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George F. Bearup, J.D. Senior Legal Trust Advisor

12-Jan-18

IRC 199A – Independent Contractors and the 20% Deduction for Pass-Through Entities

Take-Away: Apparently there is a lot of chatter these days that professionals need to quickly become independent contractors to position themselves to to claim the 20% deduction from their ‘pass-through’ entity or sole proprietor profits under the new IRC 199A. Before everyone jumps on the independent contractor bandwagon remember that there is no guarantee that just because a professional declares himself or herself to be an independent contractor, that the IRS accept that new classification.

Background: Even if an employer is willing to go along with an employee’s desire to shift from employee to independent contractor to claim the 20% deduction against profits,  a lot more goes into the decision to switch to an independent contractor than just a move to claim a new income tax deduction. For example, employees generally will have access to unemployment insurance, worker compensation, group health and life insurance, and access to participate in the employer’s qualified retirement plans. All of these benefits will need to be quantified and balanced in the decision to shift from employee to independent contractor.

IRS: Even if the employee is willing to pass on all of the perceived benefits of being an employee, the IRS will still have a say in the decision to change classifications. As a general rule, the IRS follows a rule that an individual is an independent contractor if the payer possesses the right to control or direct not only the result of the work, but what will be done an how it will be done. Restated, if the business has the right to direct and control the work performed by the worker, even when that right is not actually exercised by the employer, the worker will be still classified as an employee. The IRS normally looks at three criteria when it classifies a worker:

  • Behavioral Control:  If  instructions are given, such as when and where to work, or what tools to use, then those facts suggest the worker is an employee. Periodic on-the-job training offered by the employer also usually compels an employee classification.
  • Financial Control: If the business retains the right to direct or control the financial and business aspects of the worker’s job, the worker is most likely to be classified as an employee. If the employer invests in equipment the worker uses, that is often a sign of the level of control the employer retains over the worker. Conversely, if the worker’s services are available to the market, i.e. he/she is free to seek out other business opportunities, then an independent contractor relationship is more likely to exist.
  • Relationship Between the Parties: Merely stating in a written agreement that the workers is intended to be an independent contractor is not binding on the IRS. The more permanent the relationship, or the existence of employer-type benefits available to the worker, the more likely that the relationship will be viewed as employer-employee.

Misclassification: If the worker is misclassified as an independent contractor with no reasonable basis for doing so, the employer will still be liable for employment taxes. Obviously, too, with a misclassification, if the worker attempts to claim the new 20% deduction from his/her profits, they will pay more in income taxes and may expose themselves to understatement of taxable income penalties (20% to 40%) and interest. In short, a misclassification carries a lot of risk for the worker who claims a change in their classification from employee to independent contractor.  Since the correct classification might become a ‘close call’ for a worker, employers can file a Form SS-8 Determination of Worker Status for Purposes of Federal Employment Tax Withholding to get help from the IRS to make the correct classification. Also a good source to review is  IRS Publication 15-A Employer’s Supplemental Tax Guide, to evaluate whether a worker is an employee or an independent contractor from the IRS’s perspective.

Conclusion: It is not as simple as declaring a change in one’s title from employee to independent contractor. The IRS  imposes several tests to assure that the worker is not improperly classified. If there is no substantial change in the individual’s work function or the control that the employer has over the individual’s work, the individual may still be classified as an ‘employee’ for state and federal tax and law purposes, even though there exists a contract that formally classifies the worker as an ‘independent contractor.’ While some commentators  claim that switch to independent contractor status is the way to go in order to claim this new 20% deduction from taxable income under IRC 199A, such a switch is not nearly as simple as they  suggest.