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Tax reform proposals and your employees

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An article appeared in the business section of my weekly newspaper this past Sunday, which discussed the possibility of tax reform and how it might impact employees. There were some giant inaccuracies that were like finger nails on a blackboard. So let’s dissect them.

You can’t choose your status

The article suggested that, with an impending flattening of the income tax brackets, employees should consider telling their employers that they would prefer to be independent contractors. Sounds great, right? Except for the fact that you can’t decide your status under the tax code. The IRS decides based on the facts and circumstances. If someone is an employee today, they’re going to be an employee tomorrow, regardless of how many tax brackets there are.

The rule: For tax purposes, you’re either an employee or an independent contractor. For the most part, you can’t be both with respect to the same employer. In other words, you can’t quit and come back the next day as an independent contractor.

The exception: Employees who retire may return to work as consultants. This happens often enough, and to keep the IRS at bay, you should ensure that your retirees come back under a contract, and that their consultancy work differs significantly from the work they did as an employee.

You can’t choose whom to pay

The article also noted that under some legislative proposals, the income tax rates for businesses, including pass-through entities, such as S corps and LLCs, would be considerably lower than the personal income tax rates. We agree, based on the proposals we’ve seen so far.

But then the article seemed to suggest that employees might want to consider becoming an S corp or an LLC, to take advantage of the disparity in the tax rates. Employees, however, can’t do this. Under a long-standing tax rule, the entity who earns the income is taxable on it. In this case, the entity is the employee.

The moral: Becoming an S corp or LLC is easy enough—you just have to file all the appropriate paperwork with the appropriate state agency. But don’t be fooled if employees present that paperwork to you and say that from now on you should be paying their S corp.

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