Should You Form a Pass-Through Entity?

The Tax Cuts and Jobs Act ( TCJA) resulted in some revolutionary changes in the nation's tax laws. Among the most revolutionary is this: It is now possible for people doing the same work and paid the same amount to end up paying tax on their incomes at different rates. Under the new law, pass-through business owners can pay 20% less tax on their business income than employees pay on their wage income.

Does this mean it's time to quit your job and become a pass-through owner? Not so quick.

What Is a Pass-Through Business?

The vast majority of small business owners have pass-through businesses—that is, they are sole proprietors, partners in partnerships, limited liability company (LLC) owners, or S corporation shareholders. The net income from such businesses is passed-through the business and taxed on the owners' individual tax returns at their individual tax rates.

Until 2018, owners of pass-throughs paid income tax on their profits at the same rates as employees. So, an employee who earned $100,000 in wages would pay income tax at the same rate as a sole proprietor or an LLC owner who earned $100,000 in profit from his business.

The 20% Pass-Through Tax Deduction for Business Owners

However, starting in 2018, pass-through owners can qualify to deduct up to 20% of their business income using a brand new deduction just for pass-through businesses. This deduction is in addition to all their other business deductions. If this deduction applies, a pass-through owner is effectively taxed on only 80% of business income. So, the effective rate for pass-through owners in the top 37% tax bracket is 29.5%.

The deduction is phased out for individual pass-through owners whose business involves providing various services including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading and dealing in securities or commodities, or any business where the principal asset is the reputation or skill of one or more of its owners. The deduction is lost if taxable income exceeds certain limits.

Should You "Quit" Your Job?

If you're an employee and you earn less than the limits, you could benefit from the pass-through deduction—even if you're a service provider. All you have to do is "quit" your job and tell your employer to treat you like a independent contractor. Instead of being paid employee wages reported to the IRS by your employer on Form W-2, you'll be paid nonemployee compensation reported on Form 1099-NEC.

Because you won't be an employee, no tax will be withheld from your compensation. And, because you're now a pass-through entity, you'll qualify for the 20% pass-through deduction. You'll end up paying 20% less income tax than when you were an employee. You don't even have to form an LLC or S corporation. You can qualify for the pass-through deduction as a self-employed sole proprietor.

The Catch With This Tactic

It sounds too good to be true, doesn't it? Well, watch out; there's a catch. You must be an independent contractor to qualify. The law specifically provides that the pass-through deduction doesn't apply to income earned from performing services as an employee. (IRC Sec. 199A(d)(1).) The difference between an employee and a nonemployee is not a mere technical distinction—it is a fundamental difference.

To qualify as an independent contractor, you must be operating your own independent business. You should market your services to the public, have multiple clients, incur business expenses, and have a risk of losing money. The hiring firm can't control you on the job they way it does employees. You don't become an independent contractor simply by saying so or by signing a paper saying so.

You can't "quit" your job and continue to do the same work full-time for the same hiring firm in the same way year after year and qualify as an independent contractor. Your employer would be crazy to reclassify you as an independent contractor under such circumstances because it could be subject to severe fines and penalties for worker misclassification. These could be imposed not only by the IRS, but by state agencies like your state unemployment insurance and workers' compensation agency.

Forming a Legitimate Pass-Through Entity

If you quit your job and start a real independent business, you can qualify for the pass-through deduction. You can continue to do some work for your old employer, but you should have other clients as well.

The new pass-through deduction makes the rewards of starting your own independent business greater than ever—presumably, the intended purpose of the deduction.

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