Tax Reform: Unintended Consequences for Broker-Dealers
The "Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018" (the "Tax Act") - formerly known as The Tax Cuts and Jobs Act - was signed into law on December 22, 2017. Because of the speed at which it was passed, many analysts predicted that unintended consequences and loopholes would soon be identified. A loophole is generally defined as an ambiguity or omission in the text through which the intent of a statute, contract, or obligation, can be circumvented. The Tax Act will undoubtedly result in some arrangements which the Internal Revenue Service ("IRS") will perceive as loopholes, which will be addressed either through regulations or technical corrections. One such loophole relates to broker-dealers, the new pass-through rules, and whether establishment of an independent contractor arrangement brings justifiable tax benefits.
Under the Tax Act, a deduction is available for 20% of qualified business income ("QBI") from a pass-through entity -- partnerships, sole proprietorships, limited liability corporations ("LLCs") and S corporations. A phased out deduction is available to "specified service businesses," of which brokerage services is one, only if the taxpayer's taxable income is $415,000 or less for married filing jointly or $207,500 or less for single filers. The full deduction is available to "specified service businesses" if the taxpayer's income is $315,000 or less for married filing jointly or $157,500 or less for single filers. The pass-through deduction does not apply to tax years beginning after December 31, 2025.
The provision may prompt registered representatives to approach their employers with questions about restructuring their tax status. The reason being that for many registered representatives, their federal income tax position will be improved if they are independent contractors rather than employees of a broker-dealer firm. The 20% deduction of QBI means that a self-employed individual will be taxed at a lower rate than an employee performing substantially the same work with a broker-dealer firm.
The scenario may look like this: an individual registered representative who is presently an employee of a broker-dealer firm will give his or her proverbial two-weeks' notice, and establish him- or herself as a sole proprietor performing substantially the same services that he or she was previously performing as an employee of the broker-dealer firm. In order to take advantage of this loophole, the threshold question is whether the registered representative can establish him- or herself as a bona fide independent contractor.
The IRS has traditionally employed a 20-factor test to evaluate whether a worker is an employee or an independent contractor, with a focus on financial control, behavioral control, and the manner in which the relationship is treated by the parties. The Taxpayer Relief Act of 1997 ("TRA '97") added clarifying language to the Internal Revenue Code ("Code") with respect to independent contractor status of registered representatives of broker-dealers. Specifically, Section 921(a) of TRA '97 clarified whether a registered representative is an employee for employment tax purposes as defined in Code section 3121(d). While this clarification was made to the Code two decades ago, it has not been the subject of court interpretation (the Tax Court was asked to address this issue in 2010 but, because of the narrow issue presented in the case, it did not do so). For reasons we will not discuss here, it is not entirely clear how useful TRA '97 is in determining whether a registered representative is an employee.
Assuming that the taxpayer can establish himself- or herself as a bona fide independent contractor, the Code as amended by the Tax Act has certain anti-abuse provisions in place to deter taxpayers from converting wage income into QBI. For example, QBI may not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Therefore, if a number of registered representatives joined together to form a partnership or LLC, the amount of QBI cannot include any guaranteed payment for services rendered by the registered representatives with respect to brokerage services. Consequently, in order to take advantage of the loophole, registered representatives would need to restructure their compensation so that it did not constitute guaranteed payments (as determined under the Code's partnership provisions). Also, because the services performed by a registered representative are treated as specified services, the deduction is subject to the dollar phase out: beginning at $157,500 for single taxpayers, and being fully phased out at $207,500, and $315,000 for married taxpayers, being fully phased out at $415,000. Therefore, certain registered representatives will be unable to take advantage of the lower pass-through rates.
Even if an employee could benefit by converting his or her status from employee to independent contractor, there would be trade-offs in losing employee status. For example, as an independent contractor, the individual would be responsible for the tax on self-employment income (in contrast to an employee's share of FICA) and the computation and payment of estimated taxes. The individual may also lose the benefit of workers' compensation and unemployment compensation protection as well as the protection under certain federal statutes that provide protections to employees. In addition, he or she may not be reimbursed for worksite expenses and will not be eligible to receive employee benefits. Health and 401(k) benefits can be obtained as an independent contractor, but the cost of the benefits may be higher. None of these items are deal breakers, but they are factors that an individual contemplating conversion from employee to independent contractor status should take into account.
At the other end of the spectrum, pass-through entities unable to take advantage of the new rates will be motivated to incorporate because of the lower 21% corporate rate. Even for S corporations to which the pass-through rate would apply, for taxpayers at the highest rates, the tax for S corporations is still approximately nine points higher than for corporations, although there are countervailing considerations for corporations desiring to pay dividends.
Congress, in the passage of the Tax Act, did not intend for employees to change their status to independent contractors, or have pass-through entities elect to be treated as C corporations. Until Congress and IRS can determine how best to address these issues, however, both of these scenarios are worth evaluating. In responding to representatives' questions about establishing independent contractor arrangements, broker-dealers would have to consider many things: Should this be done for some but not others? What does it imply for supervision and control of advisers? Does it implicate any state wage and hour laws? Would it impact our advisory agreement with clients or Form ADV disclosures?