On December 22, 2017, the Tax Cuts and Jobs Act was signed into law bringing significant changes to US tax law. One provision of the Act may further incentivize individuals to work as independent contractors instead of as traditional employees.
The new provision allows for independent contractors, and for service providers structured as a partnership or other flow-through entities, the potential to deduct up to 20% of their revenue from their taxable income. And while some companies might view the opportunity to re-classify individuals from employees to independent contractors as a “win–win” scenario, it could create substantial legal exposure for employers.
New Internal Revenue Code Section 199A creates a potential 20% deduction for qualified business income (QBI).
(QBI is the profit from an active trade or business for certain taxpayers other than corporations.) As a result, beginning in 2018, two people performing a similar role, one as an employee and one as an independent contractor (with self-employment income), will have even greater differences in federal income tax treatment:
- The independent contractor would have QBI and may be eligible for the 20% deduction (up to certain income limitations),
- While the wages earned by the employee would not be eligible for this new deduction.
While this tax break could indeed incentivize workers to want to be classified as independent contractors, employers should remain cautious when re-classifying employees as contractors.
Despite the changes in tax law, the legal tests for whether an individual is technically an employee or an independent contractor remain unchanged. Under the FLSA, the following factors are typically considered when determining whether a worker is an employee versus an independent contractor:
- The extent to which the work performed is an integral part of the employer’s business.
- Whether the worker’s managerial skills affect his or her opportunity for profit and loss.
- The relative investments in facilities and equipment by the worker and the employer.
- The worker’s skill and initiative.
- The permanency of the worker’s relationship with the employer.
- The nature and degree of control by the employer.
The IRS also considers numerous factors, many of which overlap with the FLSA, but the overarching theme is control. According to the IRS, “[t]he general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
While individuals may be agreeable to being classified as independent contractors, their agreement (or even preference) is not determinative.
If the relationship goes sour, or if a government agency or court were to separately audit or evaluate the work relationship, the individual’s initial agreement to independent contractor status is unlikely to count for much. This is likely to be the case where there is no real change in the duties of the individual’s role and only a desire to re-characterize the relationship to obtain the new tax benefits.
With this, if the individuals are found to be misclassified, the company could face significant financial liability. Under the various laws, the individual could be owed minimum wages, overtime pay, unpaid employee benefits, and other compensation. In addition, the company could be liable for Social Security and Medicare taxes, income tax withholdings, unemployment taxes, workers’ compensation taxes, as well as additional associated penalties and interest. There are also potential criminal penalties under the Internal Revenue Code for situations in which the company engaged in fraud or intentional misconduct and knowingly misclassified workers as independent contractors. Employers will therefore want to make sure that a careful analysis is performed by legal counsel before an individual is re-classified or hired as an independent contractor.
For more information on the Tax Cuts and Jobs Act, and how it impacts the compensation and benefits arrangements maintained by both public and private companies, please find our recent two-part webinar series HERE.