Thanks to the Tax Cuts and Jobs Act, many workers now may be able to lower their taxes simply by converting from employee to contractor or sole proprietor, if their taxable income is less than $157,500 for singles or $315,000 for joint filers. In effect, Congress flipped traditional tax-planning upside down: in this instance, many moderate-income workers may be able to exploit a tax break that higher-income workers cannot. And by shifting their status from employee to contractor, workers potentially can reduce their taxes by thousands of dollars.
The TCJA created a 20-percent individual income tax deduction for income from pass-through businesses such as sole proprietors and partnerships. This effectively provides a lower income tax rate on this income for a sole proprietor than for an employee with similar income. As part of the new law, Congress denied the deduction to high-income owners of service businesses such as law firms, but permitted the deduction for lower-income service business owners and for owners of many other types of businesses. And for some individuals it’s not hard to convert from employee to sole proprietor, assuming your job allows you to work and charge independently for your services (and not all jobs meet these conditions).
Of course, you will need to negotiate with your employer to convert your status to sole proprietor. And you must carefully evaluate the potential loss of job security, organizational support, and retirement or health benefits. But you might enjoy substantial tax savings, including opportunities to deduct business expenses that employees cannot deduct. Sole proprietors use Schedule C of the Form 1040, which permits a wide range of these deductions, such as for the business use of automobiles and use of a home office.
Take, for example, a simplified example of a married couple where each spouse earns $100,000 in wage and salary. Suppose one of them negotiates with their employer to become a consultant for the same total compensation, including the employer’s share of payroll taxes, which is 7.65 percent (so the consultant’s net self-employment income would be $107,650). Table 1 shows that the couple could save more than $5,000 annually simply by negotiating the new work arrangement (a small savings is attributable to a longstanding glitch in the payroll tax).
If you wanted to play around with other fact patterns to see the potential savings, please try the Tax Policy Center calculator.
Congress presumably understood that more tax planning could shift down the income scale from the new preferential tax treatment for income from pass-through entities, but may have assumed the tax savings would be too small to pursue. And there are potential downsides and complications involved in changing an existing employer-employee relationship. But the tax savings could be relatively large for some workers. Only time will tell how many will take advantage of this new opportunity.
