Classification Act: Tax Planning Considerations Under the New Law.

AuthorWall, Chris
PositionRegulatory update

assembly Bill 5 (AB 5), signed into law Sept. 18 by California Gov. Gavin Newsom, codifies the "ABC" test from the California Supreme Court ruling in the Dynamex case for determining whether a worker is an employee or independent contractor.

The "ABC" lest presumes a worker is an employee unless the hiring entity can demonstrate the worker satisfies the following three requirements:

* The worker is free from the control and direction of the hiring entity;

* The worker performs work outside of the usual course of the hiring entity's business; and

* The worker has an independent business performing the same type of work the worker performs for the hiring entity.

A worker who does not pass the ABC test will be classified as an employee for certain purposes--including minimum wage and overtime rules, eligibility for unemployment and workers' compensation insurance, and requirements for the hiring entity to reimburse the worker for business expenses, among others.

AB 5 does not directly affect worker classification for income tax, payroll tax or employee benefit purposes. However, the bill may cause changes in the relationship between the worker and the hiring entity (e.g., reimbursement of out-of-pocket expenses or payment of an hourly minimum wage), which could cause an independent contractor to become an employee under the relevant worker classification rules.

This article discusses some tax planning considerations if a business reclassifies an independent contractor as an employee. It's important to note that worker reclassification for state purposes may or may not impact worker classification for federal purposes. There are several considerations that need to be evaluated when determining worker classification for federal purposes.

Section 199A

Sec. 199A generally allows a deduction for 20 percent of qualified income of an individual or trust from a pass-through entity such as a partnership or S corp. The amount of the deduction for higher income taxpayers is limited to the greater of 50 percent of the W-2 wages of the business or 25 percent of wages, plus 2.5 percent of the unadjusted basis in qualified property. For many businesses, the deduction is limited by the W-2 wages paid. Converting a worker to employee status will increase the company's W-2 wages, which may increase the Sec. 199A deduction available to the owners. Tax practitioners may be presented with the opportunity to explain how every additional dollar of W-2 wages affects...

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