The Tax Cuts and Jobs Act of 2017 (P.L. 115-97) 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 percent 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 includes 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 percent 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 percent deduction is limited to the greater of either the 50 percent of W-2 wages, or 25 percent of W-2 wages plus 2.5 percent of the original cost basis of depreciable property.
This limitation has the same threshold amounts and phase-ins as discussed above, i.e., does not apply if taxable income is less than $157,500 for single filers or $315,000 for joint filers; phases in as taxable income increases, such that the limitation applies in full when taxable income exceeds $207,500 for single filers and $415,000 for joint filers.
However, as discussed above, owners of specified service businesses can’t claim the deduction if their income exceeds these amounts in any event.
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 would be in, due to the cap on the itemized deduction for state and local taxes and other deduction changes.
For single filers, the 35 percent bracket starts at $200,000 of taxable income (down from $416,701 under old law) and the 37 percent bracket starts at $500,000 (up from $418,401, where the 39 percent bracket started). For married joint filers, the 35 percent bracket starts at $400,000 of taxable income (down from $417,700) and the 37 percent bracket starts at $600,000 of taxable income (up from $470,700, where the 39 percent bracket started).
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
Firms that are pass-through entities are not taxed under the law and nothing has changed in this regard as indicated earlier. However, 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 percent tax rate. Under TCJA, the rate becomes a flat 21 percent. 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 percent 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-corporate status. State law may permit the creation of a professional corporation (PC), professional service corporation (PSC), professional association (PA), or other entity that is taxed as a regular corporation. At this time, many are taking a wait-and-see approach, especially in light of certain other considerations:
• Accumulated earnings tax on C corporation-firms that retain earnings above their business needs, plus a modest exemption amount.
• Possible application of the personal holding company tax rules.
• Double taxation upon asset sales.
• Possibility of additional tax legislation that may change some of the factors contributing to an incorporation decision (e.g., liberalizing the personal itemized deduction for state and local taxes).
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 percent 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 percent 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 percent deduction for entertaining clients can no longer be claimed, but the 50 percent deduction for meals is retained. Meals provided for the convenience of the employer are no longer 100 percent deductible, but has been reduced to being 50 percent deductible.
It’s worth noting that a proposal to bar all firms from deducting clients’ expenses (e.g., expert witnesses, court reporters, deposition transcripts, travel costs to hearings) was not included in the TCJA. Contingent fee for attorneys within the Ninth Circuit who pay these costs can currently deduct them. Attorneys elsewhere in the country must usually treat them as loans to clients, which become deductible only if they lose the case and ultimately bear the cost (i.e., cannot recover the “loan” from the clients).
Impact on Work for Law Firms
Some of the changes under TCJA are spurring clients to seek legal assistance. Here are some areas of considerable activity:
Tax planning. Increased need for general tax planning, choice of entity and international tax planning.
Marital dissolutions. Effective for decrees and agreements finalized after December 31, 2018, those who pay alimony will not be able to deduct their payments; recipients won’t be taxed on them.
Estate planning. TCJA raised the estate tax exclusion amount substantially. The IRS confirmed that the exclusion for estates of decedents dying in 2018 is $11.18 million. This exclusion amount applies as well to gifts and generation-skipping transfers. However, this increased exclusion, which will be adjusted annually for inflation, is set to expire at the end of 2025. The increased, albeit temporary, exclusion allows for new planning opportunities which wealthy clients may want to take advantage of. For example, some may wish to use the increased exclusion through gifts now while the option exists to reduce the size of an estate on a tax-free basis.
Income Tax Planning. Attorneys should also be cognizant of the fact that clients who are individuals are not be able to deduct their fees as a result of the suspension of the miscellaneous itemized deduction for 2018 through 2025. For example, if a personal injury client receives the entire award and then shares a third of it with an attorney, all of the award is taxable and no deduction can be claimed for the attorney’s fees. (Attorneys’ fees for certain discrimination actions remain deductible as adjustments to gross income.) At present, clients with contingent fee arrangements have no relief (see Banks II, S.Ct., 2005). In effect, a client could wind up spending nearly all of the money he or she wins on a case on income taxes and fees, which may weigh on the decision about whether to pursue a case at all. However, the Supreme Court decision on this matter did not consider all possible arguments, which may be raised by a client determined to litigate in the future. The IRS may be willing to entertain some variations on the theme to permit an exclusion of the portion of a settlement that goes to attorneys (e.g., the portion of a settlement for fees paid to two legal aid firms by a taxpayer who had no legal obligation to pay legal fees was excludible from gross income [Letter Ruling 201552001]).
There has been some speculation of a second phase of tax reform that may be introduced later this year. In the meantime, the IRS is working on providing guidance on some areas that are unclear. Attorneys and their firms are cautioned to monitor these developments diligently when crafting personal and business strategies for themselves and their clients.
Joe Bublé is a partner in Citrin Cooperman’s New York City office, where he leads the firm’s tax practice. Sidney Kess is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman.