California’s Expansion Of Employee Classifications
The Supreme Court of California issued a ruling on April 30, 2018, which is likely to have a significant adverse impact on business owners. The primary issue in the matter of Dynamex Operations West Inc. v. The Superior Court of Los Angeles County was whether an entity that hires an individual worker can classify such a person as an employee or an independent contractor.
The ruling now creates a rebuttable presumption that such individuals are considered employees. The ruling, however, is limited to only California’s wage orders. As such, it would not currently apply in other contexts such as for workers’ compensation or for tax purposes. Therefore, an entity may be able to classify a worker differently depending on the context.
Wage Orders
In 1913, the Industrial Welfare Commission (IWC) was established in California in order to regulate wages, working hours, and working conditions. In 2004, the legislature of California defunded IWC, however, the wage orders established by IWC are still enforced to this day by the California Department of Industrial Relations, Division of Labor Standards Enforcement.
There are a total of 17 wage orders (not including the minimum wage order), 16 of which are broken down within various industries. Some examples include the Manufacturing Industry, Personal Services Industry, and Transportation Industry. The last wage order is for Miscellaneous Employees, which consists of individual workers who are not covered in any of the first 16 categories.
The primary purpose of a wage order is to regulate certain activities that are meant to protect the workers, such as hours of employment, overtime, wage levels, and the working conditions within each industry. For example, employers who hire truck drivers must provide their drivers a 30-minute break per every five hours of work unless the work period does not exceed six hours.
Economic Reasons For Classifying Workers As Independent Contractors
There are many reasons for classifying workers as independent contractors. Generally, it costs more for employers in aggregate to pay to employees than to independent contractors. Additionally, the hiring of an employee usually ends up triggering other expenses that otherwise would not have been made towards independent contractors. These expenses include employer-provided benefits, office space, and equipment.
In addition to the foundational expenses, there are also required payments and contributions employers must generally make on behalf of their employees. These include the employer’s share of the employee’s Social Security and Medicare taxes (“self-employment taxes”), the state unemployment insurance, and workers’ compensation insurance. While the latter two payments may vary from state to state, the self-employment tax is a federally fixed amount which totals 7.65% of the employee’s compensation whose annual taxable income generally does not exceed $128,400.
Practical Reasons For Classifying Workers As Independent Contractors
One obvious reason for such a classification is that the employer generally has more control over the staff or the ability to determine whether to have any staff in the first place. Employers generally have greater flexibility in hiring and firing independent contractors than employees. Such a leeway also reduces the likelihood of a business owner’s potential exposure to a lawsuit in response to a firing or a layoff.
Employees also have a wide array of protections under both federal and state law. These protections may range from the right to receive minimum wage, taking sick leave, having the right to form a union, and promulgating a lawsuit based on wrongful termination. In addition, an employer may suffer the additional depletion of resources that generally come with lawsuits (in the form of time, money and stress), if the employer potentially faces civil liability under the theory of vicariously liability for an unlawful act committed by an employee.
The Road To The Dynamex Ruling
The California courts have wrestled with the distinction between employees and independent contractors for some time now. The distinction has come up in various contexts. For example, in the context of workers’ compensation, the Court carved out a six-factor test in S.G. Borello & Sons, Inc. v. Department of Industrial Relations (1989).
The Borello factors consisted of the following: (1) the level of control of details by the employer on the worker’s activities; (2) the worker’s investment in the materials required for the task; (3) the worker’s opportunity for profit or loss depending on his managerial skills; (4) the level of skill required for the particular service; (5) the degree of permanence of the working relationship; and (6) whether the service is an integral part of the employer’s business.
In Martinez v. Combs (2010), the Court interpreted IWC’s definition of “employ” in the context of wage orders. The Court found three alternate definitions, any of which may deem an individual worker an employee.
- To Exercise Control over the Wages, Hours or Working Conditions;
- To Suffer or Permit to Work; or
- To Engage, thereby Creating a Common Law Employment Relationship
The first definition asks whether the hiring entity generally has the power to set and negotiate the wages, hours, or working conditions (e.g. meal and rest breaks) of the individual worker. The third definition characterizes “to employ” in a plain context where a basic common law employment relationship is created. In Dynamex, the central issue became the interpretation of the second definition, the “to suffer or permit to work” standard.
The Interpretation Of The Suffer Or Permit To Work Standard
In Dynamex, the court held that there is a presumption that the worker is an employee. To overcome the presumption, the employer must establish all three factors as applied in the “ABC” test. This is a critical point since if any of the three factors are not met, the employer will not overcome the presumption. Therefore, the particular worker will be deemed an employee if the burden cannot be rebutted in its entirety.
The ABC test consists of the following three factors: (1) the worker is “free from control” and direction over the performance of the work, both under the contract and in fact; (2) the work provided is “outside the usual course of business” for which the work is performed; and (3) the worker is customarily engaged in an “independently” established trade, occupation or business.
“Free From Control”
The Court used cases from Vermont and Washington to provide guidance on the control factor. In the Vermont case, the court held that knitters who worked at their own pace from their own home at their own time on the days they wanted to work were nevertheless under the control of the employer because the employer dictated the pattern and style of knitting.
In the Washington case, a truck driver hired by an entity was not deemed free from control because the entity required for the truck to be kept clean; for the driver to obtain the entity’s permission before taking passengers; for the driver to travel to the entity’s dispatch center in order to obtain assignments that were not scheduled in advance; and the entity had the ability to terminate the driver’s services for tardiness or for other policy violations.
“Outside The Usual Course Of Business”
The Court used cases from Maine, New Hampshire, and Connecticut to provide guidance on the outside course of business factor. In the Maine case, the court held that the harvesting of timber by workers was within the ordinary course of a timber managing entity, even though the entity was only involved in the purchasing and harvesting of trees.
In the New Hampshire case, the court held that because a resort advertised and regularly provided entertainment, the performance of live entertainers was within the course of the resort’s business. In the Connecticut case, the court held that an art instructor’s services were within the ordinary course of the museum’s business because the museum offered the classes regularly and continuously, determined the class hours, registration fees, instructor’s names, assembled brochures which announced the classes, and discounted the cost on classes for museum members.
“Independently Established Trade Or Business”
The Court used a case from Virginia to provide guidance on the independence factor. In the Virginia case, the entity provided siding installers their own tools, but there was no evidence to suggest that the side installers had their own and distinct business cards, licenses, business addresses, phones, or that they received any income from any other party besides the hiring entity.
The Court stated that by the mere fact that an entity permits a worker to engage in a similar activity for other businesses is not sufficient to meet the independence factor. Thus, the worker must actually have an independent business or occupation in order to meet this factor.
The Implications Of The Dynamex Ruling
The Court’s reasoning behind the decision arguably comes down to the protection of workers at the expense of business owners. The court reasoned that the term “independent contractor” generally refers to someone who “independently has made the decision to go into business for himself or herself.” This shows that California is headed towards the literal interpretation of the word independent as it deals with the classification of independent contractors. However, such an approach may also adversely impact the workers themselves, since business owners are likely to be less hesitant to contract with a particular worker on a project-basis unless such an engagement will be an absolute necessity for the business owner.
The primary concern of the Court is that if the worker is unilaterally determined by the hiring entity to be an independent contractor, then “there is substantial risk that the hiring business is attempting to evade the demands of an applicable wage order through misclassification.” The Court added that if an entity is able “to obtain the economic advantages that a wage order imposes” by the virtue of the classification of the independent contractor status, such an act “unquestionably violates the purposes of the wage order.”
This ruling is likely going to open the floodgates to litigation in many contexts, not only as to those issues related to wage orders. There is expected to be a wave of litigation since the court set an “exceptionally broad suffer or permit to work standard.” The ruling will also likely open the door to its potential application in other contexts, such as workers’ compensation insurance. It may even lead to its adoption on a federal level, which may also affect the classifications for federal tax purposes or other classifications on the federal level.
Finally, business owners and other entities may want to consider reclassifying some, if not all of their workers, as a result of this ruling. The penalties for the misclassification can be hefty. They can include potential liability for meal and rest breaks, minimum wage, overtime, waiting time penalties, and other penalties. California also imposes civil penalties, which can range from $5,000 to $25,000 for each violation that is found to be the result of a willful misclassification or willful aid in misclassification of workers as independent contractors.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance to its use. Additionally, certain changes in law may affect on the legality of the information provided above, and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
Read MoreTax Reform’s Impact On Individuals
During this segment, we discuss how the new changes in the tax laws may have an overall positive effect on individual rates and deductions. However, a crucial component of the Tax Cuts and Jobs Act is that the rates and other provisions of the new tax code have a sunset provision, which means that on December 31, 2025, all of the rates are likely to be reinstated unless some legislation is introduced that will retain these rates or lower them even further.
Synopsis
The Tax Cuts and Jobs Act of 2017, otherwise known as GOP tax reform bill, largely went into effect on January 1, 2018. A crucial component of TCJA is that the rates and other provisions of the new tax code have a sunset provision. This means that on December 31, 2025, all of the rates are likely to be reinstated unless some legislation is introduced that will retain these rates or lower them even further.
The following are the list of major changes under the new tax code:
- Brackets Lowered (rates sunset on December 31, 2025)
- Personal Exemptions Repealed
- Standard Deduction Nearly Doubled
- State and Local Tax Deduction limited to $10,000
- 21% flat rate for C-corporations
- Qualified Business Income Deduction for Pass-Through Businesses
- Estate Tax Exemption More Than Doubled
For more on the impact the new laws will have on corporate rates and on pass-through businesses, please refer to our previous material, including “Tax Reform’s Impact On Businesses.”
Tax Brackets
Nearly all of the rates within each tax bracket have been reduced. The only brackets that have not been reduced under the new law are for those taxpayers who fall within the 10% bracket and the 35% bracket. These rates are the same as prior to TCJA. Additionally, the top rate for individuals has been reduced from 39.6% to 37%.
For middle-income families, the lowering of the rates may have a consequential impact on their lifestyle. For example, a married couple that files their taxes jointly and whose taxable income falls between $156,150 and $165,000, their effective tax rate has been reduced from 28% to 22%. For a married couple whose taxable income falls between $237,951 and $315,000, they would previously pay 33% tax on their taxable income. Now, they will only pay 24% under the new tax code.
Personal Exemptions
Prior to the new law, every person was entitled to an exemption in the amount of $4,050. If such a person also had qualified dependents, each dependent would also qualify for the exemption. This would mean that a family of five could have potentially been entitled to an exemption in the amount of $20,250. However, the lowering of the brackets for the next eight years and the doubling of the standard deduction may offset the losses for such families who would otherwise be adversely affected by the repeal of the exemptions.
Standard Deduction
The standard deduction has nearly doubled in every category. For single filers, it used to be $6,350 prior to TCJA, now it’s $12,000. For married couples filing jointly, it used to be $12,700, now it’s $24,000.
For married couples filing separately, the rates are the same as for single filers. For those taxpayers who qualify as heads of households, they were previously allowed a deduction in the amount of $9,350, now they can deduct as much as $18,000.
S.A.L.T. Deduction
The State and Local Tax deduction, which has been limited to $10,000, was a significant deduction for California residents who were previously itemizing their deductions. California is the highest income tax state in the nation. The top bracket is as much as 13.3% of the Adjusted Gross Income of the federal income taxes.
Previously, a taxpayer who did not elect the standard deduction was generally allowed to deduct all of the amount paid to the state and locality for income or sales tax, in addition to any property taxes the taxpayer might have paid to the state and locality. However, the deduction on both the income (or sales) tax and property tax is now limited to only $10,000.
To illustrate the point, let’s look at a specific example. Assume that Gregory lives in San Diego. He pays $9,000 per year in state income taxes and $11,000 in property taxes. Prior to tax reform, Gregory could potentially deduct $20,000. Now, Gregory can only deduct $10,000, if he chooses to itemize his deductions
Other Deductions
There has also been a limit on the mortgage interest deduction for new mortgages. For those taxpayers who had an existing mortgage prior to 2018, they can still deduct the interest they pay on up to a $1 million mortgage. Under the new law, whether the new mortgage is for a new home or an existing home, the limit on the deduction for the interest paid on the mortgage has been limited to only $750,000 of the mortgage amount.
For charitable contributions, where previously a taxpayer could deduct 50% of his taxable income if that amount is directed to a qualified charity, now the taxpayer can redirect 60% of his taxable income to a qualified charity.
As for divorces or instruments of separation that are executed after December 31, 2018, the alimony paid as a result of the divorce or separation will no longer be allowed to be deducted.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance to its use. Additionally, certain changes in law may affect on the legality of the information provided above, and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
Read MoreIncome Shifting Strategies
This segment discusses different strategies that can potentially help a business owner become more tax efficient. Some methods include the restructuring of a business and establishing tax-deductible retirement plans.
Synopsis
The concept of characterization of income (or shifting of income) may result in the preservation of significant wealth. One method of shifting of income is through retirement planning. Another method is the restructuring of a business entity.
Retirement Planning
If the taxpayer is working and participating in a 401K with his employer, or he has an IRA, meaning it’s funded entirely by the taxpayer, the money that goes into such accounts may save him on taxes.
When the taxpayer puts money in such plans, he decides that instead of paying taxes now, he will instead pay taxes when he take those funds out, preferably when his tax brackets are likely to be reduced at his retirement. That’s because his total taxable income is likely to be lowered since he is no longer working, thereby lessening his income tax obligations.
Conversely, if the taxpayer decides to take the money out between now and 2025 (when the newly lowered rates are likely to expire), he may significantly save on taxes by paying at a lower rate now than take the money out later and potentially pay at a much higher rate later, even when he is no longer working for a living.
Restructuring a Business
Another way of becoming more tax efficient is by restructuring a business entity. The business owner may want to consider changing his business entity structure. There are different types of business entities, such as pass-through entities or C-corporations. The business owner may want to consider switching from a C-corporation to an S-corporation, or vice versa.
Types of Tax-Deductible Retirement Plans
For those business owners who want to shift larger amounts of income, there are other tools that they might not be aware of, including retirement plans such as establishing defined benefit or defined contribution plans, or some kind of a hybrid thereof.
72% of Small Business Owners Don’t Have Tax-Deductible Retirement Plans
There are three reasons for why small business owners do not have tax deductible retirement plans. First, business owners don’t think they will get a large enough share of the plan contribution. Second, business owners think that the plan’s administration is too costly and there is just too much paperwork. Finally, the typical business owner doesn’t know where to go for advice or how to begin the planning process.
Incentives for Having Tax-Deductible Retirement Plans
There are three main incentives for a business owner’s sponsorship of a retirement plan. First (and the obvious) are the retirement benefits themselves. The second incentive is that the retirement plans may allow for tax deductions, thereby leading the business owner to become more tax efficient. The third benefit is that if a governmentally protected retirement plan is implemented, the plan can provide asset protection, meaning the money in such accounts will generally be out of a creditor’s reach.
The Sad Truth on Governmental Retirement Programs
If you are relying on the government for your retirement savings, you need to be very careful. For example, California has unfunded pension liabilities. California currently has tens of billions of dollars of debt in its pension program. Similarly, social security has been seeing a pending crisis since the ratio of those putting in versus those taking out has gotten narrower.
Tax Incentives
As for taxes, these plans can generally give large tax deductions. In addition, they allow the taxpayer to potentially pay less taxes because the tax bracket may now be lower due to the shift in the taxpayer’s income. This is more true now than probably ever before since nearly all of the individual brackets have been considerably lowered until 2026.
There is also a new deduction for pass-through business owners known as Qualified Business Income. The added benefit of QBI sweetens the pie for the business owners who want to potentially save more on taxes than they otherwise would have under the old tax code.
Asset Protection
Both the federal government and the state provide a safeguard for the assets that are held in certain types of retirement plans. This means that if a creditor should obtain a judgment against the taxpayer, the assets held in such plans will generally be out of reach of such a creditor’s hands.
Why Tax Planning Matters
A person’s tax bracket is a significant factor in determining any potential planning strategies that may be available for him. If a taxpayer is in a lower bracket, then he might want to take some of that money out now and pay at a lower rate. If the taxpayer is in a higher bracket, he might want to consider income shifting strategies in order to lower his tax bracket. However, if the taxpayer takes money out before the age of 59.5, he will generally pay a 10% penalty in addition to the regular tax that may otherwise be due upon the withdrawal of such funds.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance to its use. Additionally, certain changes in law may affect on the legality of the information provided above, and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
Read MoreTax Reform’s Impact On Businesses
Prior to tax reform, the C-corporation tax rates ranged from 15 to 35 percent. Under the new law, there is a 21% flat rate. Also under the new law, there is this new deduction known as the Qualified Business Income deduction that is available for Pass-Through Businesses.
Synopsis
The Tax Cuts and Jobs Act of 2017, otherwise known as the GOP tax reform bill, largely went into effect on January 1, 2018. If utilized properly, the new law can be significantly beneficial for business owners. To understand how the new laws can be beneficial for business owners, it’s important to be familiar with the two types of businesses that can have an impact on the taxation of a business entity.
Taxation of a Business Entity
One way is for the entity to be structured as a C-corporation, in which case the income generated from the business may be taxed twice. For example, the corporation gets taxed at the corporate level upon earning a profit, then after the corporation makes a distribution to the shareholders, the shareholders also pay taxes on their individual tax returns. This concept is known as double-taxation. Under the new law, all the C-corporations will pay a 21% tax on their corporate profits.
The second way businesses are taxed is that instead of the tax being paid at the business level and then again at the individual level, the profits and losses pass through and get taxed at the individual level only. This is especially significant now since the individual rates are set to expire on December 31, 2025, but the 21% rate for C-corporations is permanent.
“Qualified Business Income” Deduction for Pass-Through Businesses
Under the new code, there is a special provision which allows the owners of pass-through entities to benefit from additional tax breaks that are afforded to pass-through entities.
For purposes of the tax law, the following entities qualify as pass-through businesses: sole proprietorships, partnerships, S-corporations, LLCs, trusts, and estates. However, there are different tax consequences for disregarded entities. For these types of business owners, all of their income may be considered as qualified business income.
In essence, what the new law says is that if you have a pass-through entity, you may generally receive a 20% deduction on the Qualified Business Income (QBI). For pass-through entities, the portion of the profits that the business owner is entitled to after he receives a reasonable compensation for his services is deemed as qualified business income. For example, you may consider the portion of the income that comes in the form of W-2s, meaning wages, and the portion of the profits that qualify as business income, such as in the form of K-1. The portion of the income that represents the wages does not fall within the realm of QBI; whereas the portion of the business income that is in the form of K-1 may fall within the realm of the QBI.
QBI Requirements
In order to qualify for the QBI discount and to determine the extent to which the QBI deduction will save the taxpayer on the discount, we must first determine the nature of the underlying business. There are two categories of businesses that qualify for this discount: specified service businesses and all other businesses that are not classified as specified service businesses.
What is a Specified Service Businesses?
For purposes of this tax code, a specified service business is any business – involving performance of the services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services – or any trade or service where the main asset of the business is the reputation or skill of one or more of its employees. Note, however, that architects and engineers are exempt from this category.
The Three-Tier System
For married couples who file their taxes jointly, to fall within the first Tier, the threshold for the married couple’s total taxable income may not exceed $315,000; Tier 2 is between $315,001 and $415,000; Tier 3 is any amount that is in excess of $415,000.
For single filers to fall within the first Tier, the threshold for the single filer’s total taxable income may not exceed $157,500; Tier 2 is between $157,501 and $207,500; Tier 3 is any amount that is in excess of $207,500.
How Do You Qualify for the QBI Deduction?
If your total taxable income falls in Tier 1, regardless of whether you’re a specified service business or not, you may receive a deduction. If your business falls in Tier 2, the amount of the deduction you get is generally reduced. If you are in Tier 3, depending on whether you are a specified service business or not, your deduction is either limited or you don’t get a deduction at all.
How Does the QBI Deduction Apply?
Assuming that the taxpayer qualifies for the discount and he falls within Tier 1, then the 20% discount would apply on the portion of the business income. This means that the taxpayer who earns $100,000 on his business income may pay tax only on the $80,000 of such profits. If we assume that the taxpayer falls within the 24% tax bracket, then the taxpayer would pay the 24% rate on the $80,000, not the $100,000. As such, instead of paying $24,000, the taxpayer would now pay $19,200 on the portion of the business income.
Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance to its use. Additionally, certain changes in law may affect on the legality of the information provided above, and certain circumstances of the reader may vary the applicability of the above content to his or her situation.
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