Are There Tax Incentives for Individuals to Convert Their Employment Contracts to Partnership Agreements?

The 2017 tax act (Pub. L. 115-97) introduced new §199A, which provides deduction for individuals engaged in a qualified trade or business through a partnership, S corporation, an LLC or sole proprietorship. 

The deduction equals to 20% of the individual’s qualified business income derived from qualified trade or business, which includes any business other than the trade or business of performing services as an employee or a specified service business involving health, law, accounting, athletics and financial services. The amount of the deduction cannot exceed the amount resulting either from 50% of the wages paid by the business or 25% of wages paid plus 2.5% of the business’s property used for deriving income. However, the limitation and the specified service business exclusion do not apply to individuals who make less than $157,500 (or $315,000 for a married couple).  

The new provision may provide an incentive to rearrange employer-employee relationship to one in which there is a partnership with the original partnership under a partnership agreement in which the individual’s income from the partnership can be eligible for the §199A deduction. However, there are reasons not to do so, because the deduction does not apply to certain §707 payments for services and excludes highly paid individuals providing the specified business services. Also, while favorable qualified business income treatment also might be obtained by converting the employment relationship to one in which the service-provider is an independent contractor, this potentially leaves the partnership open to an IRS employment tax audit.

For more detailed discussion of the §199A deduction, see Jeffrey N. Bilsky, and William J. Hodges: Tax Reform Impact on Partnerships and Partners, 59 Tax Management Memorandum 3 (Jan. 8, 2018).