Consider "Quitting" Your Job to Save on Taxes

The idea of "quitting" your job might sound extreme, but with the 2017 Tax Cuts and Jobs Act, restructuring your employment relationship could unlock significant tax savings. The law introduced the Qualified Business Income (QBI) deduction, a new way for small business owners and independent contractors to reduce their taxable income by up to 20%. Unfortunately, common-law employees—those working directly for an employer—don’t qualify for this deduction. However, with some careful planning and a conversation with your employer, transitioning from employee to independent contractor could lower your tax burden.

Having guided clients through this process, I’ve seen how restructuring can create a win-win scenario for both employers and workers. Let’s explore how this works, what you need to consider, and how you can decide if it’s the right move for you.

Understanding the Qualified Business Income Deduction

The QBI deduction allows certain taxpayers to deduct up to 20% of their qualified business income from their taxable income. QBI includes income from sole proprietorships, partnerships, S corporations, and even some real estate investment trusts. But this deduction isn’t available to traditional employees—those receiving W-2 wages.

For example, if you’re a freelance graphic designer earning $80,000 as a sole proprietor, you could deduct up to $16,000 (20% of $80,000) from your taxable income, significantly reducing your tax liability. But if you’re an employee earning that same $80,000, you wouldn’t qualify for the deduction.

The Opportunity: Restructuring Your Relationship

If you work in a role where becoming an independent contractor is feasible, you might be able to access the QBI deduction by negotiating a new arrangement with your employer. This doesn’t mean quitting your job entirely—it means changing the terms of your relationship. As an independent contractor, you’d provide the same services, but as a self-employed individual.

For example, a software developer employed at a company could negotiate to work as an independent contractor instead. This change would make their income eligible for the QBI deduction, creating significant tax savings. However, the shift also means taking on responsibilities like paying self-employment tax and covering your own benefits.

Potential Savings: The Impact of the QBI Deduction

The tax savings can be substantial. For every $1,000 of qualified business income, you could save up to $24 in federal taxes. If you’re earning $100,000 annually, that’s a potential savings of $2,400 just from the QBI deduction alone. These savings add up quickly, especially for higher earners.

However, there are limits to consider. If your QBI comes from a "specified service business" like medicine, law, consulting, or performing arts, the deduction phases out as your taxable income rises above $157,500 for single filers or $315,000 for joint filers (as of 2018). Additionally, the deduction is capped at 20% of your taxable income, meaning it won’t reduce your taxes beyond that threshold.

Land Mines: Negotiating Your Pay and Benefits

If you decide to explore this option, it’s essential to negotiate carefully with your employer. As an employee, your compensation package often includes benefits like healthcare, retirement contributions, and half of your Social Security and Medicare taxes (FICA). These benefits are valuable and must be factored into your new arrangement.

For instance, if your employer is paying $10,000 annually for your healthcare and $6,000 toward retirement, along with their share of your Social Security tax, your total compensation is much higher than your salary alone. As an independent contractor, you’ll need to adjust your rates to cover these additional costs.

Here’s a tip: Research the full value of your current benefits package and include it in your proposed compensation as an independent contractor. For example, if your salary is $80,000 and your benefits are worth $20,000, you should negotiate for a minimum of $100,000 in annual income as a contractor.

Implementation: Steps to Transition Successfully

If this strategy sounds appealing, here’s how to move forward:

1. Start the Conversation: Approach your employer to discuss transitioning to an independent contractor arrangement. Highlight how this change could benefit them, such as reduced payroll taxes and fewer administrative burdens.
2. Understand Your Responsibilities: As an independent contractor, you’ll need to pay self-employment taxes, which cover both the employee and employer portions of Social Security and Medicare. You’ll also be responsible for managing your own benefits.
3. Track Your Expenses: As a self-employed individual, you can deduct a variety of business expenses to offset your income. This includes travel, meals, equipment, and even home office costs if you work from home.
4. Recalculate Your Budget: Adjust your personal budget to account for higher out-of-pocket costs like healthcare and retirement savings. Consider setting up a Solo 401(k) or SEP-IRA to continue building your retirement fund.

Example: Tax Savings in Action

Take, or instance, a freelance marketing consultant, was previously employed full-time by a small firm. After learning about the QBI deduction, she approached her employer about transitioning to an independent contractor role. She worked with her CPA to calculate the value of her benefits and negotiated a new compensation rate that accounted for her additional expenses.

As a contractor, she earned $90,000 annually and was able to claim the QBI deduction, saving her over $4,500 in taxes. By tracking her expenses carefully and taking advantage of deductions, she reduced her taxable income even further. The firm also benefited from reduced payroll costs, making it a win-win situation.

Action Steps to Save on Taxes

If you’re considering restructuring your relationship with your employer, here’s how to get started:

1. Evaluate Your Role: Determine if your position is suitable for independent contractor status. Some industries, like consulting and freelance creative work, are more conducive to this transition.
2. Calculate Your Benefits: Understand the full value of your current compensation package, including salary, benefits, and employer-paid taxes.
3. Negotiate Effectively: Approach your employer with a well-thought-out proposal that accounts for both your needs and their benefits.
4. Set Up Your Business: Register as a sole proprietor or LLC, and establish a system for tracking income and expenses.
5. Consult a Professional: Work with a tax expert to ensure you maximize deductions, comply with tax laws, and avoid pitfalls.

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