NEW TAX PROVISIONS ADDED AS PART OF 2017 TAX CUT AND JOBS ACT SUBSTANTIALLY FAVOR INDEPENDENT CONTRACTORS OVER W-2 EMPLOYEES. THIS, COUPLED WITH THE 100% OHIO INCOME TAX EXCLUSION FOR BUSINESS INCOME, MEANS MANY OHIO INDEPENDENT CONTRACTORS WILL PAY FAR LESS TAXES THAN W-2 EMPLOYEES AT THE SAME PAY LEVELS.
Current estimates are that freelancers make up to 34% of the U.S. labor force. This percentage is expected to grow to 40% by the year 2020. By passing the 2017 Tax Cut and Jobs Act (the “2017 Tax Act”) in December of 2017, President Trump and the Republican Congress gave many of these independent contractors a significant Christmas present that will continue to give until 2025. Under the 2017 Tax Act, many freelancers will have the ability to exclude 20% of their earned income. W-2 employees, however, are specifically excluded from this favorable tax break. Although this favoring of independent contractors over W-2 employees is new at the Federal level, Ohio was ahead of the curve in enacting legislation providing tax breaks to independent contractors. In 2013, Ohio enacted a favorable small business deduction for Ohio income purposes. Starting in 2016, this deduction permits Ohio taxpayers with business income to exclude 100% of the first $250,000 of business income and then to only pay a favorable 3% tax rate on business income in excess of such amount. Although it appears the intent of the Ohio small business deduction was to encourage job creation, income earned by freelancers is eligible for this exclusion.
Historically, self-employed taxpayers and W-2 employees have been on equal footing when it comes to the application of the income tax laws on their respective earnings. While, in Ohio, this changed with the Ohio small business deduction, the addition of the favorable exclusion rule under the 2017 Tax Act substantially shifts the income tax advantage to independent contractors.
The 2017 Tax Act and New Section 199A. The 2017 Tax Act added Section 199A to the Internal Revenue Code. To suggest that this new provision is complicated is an understatement. At a high level, the provision generally permits individual taxpayers to exclude up to 20% of their pass-through “Qualified Business Income.” Although this provision was primarily intended to benefit owners of partnerships and S corporations, it also applies to sole proprietorships and, accordingly, independent contractors.
There are various complex limitations within Section 199A that require detailed calculations that would make a mathematician’s head spin. In addition, “service” businesses are generally excluded from the favorable provision. For many freelancers, however, these limitations (including the “service” business exclusion) can be ignored. From an independent contractor’s perspective, the key determination is whether the taxpayer’s taxable income exceeds $315,000 (in the case of a married taxpayer filing a joint return) or $157,500 (for all other filers). While it is a little unclear as to the reasoning behind the selection of these taxable income levels, a cynic might conclude that Congress simply doesn’t believe that such income levels are very significant.
It is important to note that the threshold levels described above are “taxable income” limitations. That is to say, these thresholds are determined after all deductions, including contributions to qualified plans and itemized deductions (or the standard deduction). Thus, from an earnings standpoint, this could push the threshold up to $360,000 or more.
If a freelancer’s taxable income is below the applicable threshold amount, he or she is generally permitted to exclude 20% of his or her net income for Federal income tax purposes. Even if the taxable income is in excess of such thresholds, some limited exclusion may still be available.
Section 199A is subject to a sunset provision which results in the favorable provision being eliminated after 2025. In addition, The IRS has yet to provide any guidance under Section 199A. Such guidance, when issued, could impact the application of Section 199A to independent contractors. However, early indications suggest that eligible freelancers will continue to be able to take advantage of the new provision after such guidance is issued.
Ohio Small Business Deduction. Even if the income thresholds under Section 199A are exceeded, all is not lost. Ohio freelancers can continue to take advantage of the Ohio small business deduction and exclude the first $250,000 of income, and pay a 3% tax on the excess.
Impact of New Provision. All else being equal, for eligible independent contractors, the combination of the exclusion under Section 199A and the Ohio small business deduction represents a significant tax advantage over being a W-2 employee.
Due to economics, there has been a growing trend for companies to hire more contractors to reduce benefit and other costs. As a result, in today’s world, it is not unusual for freelancers to work side by side with W-2 employees. The 2017 Tax Act has the effect of giving many independent contractors a significant raise, while the W-2 employees working next to them receive no additional benefit. Once realized, this is likely to change the workplace dynamic.
While there are many non-tax advantages of being an “employee” (e.g., workers compensation coverage, unemployment compensation, healthcare, ½ payroll tax cost), W-2 employees who work for employers providing limited benefits (or who do not need the benefits) may be financially better off being an independent contractor. From the service provider’s perspective, one substantial downside to such a reclassification is the additional payroll tax cost shifted from the employer to the independent contractor. As an employee, the employer bears the cost of ½ of the payroll tax costs associated with the employee. An independent contractor bears 100% of the payroll tax cost. However, this additional cost, while detrimental, may still be substantially outweighed by the tax savings under Section 199A and the Ohio small business deduction.
At first blush, from the employer’s perspective, employee related expenses like workers compensation, payroll taxes and unemployment insurance can be substantially reduced by hiring contractors rather than W-2 employees. Thus, converting employees from W-2 employees to independent contractors can result in savings to the employer and a substantial increase in after-tax earnings to the former W-2 employee. A benevolent employer might even pass some of these costs savings along to the former W-2 employees to compensate for the additional payroll costs or loss of benefits incurred by the ex-employees as a result of the reclassification.
Although, on paper, this appears to be a win-win situation (employer incurs lower costs and former W-2 employees net greater after-tax income), without real substantive changes in the relationship, converting a W-2 employee to an independent contractor is a risky proposition for the employer. The IRS and state agencies apply a multi-factor test to determine if an individual is an “independent contractor” or an “employee.” Simply re-characterizing the relationship on paper is likely not sufficient to effectively change the classification for tax and state law purposes. Employers who treat individuals as independent contractors that are later reclassified by the IRS or state agencies as “employees” face potential significant economic consequences.
In addition, if the employer is itself a pass-through entity, there may be an incentive under Section 199A to retain the employees as W-2 employees to avoid the application of certain limitations that might limit the owners of the employer from taking advantage of Section 199A.
From the service provider’s perspective, while there has always been some payroll tax differences favoring employees over independent contractors, the economic differences have traditionally been viewed as minor and, presumably, taken into account in setting the pay level of independent contractors. For eligible freelancers, the combination of Section 199A and the Ohio small business deduction has not only resulted in a complete elimination of this tax gap, but has shifted the balance substantially in favor of independent contractors. In most cases, these economic differences are no longer nominal and will likely result in a substantial culture and market change going forward.