29 Nov What Tax Reform Means To Law Firms?
The Tax Cuts and Jobs Act of 2017 included a 20% deduction for “pass-through” businesses. This deduction was intended to provide a benefit to owners of flow-through entities that have an impact like the reduction in tax rates for C corporations.
Section199A is an interesting maze of rules, definitions, and limitations. Service professionals have specific limitations under this section. Law firms, solo and otherwise, should revisit tax status and entity structure early in 2018 to determine whether restructuring is in order to benefit from the new tax law.
How the new tax laws will affect law firms?
As is often the answer when income taxes are the subject, it depends. For high-income attorneys in states with high state income taxes, the limitation of the deduction for state income taxes could be a very significant limitation and subject more of their income to federal income tax. For attorneys who are married with an adjusted gross income of less than $315,000 (or not married and with less than $157,500) the new deduction against business income (which attorneys with income over $415,000 married or $207,500 unmarried generally do not qualify for) may more than make up for the loss. For estate tax attorneys, the change in the lifetime exemption is significant and may create planning opportunities for attorneys and their clients.
The impact will depend on each law firm and its specific situation. Assuming we are talking about flow-through entities, partners who earn below certain income thresholds will qualify for the pass-through deduction on their flow-through income. However, many BigLaw partners are at too high an income level to qualify for this new tax deduction.
Specific practice areas will have their own concerns. A few that come to mind are divorce attorneys who will have new issues to think about now that alimony is a non-tax item and business attorneys who must consider entity formation in a new light.
Several changes in the law that impact all businesses are important to law firms.
- The reduction or elimination of deductions for certain meals and entertainment expenses will impact law firms, as they tend to spend a significant amount of money in this area.
- There is a significant change to employer-provided benefits for transportation that are no longer deductible by the firm. Many large city firms provide these benefits.
- A new credit for wages paid to employees who are out on family and medical leave may be helpful to law firms.
- There is an increased allowance for first-year expensing for the acquisition of qualified property. Some firms elect not to take advantage of these expensing rules, but many firms will benefit from this over the next few years until they phase out. Many of the states do not follow the federal expensing rules, so firms that use the first-year expensing rules for their federal return frequently have to track their depreciation separately for the states.
- A new limitation on the deduction of business interest expense most likely will not impact firms taxed as partnerships, but very well could impact firms taxed as corporations.
- The pass-through deduction for partners and S corporation shareholders is only useful in certain situations because of the exclusion for law firms unless the partner/shareholder is below the income thresholds.
- The lowering of the corporate tax rate will certainly benefit those firms that are taxed as corporations.
What should law firm managers be most concerned about regarding the new tax law?
The new tax law eliminates the deduction for entertainment expenses. This may be a big difference for medium and large firms. “Client Appreciation Events” and similar functions are potentially no longer deductible, so firms will need to revisit these activities and see if they are still a good idea or if there are possibly other ways to promote business development and client appreciation.
Another issue that stands out regardless of practice area or size is: Who am I billing? Is it an individual who may no longer deduct your fees (due to miscellaneous itemized deductions being suspended) or is it a business? Sometimes these lines blur with a closely held business or an activity that borders between passive investment and a trade or business. While it may not have mattered in the past, it certainly does now. Attention to details like this shows clients you are keeping their interests in focus.
Additionally, certain legal fees will no longer be deductible by the firm’s clients as the miscellaneous itemized deduction for legal fees has been eliminated. Generally, settlements not relating to the plaintiff’s business will be taxed on 100% of the recovery. For high-income taxpayers, the legal costs of the claim combined with 100% of the recovery being taxable will leave little left for the claimant. Law firms should make sure they make appropriate disclosures to their clients.
Should firms consider changing their structure to secure more favorable tax treatment?
The issue of entity structure is complex and depends on many aspects of each particular firm. Although income taxes are certainly one of the big issues to consider, there are other items such as the firm’s management structure, liability issues, and how owners transition into and out of the firm.
That being said, there were certainly big changes in the tax law that will affect businesses in all industries. Now is a good time for businesses to think about whether they are in the right structure for their current and future situation.
The changes are significant enough for businesses to go through a discernment process to determine if changing structure is an advantage under the new law. There is not a “one size fits all” answer to this question. By doing “what if” scenarios based on projected earnings and related income taxes, the law firm will be able to make a more informed decision.
What Businesses Are Qualified Trades or Businesses?
Pass-through businesses are eligible. “Pass-through” for this purpose includes partnerships, S corporations, disregarded entities, and sole proprietorships. If an LLC elects C corporation tax status, it will not be a qualified trade or business. Limitations apply to “Specified Service Trade or Business.” Most law firms will be a Specified Service Trade or Business. To the extent a pass-through entity is a Specified Service Trade or Business, the deduction for the owners of the entity will be phased out.
Specified Service Trade or Business is defined by reference to IRC Section 1202(e)(3)(A), except that engineering or architecture are excluded. Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services are considered Specified Service Trades or Businesses. The term is additionally defined as any trade or business where the principal asset is the reputation or skill of one or more of its employees.
Limitations for Specified Service Trades or Businesses.
For an owner of a Specified Service Trade or Business, if the taxable income of an owner is less than $157,500 for a single taxpayer or less than $315,000 for a married taxpayer, the limitation does not apply, and taxpayer’s trade or business will be treated as a qualified trade or business. If the taxable income of a business owner who is a single taxpayer is greater than $157,500 but less than $207,500, a phase-out of the deduction shall apply. If the taxable income of a married taxpayer is greater than $315,000 but less than $415,000, a phase-out shall apply.
Separate Limitation Based on Taxable Income.
Even if a business is a qualified trade or business (and not a Specified Service Trade or Business), various limitations apply if taxpayer income exceeds $157,500 for a single taxpayer and $315,000 for a married taxpayer. When a business owner’s income exceeds the threshold amounts, limitations apply based on the amount of W-2 wages paid and the amount of qualified property owned by a qualified trade or business.
Example of How 199A Applies to Law Firms
A married lawyer has $200,000 of flow-through income from a law firm and taxable income of $250,000. The lawyer has no other flow-through income. They will have a pass-through deduction of $40,000 ($200,000 * .20). The limitation regarding Specified Trade or Service Business does not apply because the lawyer’s taxable income is below the phase-out threshold.
A single lawyer has $180,000 of flow-through income from a law firm and taxable income of $180,000. The lawyer has no other flow-through income. They will have a pass-through deduction of $10,890 rather than $36,000, because they are subject to the phase-out. The calculation is as follows:
- 180,000 – 157,500 = 22,500
- 22,500/50,000 = 0.45
- 1-0.45 = 0.55
- Applicable % = $99,000 QBI; $19,800 (20% deduction), $0 W-2 and Qualified Property.
- 19,800-0 = $19,800
- 0.45 * $19,800 = $8,910
- 19,800-8,910 = $10,890
A married lawyer has $425,000 of flow-through income from his law practice. This married lawyer has taxable income of $450,000. They will receive no pass-through deduction.
A Law Firm Challenge–Owners are Impacted Differently.
When applying strategies to seek the benefit of the pass-through deduction, taxable income of each law firm owner must be considered, and each law firm owner will be impacted differently.
Assume a two-partner law firm. One partner is married to a stay-at-home spouse. The other partner is single. Both partners contribute equally to law firm revenues and share expenses. Assume that the law firm has $450,000 in income for Year One and that such income will be split equally. The single partner receives $225,000 and gets no pass-through deduction. The married partner receives $225,000 and receives a $45,000 deduction.
A similar disparity could occur if both partners are married, and one has a spouse with no income and the other has a spouse with income. Assume that the first married partner has $225,000 of income from her law firm and that her spouse has no income. The married partner will have a $45,000 deduction. Assume the second married partner has a spouse with $300,000 income. The second married partner will have no pass-through deduction.
Some Planning Thoughts For Law Firms.
- Managing law firm income becomes paramount. To the extent law firms have partners who might be impacted by phase-outs, consider increased contributions to retirement and benefit plans. To deal with the disparities for partners who are differently situated, consider a plan type that allows different types of contributions.
- Use Section 179 and bonus depreciation with care. Consider the level of deduction that will be most beneficial to assist as many partners as possible in being able to take advantage of the pass-through deduction. While it may be tempting to take as much depreciation as possible in a year, it might be more beneficial to spread out deductions. Do a five-year analysis.
- Consider electing C corporation tax status. Law firms operated as C corporations will receive the benefit of the 21% tax rate on C corporation income and may elect a fiscal year other than December 31. Law firms that distribute most of the firm income may not see benefits from this approach. Additionally, if income is retained in the C corporation, such income will be subject to a double tax when distributed.
- Move income streams to a C corporation or to a different flow-through entity to which limitations do not apply. For example, if law practice owns a building, move the building to a separate entity and pay rent to the separate entity. Alternatively, if a law firm offers web-based products for clients, revenue from such products can likely be treated differently than revenue from traditional legal services. The definition of specified services includes that the principal asset is the reputation or skill of one or more employees. Consider moving any revenue stream that does not meet that definition to a different entity.