If you are self-employed or work as a freelancer, the plan announced by the Trump administration this week to overhaul the U.S. tax code may have a big impact on how you opt to pay yourself — and whether or not you want to take the step of incorporating your business.
As part of the sweeping changes proposed this week by Secretary of the Treasury Steven Mnuchin and Director of the National Economic Council Gary Cohn, the top rate for federal corporate taxes would drop to 15 percent. More importantly, the administration made it clear that small businesses would be able to enjoy the benefits of those cuts.
“What we’ve said is that the business rate is going to be available for small and medium-size businesses as well as corporations,” said Mnuchin of the new, far-lower proposed business tax rate.
A huge potential tax benefit
At this point, it’s premature to suggest all freelancers and self-employed people who have their income reported on 1099-MISC IRS forms should rush out and incorporate themselves in anticipation of a big cut on their taxes. But if the announced plan passes, it’s hard not to jump to the conclusion that incorporating would have a major tax benefit.
In fact, when the original version of President Donald Trump’s proposal was unveiled by then-candidate Trump last summer, Forbes magazine reported it with the headline “Under New Trump Tax Plan, We’ll All Become Freelancers.”
The key to the proposed tax changes for freelancers and self-employed people lies in how “pass through” income is dealt with as it moves from a partnership, S-Corp (the simplest kind of corporation you can form) or a limited liability company (LLC) to the individual or individuals who own the partnership or company.
Trump’s tax plan would set a top rate of 35 percent on personal income. However, owners of partnerships, S-Corps and LLCs could benefit from the much lower 15 percent rate on pass-through business income.
That rate would only apply to money paid as profits from the business, not as a salary. Strictly speaking, companies are supposed to pay the people who work for them before distributing “profits” to owners. So if you are the owner of the company and work for it, there is an expectation that you’ll pay yourself a “reasonable” wage — which will be taxed at a higher personal income tax rate.
But once you’ve paid yourself that “reasonable” salary, remaining income could qualify for the lower pass-through rate.
The tax reform devil is in the details
Incorporating to lower your tax burden sounds great, but the reality is a little more complex. According to an analysis by The Tax Policy Center — a joint venture of the Urban Institute and Brookings Institution — the big challenge will lie in how the government determines what is allowed as pass-through income.
The report further suggested that so many self-employed people might set up these pass-through entities that it could force government to consider a much stricter way of vetting them. The Tax Policy Center warned:
Current-law rules are difficult to enforce, leading to significant avoidance of payroll taxes; with the much larger rate differential under the revised Trump plan, avoidance would be much more prevalent.
In fact, Mnuchin said on Wednesday that he is aware of this issue and that the administration would plan for it by putting rules in place so wealthy people can’t create pass-throughs “and use that as a mechanism to avoid paying the tax rate that they should be on the personal side.”
Mnuchin also responded to a direct question about how the new provisions would apply to freelance or contract workers and suggested the plan remains a work in progress in terms of how these new tax rules will apply to such workers:
As it relates to the definition of contractors and things along those lines, those will be the details we will be working with Congress on as we turn this into a bill that will get signed by the president.
Trump’s tax reform plan might change
One other important caveat is that this remains a proposal from the president — it is not yet law. The plan will have to jump over significant legislative hurdles before it gets to be law. In the meantime, it might be worth reviewing other reasons to incorporate. If some form of the president’s plan makes it into law, you might have an extra reason to incorporate soon.