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.