Guest Post: Independent Contractors and The New Tax Law

This is a guest post from Platinum Sponsor Anjali Shah, CPA, CFP of FIT Advisors. She is a fee-only financial advisor with a decade of experience in tax consulting and financial planning. She founded FIT Advisors to empower Gen X professionals to discover and reach their life goals while building a stable financial future. Anjali understands the needs of physicians (she is married to one) and how to plan for their busy and evolving lives. To learn more, set up a free initial consultation. With the new tax law, more and more physicians may be exploring opportunities as a 1099/independent contractor instead of an employee. The article below goes through the recent tax law changes and things to consider between an independent contractor and employee.

What changed with the new tax law?

The short answer to that is a lot! Specifically, the new tax law made changes to how pass through entities (partnerships, LLCs, S Corporations) and C Corporations are taxed. Pass through businesses may deduct up to 20% of their business income on their individual tax return. The new deduction provides some tax relief to small businesses, but unfortunately, it limits the deduction for certain service related businesses. These service related businesses include the fields of health, law, consulting, financial services, etc. The new tax law carved out engineers and architects from this limitation. Unfortunately that means most, if not all, medical professionals will be subject to the limitation. How does the limitation work? The deduction is limited based on a threshold amount – it starts at $157,500 for an individual and $315,000 for a married couple and fully phases out once income hits $207,500/$415,000. Even though the limits are for a single vs. married person, it is still assessed at the business level. Thus, high earning dual income households may be able to get the deduction depending on how much business income there is. The deduction is taken on the individual tax return, not the business return. On the other side of the business spectrum, corporations are now taxed at a flat 21%. Great! Why don’t I just incorporate as a C corporation? The tricky part about C corporations is that they are taxed twice – at the corporate level and then any profits that are distributed to the owners are taxed at capital gains rate. The new tax law still retained the higher capital gains rate of 20% and the net investment income tax of 3.8%. Thus, depending on what your tax brackets are you may be paying 44.8% (21% at the corporate level, 23.8% capital gains rate) while the top federal individual income tax bracket has come down to 37%.

Does it make sense to become an independent contractor instead of an employee with the new tax law?

The answer to that really depends on a number of factors. The first item to keep in mind is that independent contractors do not receive benefits. If you are an employee, your employer may provide health care coverage, disability, retirement plan contributions and more. As an independent contractor, you pretty much pay for everything out of pocket – but you can take a lot of the expenses as a “business” deduction to offset your income. It is important when deciding between 1099 vs. W-2 offers, to negotiate a higher rate (hourly/RVU based) as an independent contractor since you receive no benefits. The second factor to consider is whether you have the diligence to ensure your taxes are paid in for the year. When you are an employee, your employer will withhold taxes on your behalf and remit it back to the IRS. The IRS requires every taxpayer to pay their taxes in throughout the year – whether through withholding or estimated tax payments. As an independent contractor, the burden falls on you to ensure this is done. The other tax implication of an independent contractor is self employment tax. Self employment tax is comprised of Social Security and Medicare – the total rate is 15.3%. This is assessed on top of your regular income tax. As an employee, you are only required to pay half of this amount and your employer covers the other half. As an independent contractor, you are technically both the employer and employee so you pay the full amount albeit you receive a tax deduction for one half the amount. This can be a sizeable tax hit that needs to be factored in. The last item to consider is whether your income will be below the threshold amount for the pass through deduction. As discussed above, once income from the business exceeds $157,500 for a single person or $315,000 for a married couple the deduction begins to go away. For many physicians, their incomes will be higher than the threshold amounts so the benefit may go away entirely. If you are not able to get the pass through deduction there are still benefits to being an independent contractor – running expenses through the business, ability to contribute more to a retirement plan, flexibility on hours/shifts, etc.

I want to be an independent contractor but my future employer won’t allow it, why?

You’ve decided to take the route of independent contractor but your employer won’t allow it. You may wonder why…it seems easy enough. Unfortunately, the employee vs. independent contractor designation is an area the IRS highly scrutinizes. Further, the penalties for getting the classification wrong are cumbersome so for many employers it might be easier to just classify workers as employees. The IRS lays out a framework of what may designate a worker as an employee versus an independent contractor. Unfortunately, there is no magic formula. As stated on the IRS’s website “There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.” Let’s look at a few of the factors the IRS considers when making the determination. The IRS looks at whether an employer has the right to direct or control how a worker does work. What exactly does this mean? For example, is there written instructions as to when and where work should be done, what tools to use, tasks to be performed, etc i.e., employee handbook. Other items include whether an evaluation system is in place to measure the work and if the job provides training to its worker. If one or more of these facts are present, it is likely the worker is an employee and not an independent contractor. The IRS also examines the financial aspects of the role. Examples of this include whether the worker is reimbursed for expenses incurred on the job or does the worker get a guaranteed amount of payment on a regular basis? These factors point to an employee. An independent contractor, on the other hand, usually only gets paid on the hours worked and is free to seek out other business opportunities even while working for the employer. An interesting rule is that written contracts are not sufficient to determine a worker’s status. If your employer puts together a contract with language that states you are “an independent contractor, responsible for paying his or her own self employment tax” it holds no weight. The IRS is not required to follow the contract and instead will look at the relationship between the worker and employer. Part of looking at the relationship is whether the worker receives benefits, is their job permanent or does it end after a specified time and is the worker provided services that are key to the business. If you are currently an employee and want to make the switch to independent contractor with your current employer, the case is stacked against you so you may need to seek out a role elsewhere. As mentioned earlier, the tough part about these rules is that there is a lot of ambiguity. Thus, employers may take the safe route by classifying workers as employees.

Now what should I do?

When deciding between various job opportunities, it is important to put each job on equal footing. Start with the W-2 role and list out the income items – salary, bonus, CME reimbursement and employer retirement plan contributions (this is any match or profit share). Next, put a monetary value to the benefits you will receive – health insurance, holiday/vacation (remember as an independent contractor you don’t receive any paid time off) and self employment tax savings. Finally, if there are any other benefits your employer offers, add that in – disability, life insurance, etc. Add everything up and compare that to what you would receive as an independent contractor. Many people are surprised by the numbers so it is helpful to line up the roles from a monetary perspective. Make sure to also consider the non financial aspects of a role since those can be just as important! Anjali Jariwala is a CPA and CFP®. She founded FIT Advisors to provide comprehensive Financial Planning, Investment Management and Tax Planning services. She uses an innovative business model that is evidence-based and aligns closely with the needs of physicians.]]>