Preface
Hey everyone!
Today's article talks about the differences between owning a business and being an employee. As a licensed CPA, I get a lot of questions about this.
Usually, I explain my perspective on this in real-time. But lately, I've been getting these questions so much that I decided to write them down.
The biggest recurring theme of questions from people who get paid for their services - regardless of their employment status - is that they want to know about the tax benefits.1
People paying for services want to know if they need to set someone up on payroll or if they can pay them as a contractor.
We're going to talk about all of this.
How I Know
I've been self-employed for multiple years, so I understand the motivation to be an independent contractor instead of an employee.
I also understand why people paying for services want to hire independent contractors instead of employees.
But wanting the label isn't enough; you have to fit the mold. So, let's slow down and look at the entire concept.
Before we look at this in-depth, let's examine my qualifications to discuss this topic.
First, I started my career doing highly manual Accounting work. Reviewing employee expenses; reimbursing them; paying vendors (via ACH, wire, and many times with checks); collecting W-9s; issuing 1099s, etc. So, I've dealt with this phenomenon at scale. I have resolved these questions multiple times and have performed the mechanics involved in making these payments.
If you combine that with my status as an actively licensed CPA and the fact that I've studied this topic at a depth most have not, I can confidently say that I can pinpoint where the confusion is.
I will not explore the benefits of being a business owner versus an employee in this article. Instead, I will focus on the most controversial - and quite frankly unexplored - topic: worker classification.
I'm not going through the benefits of each type of worker classification for two reasons:
Anybody can do that.
Getting this topic right opens the door to the benefits of being a business owner/contractor. So you'll get that answer as an output of this discussion.
Everyone wants to own their own business, but they don't want to take on the risk of pursuing it full-time. This is completely understandable. To counteract this, people have constantly urged would-be business owners to take steps to build the business while working their full-time jobs.
The legal framework for doing this was very opaque until this year. Partly thanks to legal deception from employers but also thanks to a regulatory framework that enabled this deception.
The Boss Hierarchy
Cardi B boasted on Bodak Yellow that she was a boss, not a worker.
One way to think of the opportunity that these pieces of legislation present for professionals is to say that Cardi B was wrong.
The term worker technically covers people who own businesses AND people who are employees. Technically, we're all workers; you can be employed by a firm and be self-employed - employer and employee status is not binary. So, worker classification and the "boss hierarchy" are an illusion.
Those paying for services do have to classify workers, though; they can't just call it an illusion and be done with it. They have to deal with the complexity.
So there needs to be another metaphor for worker classification. We can use the video for "Falling Back" by Drake from his album Honestly, Nevermind to illustrate this. In the video for the song, Drake gets married to over a dozen women.
"I, ____, take you, ____, to be my wife (or husband), to have and to hold from this day forward…"
Marriage means you commit to be with one person until you die. The Drake video inverts this idea, and it's hilarious. One reason it's hilarious is because it's ridiculous. If Drake is getting married to all of these women, he's not committing. Two, because he's implying that he's somehow above marriage. That even a holy sacrament wouldn't control him.
And that's why - on top of being funny - this music video is an excellent illustration of worker classification. Whether a worker is an independent contractor or an employee depends on the substance of the relationship between the one providing services and the one paying for them.2
That control is a subset of 1 out of 3 categories that explain whether the substance of the relationship would classify the service provider as an employee or an independent contractor (Behavior Control; Financial Control; and Relationship of the Parties). Ironically, they all find interesting metaphors in the context of the Drake video.3
For example, an independent contractor is generally free to seek business opportunities. If you enter into an agreement with a company that claims to “have and hold” your services exclusively - meaning you can’t offer those services to the market - an argument can be made that you are an employee and not a contractor, so taxes must be withheld from what you are paid. Just like if you're not in a relationship, you are single and ready to mingle. If marriage was an employment contract - and worker classification was solely determined by one's freedom to seek other opportunities - Drake would be an independent contractor in the Falling Back music video.
This degree of financial control exercised by one party over another is one of the core tenets of the financial control category, which is part of a larger checklist.
As an aside, employment agreements are currently too narrow with respect to financial control. Taxpayers are about to wake up to this fact. . .
In some ways, they already have. For example, professionals sense that their employers shouldn't be able to limit their ability to participate in outside activities (ex., CPAs building CPA firms while working at CPA firms).
Occasionally, business owners know more than advisors like lawyers and accountants, at least in the context of pursuing opportunity instead of mitigating risk. Because one of the things taxpayers understand on a visceral level about starting businesses - that legal and accounting professionals don't give them credit for - is that they rightfully include all of the elements of founder-market fit into the worker-classification discussion even if they can't articulate the legal stuff.
One element of starting a business is to use your current environment as a launching pad. In our opinion, that also includes the talents and skills that a current employer might be utilizing.
If you use those same skills outside of that employment relationship, it must be in a way that doesn't harm the employer's legitimate business interests. But if those interests aren't harmed, starting a business while working is fair game. With that being said, how do employees build side hustles without ending up in hot water like Carter Bryant?
That's what I will synthesize in the second half of this article.
I’d like to express my views on employment contracts because many employers will end up on the wrong side of history. Legal departments take the lazy/easy way out during the hiring process. They provide boilerplate employment agreements, and employees don't have much power in negotiating their covenants.
This is especially true if they are hired by a large company or if they are early in their careers.
Employees sense this is unfair, but as LaLa Anthony described at the ForbesBLK summit, they must sign the agreement before they start working, so they're stuck in a bind.
Moreover, how many employees can retain an employment lawyer between when they receive their prospective employment agreement and when they must sign it before it expires?
Employers typically attach a timer to these contracts and say they must be executed in 24-48 hours, which means that you have to move quickly to get comfort over the language in the agreement in 32 hours (if you get a full 8 hours of sleep each day).
Prospective employees are afraid of the bite from their employers for participating in outside activities. Yet, the truth is that restrictive covenants prohibiting participation in the open market are mostly toothless. We'd learn this if these broad covenants were ever brought to a court of law, but let's be honest: how many of these disagreements make it to court?
So what we have in the United States is a swath of employers taking advantage of this framework, essentially coercing service providers to sign contracts with unenforceable restrictive language.
In the worst-case scenario, employees feel too inexperienced to articulate (in legal terms) what the agreement should say. The best-case scenario is that they have questions looming in their minds during their entire tenure with their employer.
Could I be making more by pursuing a side hustle?
Was I tricked into selling my expertise for less than it's worth?
Those questions aren't answered.
What ends up happening is that employees say "to hell with it" and start a business anyway, hoping their employer never finds out. Basically doing what N.O.R.E. did…4
I think a lot about what Nipsey Hussle said in the song "That's How I Knew.":
Giants gon' crumble. Big companies gon' crumble.
New companies gon' pop up outta nowhere,
and it's-it's gon' be dramatic like that. I believe that.
He was alluding to how quickly the "changing of the guard" will take place when the next generation displaces incumbents by embracing available technology.
This was a prescient observation. Data shows companies are reaching the billion-dollar market-cap milestone quicker than their predecessors.
If we look closer, we see that this changing legal environment for employer-employee relationships is a platform shift that will birth many new businesses.
I've said again and again that our definition of technology is too rigid.
Peter Thiel calls technology any new way of doing things. The shift taking place - where regulation removes information asymmetry from the first phase of the employer-employee relationship - IS technology.
To highlight this reality, it is worth noting that my comments on this topic are not conjecture. States like New York and New Jersey have already begun looking closely at their laws on non-competes, which will make the reality of employment look more like Drake in the video for Falling Back.
Combine this with:
existing "de facto unenforceable non-competes,"
the proposed FTC rule that would apply retroactively to existing agreements, and
overly broad non-solicitation and non-disclosure agreements,
And we can imagine every company that took advantage of that information asymmetry rushing to understand the new landscape while also atoning for their sins in public.
Mind you, I have yet to talk about the Workforce Mobility Act (WMA). The (WMA) is bipartisan federal legislation pending in Congress. It would prohibit non-competes nationwide, with a few minimal exceptions.
Unlike the proposed FTC rule, the WMA would not apply retroactively to existing agreements. But it is still a significant piece of legislation. The information asymmetry that birthed the boss hierarchy facade will evaporate soon. . .
Summary: Give Me The Bread Instead
On the Milion Dollaz Worth of Game podcast, Gillie and Wallo hosted an accountant to talk about how to save money on taxes.
Here’s the video if you want to check it out5:
Before I share what parts of the video I agree with and which I disagree with, I want to summarize his points.
In the video, the Accountant talks about how taxpayers can get a salary increase and save on taxes at the same time.
He starts by describing how when you start a job, you have to fill out a W-9 and an I-4 form and says that most people think you have to be paid as an employee when you don’t. You can ask your job to pay you as a contractor.
He argues that the company paying you would save 7 percent of every dollar they pay for your services if they call you a contractor instead of an employee.
This 7 percent - or, more specifically, 7.65 percent - is the employer’s share of what’s commonly referred to as FICA taxes. The employer’s 7.65 percent and the employee’s 7.65 percent comprise the total 15.3 percent self-employment tax.
He encourages his students to use the 7.65 percent as a negotiation point.
The logic is that because they wouldn’t have to pay this tax every time they run payroll, they should make you a contractor and give you the bread instead of giving it to the IRS.
He also explains the 20 percent deduction you get for being in business. This is the Qualified Business Income deduction (or QBI deduction) that lets you deduct 20 percent of certain types of income.
He then talks about how when you ask the company paying for your services to call you a contractor, they have the right to say yes unless it is a government or a city job.
Seventy percent of his students who do this get “approved to be paid as a contractor.” They also get a 7 percent raise from the company buying their services.