Accommodating Your Employee’s Request to Switch to Independent Contractor Status

You run a small or  medium-sized business, you’re busy, and maybe you haven’t given much thought yet to how the recent changes to the tax laws might affect you or your businesses, when one of your best employees approaches you about switching from employee status to independent contractor status so that she can take advantage of the new tax laws. (My last blog post discussed why employees might want to make that switch.) Your first instinct might be to say sure, why not? For one thing, this is a loyal employee and you like the idea of accommodating her and helping her save money. Additionally, you have always known that there are financial advantages to businesses in hiring independent contractors over employees, most notably that you do not have to pay any FICA taxes on behalf of an independent contractor. And this employee in particular has a good salary and participates in your company’s matching 401(k) plan to the fullest extent. She also has her entire family on the company’s generous (and expensive) group healthcare plan. You also suspect she is planning to have another child and take advantage of the company’s paid maternity leave again. If she becomes an independent contractor, she would not be entitled to any of these employee benefits. Seems like a no-brainer to allow her to switch, right?

Not so fast. While it is true that you would no doubt welcome the opportunity to not have to withhold and pay FICA taxes for her, pay for her and her family’s health insurance, and pay for her to go on another paid maternity leave, if the IRS determines that, for tax purposes, she is really an employee, your company could end up getting hit with a hefty bill in back taxes, and even fines. That’s because under IRS regulations, just because you decide to make someone an independent contractor, doesn’t mean the IRS can’t later deem them an employee for payroll withholding purposes. If this is an employee who primarily works on-site for set hours utilizing company equipment and is under your (or another manager’s) supervision, then this is probably not someone who will be able to qualify as an independent contractor. However, if this person sets her own hours, spends much of her time working off-site, uses her own equipment for which she does not receive reimbursement, and generally works independent of any supervision, then independent contractor status might be something to consider.

But even if the risk of an IRS challenge to her independent contractor status is low, there could be other unintended consequences that result from reclassifying an employee as an independent contractor. Does this employee create anything for you? Does she work on the company’s website, write articles to include in the company newsletter, write software programs for the company or its clients, or work on inventions? As an employee, anything she creates within the scope of her employment is (generally speaking under most states’ laws) automatically deemed to be owned by her employer. Not so for independent contractors. Additionally, if she is subject to a non-compete, that non-compete will either terminate along with her employment status (e.g. if she was under an employment contract that included a non-compete provision) or at the very least will be a lot harder to enforce.

Accordingly, employers need to be careful. Any employer approached by an employee about switching should seek the advice of legal counsel to assess the risks and consequences of doing so.

Should You Quit Your Job To Take Advantage of the New Tax Law?

You love your job. You earn a good living. But what if quitting your job could actually save you money? Under the new tax law, there are people who could enjoy significant tax cuts by quitting their jobs and getting re-hired by the same employer as an independent contractor.

The Tax Cuts and Jobs Act of 2017, which was signed into law on December 22, 2017 and takes effect for tax years beginning January 1, 2018, offers some significant tax advantages to individuals who offer services through a pass-through entity, such as an LLC or S corporation. In a typical structure, the individual forms a pass-through entity, and then the entity is engaged as an independent contractor by a company in need of the individual’s services. Utilizing a pass-through entity to offer the owner’s services has been a common practice for a lot of professional service workers, such as computer programmers, architects, and web designers, because an entity offers liability protection, and a pass-through entity means that the individual does not have to pay taxes at the corporate level (avoiding the so-called double taxation). The new tax law just sweetened the deal even more by allowing many owners of pass-through entities to deduct twenty percent of their revenue from their taxable income.  That’s why working for your employer as an independent contractor through a pass-through entity instead of as a traditional employee could save some individuals a lot of money in taxes. (Certain professions, such as doctors, engineers, lawyers, and accountants, are subject to income phaseouts that start at $157,000 for single taxpayers, $314,000 for married taxpayers.)

But wait, there’s more! Not only did the deal get sweetened for people who offer services as independent contractors through pass-through entities, but it also made life a little tougher (or, at least, a little more expensive) for traditional employees. Employees who have been deducting their unreimbursed work-related costs will no longer be able to do so. That’s because the new law eliminates this itemized deduction. Depending on how much in unreimbursed expenses an employee incurs, that could be a significant tax deduction that will no longer be available to them starting this year.

So with the new tax laws being skewed in favor of independent contractors and against employees, should employees be turning themselves into independent contractors? Should, for example, an architect who is employed by an architectural firm consider approaching her firm about switching from being an employee to being an independent contractor? Since she’s not limited by the specified service businesses rules (architects were essentially specifically excluded), she could set up an LLC of which she is the sole member, her firm could pay her LLC for her services, and all the income received by the LLC would pass through to her. She would then be able to deduct 20% of her income. Additionally, she would not have to worry about those unreimbursed expenses not being deductible because she would be able to deduct any work-related expenses as business expenses. Sounds like a pretty good deal, right? Well, from a purely tax standpoint, it is! But there are some potential downsides that need to be considered.

By changing over to an independent contractor she would be giving up her status as an employee. This means that she would be giving up certain protections and benefits. For example, the Title VII anti-discrimination laws protect employees, not independent contractors. So if her firm terminated her employment while she was still an employee, she could file a Title VII violation claim against them if she felt she was fired for being a woman. However, once she is an independent contractor, she loses that protection. Additionally, if she has been enjoying certain employee benefits, such as group healthcare, matching 401(k) contributions, paid vacations, etc., she loses all of those too. She also loses FMLA and workers comp protection (if she gets pregnant or sick or is injured on the job) and unemployment protection and COBRA (if she loses her job). There are many benefits to being an employee over an independent contractor that would be lost to anyone making the switch.

With all that said, because the new tax law so heavily favors independent contractors over employees, employees will want to consider whether they should form a pass-through entity and operate as an independent contractor through their entity. Anyone considering doing so, should first speak with their accountant and seek legal advice to make sure that the pros outweigh the cons for their particular circumstances. Additionally, employees may be able to negotiate the terms of their switch with their employer, since switching could benefit the employer too.

In my next blog post, I will discuss the employer-side pros and cons and what an employer should consider if an employee approaches them about making the switch to independent contractor status. In the meantime, for more details on the tax implications of incorporating, or for other scenarios involving incorporation, see Kelly Erb’s post at Forbes.