Employees and the self-employed – a comparison under the Tax Cuts and Jobs Act
Employees should weigh the pros and cons of self-employment, and advisors can help them understand the implications of the new tax law
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- Factors for determining if a taxpayer is an employee or self-employed
- Quick Reference to the Tax Cuts and Jobs Act
- The self-employment tax (SE tax) and Schedule SE
The 2017 Tax Cuts and Jobs Act (TCJA) is favorable to businesses of all types, including C corporations and pass-through entities such as S corporations, partnerships, LLCs, and sole proprietorships.
Corporations now have lower taxes
The benefit for C corporations comes from the new, reduced flat corporate tax rate of 21% (down from a maximum 35%, with much lower effective tax rates for many companies). Plus, taxpayers who are self-employed or who are owners or partners in pass-through entities may now deduct 20% of their qualified business income (QBI) from taxable income before determining their federal tax.
What does this mean for employees?
Some employees may have a new incentive to become self-employed or start a business. In addition to creating the 20% deduction for business owners, the new law removed the employee deduction for unreimbursed job expenses. That, along with the higher standard deduction, may make self-employment an interesting prospect for some employees.
But before employees make any changes, they should understand the ramifications in addition to the potential tax benefits of making the switch.
Employees need to weigh the pros and cons of self-employment
If employees seriously consider replacing a salary with earnings from self-employment, they will need to make sure they’ve got all their bases covered. This includes:
- Forming a solid value proposition for clients or customers,
- Setting up an accounting or bookkeeping system, and
- Establishing all the other tools and services needed to open or operate a business – a separate bank account; business credit card; legal, financial, and tax advice; a business plan; marketing and pricing strategies; and more.
Additionally, the IRS may question former employees’ status as self-employed. This commonly happens if an individual receives a Form W-2 from an employer in 2017, and then receives a Form 1099-MISC from the same employer in 2018 as his or her only source of earnings. Treasury regulations and the IRS will consider all facts and circumstances about the employer-employee relationship. But generally, if most of a taxpayer’s income comes from one employer, the IRS may be suspicious of the self-employed status.
Here, we’ll look at two fictional taxpayers and how their situations play out under the new law.
Sarah, the self-employed, and Josh, the employee
Let’s consider Sarah, a single, self-employed marketing consultant, and Josh, a single taxpayer who works as a mid-level manager in a corporate marketing department. Each claims the standard deduction.
Sarah operates as a single-member LLC and files Schedule C to report her business income and expenses. She has several clients, sets her own appointments, and meets with her clients regularly. She has a separate bank account for her business and operates her consulting activity strictly as a business. At any given time, she is engaged with eight to 10 clients, although she has provided services for about 100 clients since she opened her business.
In 2017, Sarah received $200,000 in gross income, paid out $125,000 in expenses, and earned $75,000 in net profit. Josh earned $75,000 in salary. Neither made any contributions to a retirement plan in 2017.
How do their federal tax liabilities compare?
Sarah’s federal tax liability was higher than Josh’s (pre-TCJA)
As a self-employed taxpayer, Sarah’s net profit of $75,000 is subject to self-employment tax (SE tax) of 15.3%. Self-employed taxpayers pay the full 15.3% because they pay the employer and the employee portion of employment taxes by contributing 7.65% tax (6.2% Social Security on earnings up to $128,400, and 1.45% Medicare) on all SE income. Employees, on the other hand, pay only 7.65% (half of the 15.3%), and their employers pay the other half.
However, before calculating her SE tax, Sarah may deduct the “employer’s” half of the SE tax (7.65%) as a business expense, effectively reducing the $75,000 net profit to $69,263 [($75,000 – (100%-7.65%)] for the purposes of calculating her SE tax. Thus, the SE tax is $10,597 ($69,263 x 15.3%), and appears on her Form 1040 line 57, Self-Employment Tax.
One more adjustment is needed for the self-employed taxpayer. Sarah can reduce her gross income by half of the SE tax she paid as an above-the-line adjustment. Thus, she can reduce her gross income by $5,299 ($10,597 x 50%), leaving an adjusted gross income (AGI) of $69,701 ($75,000 - $5,299).
After adjusting for her 2017 standard deduction of $6,350, and personal exemption of $4,050, Sarah’s taxable income is $59,301, and her calculated tax is $21,167.
Here is a summary of Sarah’s tax items:
Gross Income (Business Income) $ 75,000
Deduction for ½ SE Tax (5,299)
Adjusted Gross Income (AGI) $ 69,701
Personal Exemption (4,050)
Standard Deduction (6,350)
Taxable Income $ 59,301
Calculated income tax $ 10,570
SE Tax 10,597
Net federal tax (Form 1040, Line 63) $ 21,167
Josh’s federal tax liability was lower than Sarah’s (pre-TCJA)
What about Josh, the corporate employee? Josh’s $75,000 salary requires his employer to withhold Social Security taxes (6.2%) and Medicare tax (1.45%). Josh pays combined FICA taxes of $5,738, consisting of $4,650 in Social Security taxes ($75,000 x 6.2%) and $1,088 in Medicare tax ($75,000 x 1.45%).
Josh salary of $75,000 produces a federal income tax of $11,895, as follows:
Gross Income (wages) $ 75,000
Adjusted Gross Income (AGI) 75,000
Personal Exemption (4,050)
Standard Deduction (6,350)
Taxable Income $ 64,600
Net federal income tax $ 11,895
Clearly, by this comparison, Josh, the wage earner, pays less in federal income taxes. However, note that Sarah’s SE tax (SECA) is added to her federal tax on Form 1040, whereas Josh’s FICA (payroll) tax is not. So, to make for a better comparison, Josh’s FICA tax of $5,738 should be added his federal income tax bill of $11,895, resulting in a total of $17,633:
Calculated income tax $ 11,895
FICA tax 5,738
Net federal tax (Form 1040, Line 63) $ 17,633
Josh’s total federal taxes (income and payroll) are $3,534 less than Sarah’s, due primarily to the SE tax. Both are in the 25% marginal tax bracket.
Below is a summary of Sarah’s and Josh’s tax calculations.
How will the TCJA affect Sarah and Josh in 2018?
Note that for 2017, the self-employed taxpayer, Sarah, ended up paying more federal taxes than Josh, the employee, even though (1) only 92.35% of her income was subject to SE tax, and (2) she deducted half of that tax.
Let’s see how their tax bills change in 2018, after the TCJA is in effect.
As noted at the beginning of this article, a 20% deduction is available for pass-through entities and is one of the “juicier” provisions for small businesses under the new tax law. However, a few rules apply to the new 20% deduction.
- The 20% deduction is based on qualified business income (QBI). Several rules and restrictions define what qualifies as QBI. Generally, QBI includes all domestic income in a trade or business, including business income, but not investment income or capital gains or losses. For simplicity, we will assume that all of Sarah’s income is QBI.
- The 20% deduction is a deduction from taxable income, not adjusted gross income. So, a taxpayer who doesn’t itemize can still claim the deduction.
There are other rules and limitations on the pass-through deduction, but we will assume that Sarah can safely claim the full deduction.
Sarah significantly reduces her tax bill for 2018, but it’s still higher than Josh’s
Below are the few key lines in Sarah’s Schedule C and SE – not different from 2017. However, her total federal tax of $15,931 for 2018 is almost 25% less than her tax of $21,167 for 2017.
Here are the factors that resulted in the tax reduction:
- Sarah lost the personal exemption of $4,050 (for 2017). This was the only unfavorable result for Sarah.
- Sarah’s standard deduction increased to $12,000 (from $6,350 in 2017).
- Sarah deducted 20% from her QBI, reducing her taxable income.
- Sarah had lower tax rates (she’s now in the 22% tax bracket in 2018).
Josh’s 2018 total tax liability is lower, but much closer to Sarah’s final bill
As in 2017, Josh’s salary of $75,000 results in FICA taxes of $5,738.
Gross Income (wages) $ 75,000
= Adjusted Gross Income (AGI) 75,000
Standard Deduction 12,000
Taxable Income $ 63,000
Net federal income tax $ 9,800
Calculated income tax, per above $ 9,800
FICA tax 5,738
Net federal tax (Form 1040, Line 63) $ 15,538
Josh’s total federal tax bill is a lot closer to Sarah’s now. Sarah’s 20% deduction basically reimbursed her for her SE tax.
Here is a summary of their 2018 tax calculations:
The 20% deduction can be a valuable benefit for self-employed individuals and business owners
The 20% pass-through deduction, without question, is a new benefit for pass-through entities beginning in 2018 (and expiring after 2025). But the value of the benefit is limited depending on taxpayers’ specific situations including:
- The amount of QBI
- The amount of taxable income (the deduction is limited for certain higher taxable incomes)
- The type of business (for example, service businesses aren’t eligible for the deduction if the taxable income is over the phase-out range), and more.
All pass-through entities qualify for the deduction, subject to various limits. Therefore, a change in entity type from one pass-through type to another (say, from a sole proprietorship to an S corporation) may have little impact on the taxpayer’s total federal tax bill.
Employees should consider all the implications of making a change
The decision to become self-employed is more than a path to deducting expenses that employees can no longer deduct, or a grab for a new pass-through deduction. For an employee contemplating self-employment, there are a myriad of considerations, and tax planning is only one aspect:
- Whether the individual is truly self-employed, or conducting work as an employee under the guise of self-employment.
- If self-employed, the risks (and rewards) of owning one’s business, winning clients or customers, having a business and marketing plan, etc.
- The type of business entity the individual should form – sole practitioner, LLC, C or S corporation, or partnership with one or more other individuals
- Replacing benefits lost as an employee, such as health insurance
Employees who are considering quitting to start or buy a business should consider all the implications of that decision before submitting their resignation.
Questions about business taxation under the TCJA represent a great opportunity for tax professionals to advise and educate their clients on the tax impacts.
 Treasury Reg. §1.183-2(b)
 Self-employment taxes are called “SECA,” instead of “FICA” (payroll) taxes, and are authorized under the Self-Employment Contributions Act (SECA). FICA taxes are covered under the Federal Insurance Contributions Act.