Inevitably, loopholes arise whenever any major legislation is enacted, whether intentional or unintentional. One possible loophole created by the new pass-through rules under the Tax Cuts and Jobs Act (TCJA) could provide significant tax benefits for broker-dealers, according to a new client alert from the Wagner Law Group.
Under the TCJA, an individual taxpayer generally may deduct 20% of qualified business income (QBI) from a partnership, S Corporation, sole proprietorship or limited liability corporation. The authors explain that 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 deduction currently is scheduled to expire after 2025.
According to the alert, this provision may prompt registered representatives to inquire about restructuring their tax status, with the thought that “their federal income tax position will improve if they are classified as independent contractors rather than employees of a broker-dealer firm.” The thought is that a self-employed individual will be taxed at a lower rate under the 20% deduction of QBI, compared to an employee performing substantially the same work.
The scenario could involve a currently employed registered representative of a broker-dealer firm who resigns and subsequently becomes a sole proprietor performing substantially the same services that he or she was previously performing as an employee of the broker-dealer firm.
To take advantage of this loophole, however, the alert explains that the “threshold question is whether the registered representative can establish him- or herself as a bona fide independent contractor.” Even then, the TCJA has certain anti-abuse provisions to deter taxpayers from converting wage income into QBI.
The alert cautions that one such provision is that “the amount of QBI cannot include any guaranteed payment for services rendered by the registered representatives with respect to brokerage services.” Consequently, registered representatives would need to restructure their compensation so that it does not constitute guaranteed payments, the firm advises.
In addition, the firm emphasizes that because the services performed by a registered representative are treated as “specified services,” the deduction would be subject to the dollar phase out thresholds, resulting in certain registered representatives being unable to take advantage of the lower pass-through rates.
The alert further stresses that such a decision would require other trade-offs in losing employee status, including responsibility for self-employment taxes, paying estimated taxes and losing certain worker benefits and protections, none of which may be dealbreakers, but are factors to consider.
While Congress did not intend for employees to change their status to independent contractors under the TCJA, the firm suggests that until Congress and IRS can determine how best to address this issue, the scenario is worth evaluating.
Other questions that broker-dealers would need to consider include:
- 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 advisory agreements with clients or Form ADV disclosures?