Single) 

Independent Contractor (Single)




S-corporation Earnings Distributed



Total Compensation



20-percent Business Income Deduction



Taxable Compensation (after 20-percent business income deduction)



Marginal Tax Rate



Tax Liability




As the above example, focusing solely on Federal income tax, demonstrates that the new rates create a major incentive for employees to become independent contractors.  But, does that mean the accounting firm (a.k.a. the employer) should reclassify its employees as independent contractors? Not necessarily! 

Whether an individual should be classified as an employee or as an independent contractor depends upon a number of factors; not simply upon the wishes of the employer and/or employee.  And, over the past eight years, the DOL has been engaged in a crusade against the misclassification of workers as independent contractors rather than employees.  In other words, if an employer gets it wrong – and misclassifies an employee as an independent contractor – the employer puts itself at significant risk of legal liability and penalties.

To determine whether your business can or should reclassify an employee as an independent contractor, your business must first decide which independent contractor test applies in your jurisdiction. The test for determining whether an individual is an independent contractor or employee varies from jurisdiction to jurisdiction and statute to statute; however, the most common test is known as the “right-to-control test.”  Under this test, if the right to control his/her own work is vested in the individual, s/he would generally be considered an independent contractor.  If, on the other hand, the right to control is vested in the company, the individual would generally be considered an employee.  In evaluating an individual’s right to control his/her own work, courts and other agencies look at a number of factors, such as (1) the individual’s obligation to furnish necessary tools, supplies, and materials; (2) the individual’s right to set his/her own schedule; (3) the method of payment, whether by time or by job; and (4) whether the work is part of the regular business of a company. 

This blog covers the basic issues involved in reclassification of a worker and there are many more tax and non-tax issues an employer must consider before reclassifying.  Accordingly, it is prudent that employers first consult with legal counsel to before reclassifying an employee to an independent contractor.   

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.

- Melissa Schilling & Cody Edwards


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