For as long as I can remember, contractors paid higher taxes, when compared to a similar W-2 salary job. But, not any more! Thanks to the 2017 Trump tax reform and its new pass-through deduction, starting in 2018, self-employment or 1099 contracting is now a better tax choice than a salary, under most circumstances. In fact, it’s way better! A 1099 contractor or self-employed individual with a median salary can now save thousands of dollars in taxes with the pass-through deduction. Sign me up!
1099 vs. W-2
First, a few definitions. If you’re a regular employee (full-time or part-time) of a company, then you earn a W-2 salary. If you’re an independent contractor or freelancer, you instead get a 1099. Some of us have opportunities to work as either a W-2 employee or a 1099 contractor (or even to be self-employed as a small business owner).
In the past, it was usually a better tax choice to be a W-2 employee than to be self-employed, because employees paid slightly lower taxes on equivalent pay. On top of that, employees receive more benefits, such as healthcare and 401k matching, and have better job security. It was better to be an employee by a lot of measurements.
But thanks to the 2017 Trump tax reform, this is no longer the case. Yes, employees still have better benefits and job security, but now 1099 contractors and self-employed individuals will pay considerably lower taxes on equivalent pay – so long as you qualify for the deduction and stay under certain high income limits.
Related Content: The 2017 GOP Tax Bill: How To Pay Zero Taxes
If you can negotiate higher compensation to offset the lack of benefits and job security, then now might be the best time ever to leave your permanent employee position behind and become self-employed or a 1099 contractor.
What do I mean by “equivalent pay”? Even if you ignore the fringe benefits that employees receive, $100k paid to a contractor is less money then $100k paid to an employee. That’s because the employer pays half of the employee’s Social Security tax on their behalf, on top of the $100k salary. So, an employee receiving a $100,000 salary is actually equivalent to a 1099 contractor receiving $107,650.
The difference is the 7.65% Social Security tax that the employer pays on behalf of its employee. An employee only pays the remaining half of Social Security from her $100k salary. Meanwhile, a 1099 contractor has to pay the entire Social Security tax (called “Self-Employment Tax”) on her own. For this reason, any employer should be happy to gross-up a contractor’s pay by at least 7.65% over a W-2 employee… maybe more to compensate for benefits too.
So, an employee receiving a $100k salary is getting equivalent pay to a 1099 contractor receiving $107,650.
But now, thanks to the new pass-through deduction, a 1099 contractor will save thousands of dollars in taxes on that equivalent pay. Here’s how:
The New Pass-Through Deduction
The 2017 GOP tax bill included a new 20% “pass-through deduction”. The deduction is calculated as 20% of “qualified business income”, but also cannot exceed 20% of the difference between your taxable income and any capital gains. So if you have relatively large itemized deductions or capital gains, your deduction will be limited.
This pass-through deduction is available for pass-through business owners, such as S-corps, LLCs, and partnerships, but it’s also available to 1099 contractors, freelancers, side-hustlers, and sole-proprietors. Basically, anyone who is not paid as a W-2 employee or through ownership of a C-corp could qualify for the deduction.
The pass-through deduction is calculated as the lessor of:
- 20% of your qualified business income, net of business expenses; or
- 20% of the difference between your taxable income (prior to the pass-through deduction) and any capital gains.
For contractors or self-employed who don’t have any other substantial income other then their self-employment work, the pass-through deduction won’t be a straight 20% of their self-employment income. Rather, it will be calculated as the second item above: 20% of taxable income before the pass-through deduction and less capital gains. That’s going to be a smaller number, because taxable income is after all deductions. Plus, if you have large itemized deductions or capital gains, those can further limit your pass-through deduction.
But, as you will see below, the pass-through deduction can still be a huge benefit for contractors and self-employed.
The pass-through deduction is deducted after AGI, which means it won’t reduce your self-employment tax. And depending on how your state income tax works, it may not reduce your state income tax either. But it will significantly reduce your federal taxable income, subject to certain income limits (discussed below). The pass-through deduction could easily save you thousands of dollars overall in taxes.
Save Thousands of Dollars in Taxes
Here’s what that looks like for an individual earning $100,000 as an employee, or the equivalent $107,650 as a 1099 contractor:
|W-2 Salary||1099 Contractor or Self-Employed|
|Social Security or Self-Employment Tax||($7,650)||($15,210)|
|SE Tax Deduction||$0||($7,605)|
|20% Pass-Through Deduction||$0||($17,608)|
2018 tax year. In this model, the 20% pass-through deduction is limited by 20% of the excess of taxable income before the deduction, less capital gains. This is calculated as 20% x (AGI minus the standard deduction). Assumes all self-employed income qualifies for the 20% pass-through deduction, and taxpayer has no capital gains.
In this case, that’s a net difference of $3,954 additional take home pay for the 1099 contractor, compared to a $100k salary job, thanks to the 20% pass-through deduction. That’s a massive tax benefit just for being a contractor!
Before the new tax law passed, the contractor would have paid higher taxes with an equivalent salary. But, now, you can have major tax savings by being a contractor!
Using the same model, here’s how much an individual can save in taxes at different salary levels by making the switch to contracting:
|Annual Salary||Self-Employed Tax Savings|
2018 tax year. Compares individual filing with standard deduction under a W-2 vs. a 1099 contractor with grossed-up equivalent pay. The 20% pass-through deduction is limited by 20% of the excess of taxable income before the deduction, less capital gains. This is calculated as 20% x (AGI minus the standard deduction). Assumes all self-employed income qualifies for the 20% pass-through deduction, and taxpayer has no capital gains.
You can see that lower income taxpayers don’t stand to benefit as much from the new pass-through deduction. This is partly because lower income taxpayers are already paying lower taxes to begin with, and so don’t stand to save as much. But its also partly due to the way the pass-through deduction is calculated. For lower income taxpayers, it’s probably still a better choice to be an employee.
But for folks with average or above-average incomes, the tax benefit of consulting can be quite compelling.
Like most tax provisions, the new pass-through deduction is subject to upper income limits. The limits can be quite complicated. If you have more than $157,500 individual or $315,000 couple in total taxable income, prior to the pass-through deduction, then you will be subject to one or more of the income limitations.
There are two income limitations. The first is called the wage & property limit, and it applies to everyone. Under the wage & property limit, the deduction is limited by the greater of:
- 50% of the wages you pay to employees. Obviously, if you’re a 1099 contractor with no employees, then that would be 50% of $0, which is $0; or
- 25% of the W-2 wages you pay to employees, plus 2.5% of certain “qualified business property” (basically depreciable equipment held for use). This will also be $0 for most 1099 contractors.
The wage & property limit is phased in over a $50,000 range for individuals or $100,000 for couples. So, the limit is fully in place if your income is over $207,500 for individuals or $415,000 for couples.
The second income limit on the pass-through deduction only applies to service businesses. As defined, “service businesses” includes the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any service provider “where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”. This would include a lot of 1099 contractors too.
The service business limit is phased in over the same income range on a pro-rate basis. So, if you are 80% of the way through the phase-out range, then only 20% of your self-employment income is deductible. If you are beyond the phase-out range, you can no longer take the deduction at all if you are a service business.
Since most 1099 contractors are service businesses, that effectively means most contractors cannot use the deduction if their income is beyond the phase-out limits.
If you’re beyond the income limits, then the tax benefits of being an independent contractor or self-employed would no longer apply.
The Other Big Caveat
Of course, you can’t just become an independent contractor in name only, while still carrying out the same duties as an employee. An independent contractor is supposed to be independent, and to direct her own work. Companies abuse this distinction all the time by classifying workers as contractors, while treating them as employees.
Unfortunately, if you cannot prove that you act as a contractor, then you could get yourself in a bind with the IRS. You could face tax penalties thanks to the new pass-through deduction.
See here for IRS rules on defining independent contractors.
There are some other scope limitations on the pass-through deduction. For example, foreign income is not eligible for the deduction, and neither is most investment income. If you have any doubt whether you can qualify for the new pass-through deduction, I’d advise checking with a tax expert, picking through the original tax bill, or waiting for official IRS guidance before making any major decisions about your employment status.
But for most of us earning a median income through a day job, contracting or self-employment is now a better tax choice than to be a full-time employee.
Who knew that changing your employment status could be so lucrative?