Tax Reform Raises Questions on Employee Classification

Now that President Donald Trump has signed the bill overhauling the U.S. tax code, employers are on a tight timetable to get things organized since a bulk of it took effect on January 1, 2018.

Besides requiring employers to deal with new payroll forms (including the IRS’s W-4) and other changes, the new law sparks many other questions for employers. Among them: How might current employees wish to change their classification status?

William C. Foley, an attorney with Axley Brynelson, LLP, in Madison, Wisconsin, says employers certainly will be interested in new forms and guidance from the IRS and how the new tax law will affect their fourth-quarter financial statements. But it’s unclear when the IRS will be able to issue revised forms, and relief may be available on financial statements. But there’s a different issue—related to the employment relationship—that also requires thought and planning, Foley says.

Law’s Effect on Employee Classification

The scramble surrounding the new law is expected to have both employers and employees looking at how employees are classified, Foley says. “I do think this will be a hot topic going forward.”

In an article in the January 2018 issue of Wisconsin Employment Law Letter, Foley explains that under the old law, income earned by pass-through entities—sole proprietorships, partnerships, limited liability companies (that have elected partnership tax treatment), and S-corporations—is passed through to the owners, who then pay income tax based on the individual income tax brackets that apply to their income level.

Under the new law, some or all of an entity’s income will be taxed effectively at a flat rate. That means that business owners who earn taxable income that otherwise would be taxed above that rate, based on their income tax bracket, could achieve a tax savings by applying a flat pass-through rate to the entity income. High-income earners likely will see tax savings if their income is taxed via a pass-through entity instead of as employment wages, Foley explains in his article.

Foley advises employers to be prepared to review employee and contractor classifications to make sure they have a “systematic, documented process in place” if the issue comes up.

“What is most clear at this time is that the new tax bill weighs sharply in favor of (certain) pass-through income, over simply W-2 wages,” Foley says. “Under the new rules, many owners of pass-through entities will see a significant reduction in the amount of income taxes they pay. So employees may well (and probably should) review their status and may apply stronger pressure to their current employers in making such a change than they may have in the past.”

Foley says employers should expect some workers to explore forming a sole proprietorship and position themselves as a business partner/vendor of the company to achieve a reduction in the amount of taxes they pay. If that happens, employers need to understand the complexities of employee versus contractor classification.

Misclassification of employees as independent contractors has been a focus for the U.S. Department of Labor (DOL) for years, but in June 2017, the administration withdrew a DOL administrative interpretation that had taken the position that “most workers” were employees rather than independent contractors. Foley says it’s unclear what position the DOL will take on employee classification.

In his article, Foley reminds employers that courts have found that “an employee of a properly formed, separate business entity may ultimately be considered an employee of the labor-recipient entity if facts exist to suggest that this is more proper than considering the individual an employee of her own legal entity.” Therefore, such an individual “should be reviewed to properly document that she isn’t (or, possibly, is) an employee of the company.”

What to Do Now

So what should employers do right away now that the new tax bill has been signed? Foley says that from an employer’s perspective—depending on the organization—“the best answer may be to simply get everything else organized now. That is, it would be a good time to address any nontax issues that the employer actually has control over, while the tax reform ripples make their way across all organizations. Then, the organization can limit distractions whenever the time comes to ‘press go’ on the change initiatives.”