Impact of the New Tax Act on Law Firms

As seen in Westchester and Fairfield County Business Journals

The Tax Cuts and Jobs Act of 2017 is transformative legislation that dramatically changes the tax landscape for individuals and businesses for years to come. It has an impact on the income tax that attorneys will pay and it also affects the work that firms will be asked to do.

Tax impact on attorneys’ personal returns

Most law firms are set up as limited liability partnerships (LLPs), where income, deductions, credits, etc., pass through from the firms to their partners. Partners pay income tax on these items on their personal returns. The Tax Cuts and Jobs Act (TCJA) created a new “qualified business deduction” for owners of pass-through entities. This 20% deduction is not a business deduction or an adjustment to gross income; it simply reduces taxable income.

However, the new deduction has various limitations that restrict or bar its benefit to partners. There is an overall limitation for “specified service businesses,” which include the performance of services in the field of law. However, any partner with taxable income from all sources (not just business income) below $157,500 for single filers and $315,000 for married persons filing jointly, can take the deduction. As a partner’s taxable income increases from $157,500 to $207,500 for single filers, and from $315,000 to $415,000 for the joint filers, the deduction phases out, such that no deduction can be claimed when taxable income exceeds $207,500 for single filers and $415,000 for joint filers. However, guaranteed payments to a partner do not qualify for the deduction, irrespective of a partner’s taxable income.

To benefit partners whose personal taxable income may permit this deduction, firms may want to look at how they characterize payments to partners. Many firms treat some or all payments to partners as guaranteed payments. However, as mentioned above, for purposes of computing qualified business income to which the 20% deduction applies, guaranteed payments do not qualify for the deduction but a distributive share of partnership income does qualify. Tax and economic considerations about how to allocate payments (how much to treat as a distributive share and how much to treat as a guaranteed payment) are complicated and must take into account the definition of “guaranteed payments” under the Internal Revenue Code. What’s more, a change in how payments are treated will likely require an amendment to the partnership agreement.

There is also a W-2 wage limitation, wherein the 20% deduction is limited to the greater of either the 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the original cost basis of depreciable property.

With or without the benefit of the qualified business deduction, partners may find themselves in lower tax brackets, especially if they file joint returns, due to the changes in the tax brackets. However, some partners may end up in a higher tax bracket that they otherwise wouldn’t be in, due to the cap on the itemized deduction for state and local taxes and other deduction changes.

There is a new limitation for losses that pass through to owners. An excess business loss of a taxpayer, other than a C corporation, is not immediately deductible. Instead, it is treated as a net operating loss that must be carried forward. An excess business loss is the amount of business deductions in excess of business gross income or gain plus a threshold amount ($500,000 for joint filers; $250,000 for other taxpayers). The limitation applies at the individual level.

Tax impact on incorporated firms

Law firms that are set up as a C corporations will enjoy a substantial tax cut on the net income that they retain in the corporation. Until now, such firms were treated as personal service corporations (PSCs) subject to a flat 35% tax rate. Under TCJA, the rate becomes a flat 21%. That said, there have been no changes to the double taxation that results when C corporations distribute earnings to owners as dividends; net income is taxed first to the corporations and then the after-tax amount is taxed to the owners, with no deduction for the distributions by the corporations. The dividends would be taxed at 23.8% for non-corporate taxpayers.

This dramatic contrast between the tax on firms that are regular corporations and those that are pass-throughs may prompt discussion among partners about whether to convert to C-corporation status. At this time, many are taking a wait-and-see approach, especially in light of certain other considerations such as accumulated earnings tax.

Impact of tax changes for all types of entities

Law firms are businesses that can take advantage of the tax breaks designed to encourage capital investment, including:

• Section 179 (first-year expensing). TCJA increased the dollar limit on the deduction for 2018 to $1 million. This limit phases out when total purchases of qualified property exceed $2.5 million.
  
  
• Bonus depreciation. This is 100% of the cost of qualified property, which can now be used for both new and used property.
  Of course, law firms as businesses are subject to new limitations and other unfavorable rules, including:
  
  
• Limit on the deduction for business interest. No deduction is allowed for the net interest expense in excess of 30% of adjusted taxable income (the calculation of which changes in 2022). However, businesses with average annual gross receipts in the three prior years not exceeding $25 million are not subject to this limitation. However, gross receipts of related entities must be aggregated.
  
  
• Bar to a deduction for entertainment expenses. The former 50% deduction for entertaining clients can no longer be claimed, but the 50% deduction for meals is retained. Meals provided for the convenience of the employer are no longer 100% deductible, but has been reduced to being 50% deductible.