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Contracting Is Now a Better Tax Choice Than a Salary

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

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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.


Equivalent Pay

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.

Pass-Through Deduction - save thousands in taxes as a 1099 contractor or self-employed

The pass-through deduction is calculated as the lessor of:

  1. 20% of your qualified business income, net of business expenses; or
  2. 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 Salary1099 Contractor or Self-Employed
After-Tax Income$77,051$81,004
Gross Income$100,000$107,650
Social Security or Self-Employment Tax($7,650)($15,210)
SE Tax Deduction$0($7,605)
20% Pass-Through Deduction$0($17,608)
Standard Deduction($12,000)($12,000)
Taxable Income$88,000$70,436
Income Tax($15,300)($11,435)

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 SalarySelf-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.


Income Limits

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:

  1. 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
  2. 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.


Service Businesses

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.

Sweet Spot

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?


Jojo Bobo


6 Responses
  • Jeff L
    February 3, 2018

    Hi Jojo:
    Thanks for the analysis. This is very similar to my family circumstances but I think if you add health insurance to the equation, wage earners will still be far better off than self-employed workers and it gets worse the older you are. It may work if you qualify for ACA benefits but your example would not.

    Here are some numbers to use in your estimates. I derived them the National Association of Insurance Commissioners. The average claims per person is about 300 per person or $3600 per year. The average corporation pays 75% and the employee 25% or ~$1000 per year per person irrespective of age. So this is a simple way to estimate employee premiums.

    On the other hand, self-employed persons have a little more than this average claim but if you don’t qualify for subsidies, you pay the whole cost PLUS the policy is age rated. Once you hit 40, you are going to easily pay $10,000 per year and over 60, $13,000 per year per person. You can only deduct this from adjusted gross income and not from schedule C income which cuts this amount a little after taxes. But it is still far more than the difference you cite in your example.

    Jeff Lapides

    • JoJoBoBo
      February 4, 2018

      Hi Jeff,
      Definitely, if you don’t get compensated for your extra expenses as a contractor (such as health insurance), then contracting is worse. But, I’ve found that employers generally are willing to pay contractors more than employees in recognition of those extra expenses. As a rule of thumb, an employee costs a company about 120 – 150% of the employee’s salary. For example, an employee with a salary of $100k actually costs the company about $120k – $150k, after you consider things like SS taxes, workers comp insurance, and benefits. For this reason, a contractor shouldn’t accept the same top-line pay as the employee.

      But when we compare apples-to-apples, an employee making $100k vs. a contractor making the grossed-up equivalent ($120k – $150k), then the contractor is in a better tax situation.

      Obviously, there are other reasons NOT to be a contractor – such as job security – but for some people, contracting just got a lot better.
      Cheers, JB

      • RayB
        February 5, 2018

        As an independent contractor, you can also write off 100% of your Healthcare Premiums, which helps reduce the overall costs of Medical Insurance.

        • Guillermo Birmingham
          February 8, 2018

          Not just health insurance but also many other expenses that a W-2 employee can’t deduct. Indpendent contractors have the ability to more easily spend pre-tax dollars than do W-2 employees. And you lose when you spend after tax dollars…every time. For instance, many parents give their kids an allowance, pay for their braces, pay for private school, etc. What if there was a way to pay for your children’s costs as a business expense…there is…hire them into your business…pay them wages, deposit the funds into a custodial account…then pay for them braces with that money…you can’t do that as a W-2 employee and most dental insurance plans don’t cover the cost fully of braces.

          That’s just one example of many that can be employed to counter, my job pays for my health insurance argument. That’s why it’s important to seek the counsel of a good tax strategist like myself and my colleagues who publish this site.

          Guillermo A. Birmingham, CPA

  • Rob
    February 13, 2018

    I don’t understand the wage limit. If you gross 200k under your s-corp and only pay yourself 60k, what us the math there?

    • JoJoBoBo
      February 13, 2018

      So your pass-through income would be $140k, and your W-2 wages paid is $60k (assuming you have no other employees, other than yourself). The pure pass-through deduction is 20% of $140k, or $28k. The wage-and-property limit is either 50% of $60k (or $30k), or 25% of $60k ($15k) PLUS 2.5% of qualified business property. If you have no depreciable assets in the business, that would be $0. So, your wage limit may be as low as $15k, and it would reduce your pass-through deduction if your total taxable income is beyond the thresholds – which it sounds like it probably is. There are other limits too, so I can’t say if this is really your situation… but it illustrates the math of the limitation. -JB

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