The 2017 Tax Cuts and Jobs Act specifically impacts law firms. Certain pass-through structures, including law firms, were singled out in the tax law, and as a result, many firms will need to review their structure and determine what adjustments, if any, should be made. In this month’s roundtable discussion, our panel of expert accountants tackles the key considerations every law firm leaders should keep in mind.
Nicholas Gaffney (NG) is the founder of Zumado Public Relations in San Francisco, CA, and is a member of the Law Practice Today Editorial Board. Contact him at firstname.lastname@example.org or on Twitter @nickgaffney.
|William (Bill) Norwalk (BN) is the tax partner in charge of Sensiba San Filippo and has over 30 years of experience providing tax services, management advice and business strategy consulting to his clients. He specializes in planning for proper entity choices, estate planning and performance and milestone measurement.|
|Brian Annand (BKA) is a shareholder at Geffen Mesher, where his practice focuses on professional services, real estate, and manufacturing. Brian’s specializations include S corporation and Partnership taxation. He works with several law firms on tax planning and consulting and recently made a presentation on the implications of the new tax law to law firms and other professional service firms.|
|Bill Apple (BA) is a partner in the Tax and Assurance Group of Baker Tilly Virchow Krause, LLP. Bill has more than 25 years of experience advising clients in their business and personal income tax matters, financial planning and various other types of business transactions.|
NG: How significantly does the Tax Cuts and Jobs Act impact law firms?
BN: 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.
BKA: 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.
BA: 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.
NG: What should law firm managers/owners be most concerned about regarding the new tax law?
BN: Their clients may come to them for action based on what they have heard on the street relating to the new tax law. They should take care not to take what these clients say at face value and advise clients based on their faulty assumptions.
Since fewer individuals will be subject to the estate tax, current or prospective clients may feel they do not need the services of an attorney. I actually think the change in law is a compelling reason individuals should review their wills and trust agreements with their attorneys. Firms should reach out to their clients to update their planning before their competitors do.
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.
BKA: 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.
In the end, I believe this is an opportunity for firms to focus on addressing client needs and opportunities under the new tax regime. This is a great time to coordinate with your client’s tax advisors to make sure any opportunities are properly evaluated.
BA: There have been numerous discussions about planning opportunities and ideas that firms may use to take advantage of some of the new provisions, particularly the pass-through deduction. The overriding message should be that this bill was drafted fairly quickly and contains a number of ambiguities. People need much more guidance in several areas, so it may be worthwhile waiting until the Joint Committee on Taxation Blue Book is released to see what additional guidance regarding the intent of these provisions may be reflected in that document. It is also still too early to know how the Internal Revenue Service (IRS) will view some of these areas, particularly the pass-through deduction. If the firm wishes to be on the leading edge and isn’t afraid of dealing with the IRS, then making moves now is reasonable, but if the firm isn’t interested in being the test case, then the advisable approach is to consider various planning ideas and concepts while waiting to see how some of them are viewed by Congress through technical corrections legislation and its blue book and by the IRS through regulations, before implementation.
NG: Should firms consider changing their structure to secure more favorable tax treatment? Is it likely the IRS will issue guidance which would affect such changes?
BN: I believe that 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.
The IRS has started to issue some guidance and will continue to do so. It is possible that the guidance will change decisions in some gray areas, especially relating to what will be determined to be Qualified Business Income entitled to the new 20% deduction.
BKA: 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.
It will be interesting to see what additional guidance the IRS comes out with related to this matter. They could certainly release something that will have an effect on firms’ decisions.
BA: We have had numerous discussions with clients and have even calculated some scenarios regarding converting from a partnership to a C corporation because of the new lower corporate rate. While it is true that a C corporation will only pay tax at 21%, most professional service firm owners want to draw most of the income out of the business each year. They generally do not have significant capital needs that require a large investment in the firm. While any income left in the corporation will only be taxed at 21 percent, any money paid out to the owners in the future will be a dividend, taxable to the owner and not deductible by the corporation, so the combined tax rate will be at least as high as the individual rate on pass-through income. Generally, a pass-through should only consider converting if it has capital needs for a long period of time or wants to use the corporation as an investment vehicle. There are other potential issues with using the corporation as an investment vehicle that are beyond the scope of this discussion.
Moving away from a corporate structure is very difficult for law firms because of the immediate tax liability that could be created upon liquidation of the corporation, so firms that are currently taxed as corporations would generally have a significant tax burden to move to a partnership tax structure.
NG: How does the personal service corporations (PSC) exemption for lawyers impact their tax rate?
BN: Under the old law, personal service corporations were taxed at a flat rate of 35%. The corporate rate has been reduced to 21%.
BKA: The new tax law allows personal service corporations the same reduced 21% corporate tax rate that applies to non-personal service C-corporations. This may be a huge benefit for PSCs who are retaining earnings in the company and have historically been hit with a 35% federal income tax rate.
The IRS has the ability to reallocate retained earnings as a deemed distribution if they consider it appropriate. So, any firm considering the switch to a C-corporation must evaluate the tax treatment of compensation, deemed dividends and retained earnings.
BA: Previously firms taxed as corporations paid a flat 35% tax rate on any income remaining in the corporation. Now that rate has been reduced to 21%. Most firms taxed as corporations don’t have significant taxable incomes since the shareholder-attorneys draw salaries from the firm which are tax-deductible to the firm. With the Brinks case that was decided a couple of years ago on the mind of most corporate structured firms, many firms are considering leaving a bit more income in the corporation and possibly paying a dividend to the shareholders. Whatever taxable income the firm has will certainly benefit from the lower rate and make the idea of paying a dividend to the shareholders more palatable as the total tax burden between the corporation and the individual shareholder will not be significantly higher than that of a partner in a partnership, as it was under the old rates.
NG: Is the idea of spinning off associate attorneys in law firms into a separate entity, so that they get the benefit of the pass-through because they are at lower income levels, feasible?
BN: This is often referred to as “cracking” and “packing,” a term used in the context of breaking off business lines to benefit from the QBI deduction (cracking) or jamming so much non-service based activities into a current service business that it becomes not subject to the service business limitations (packing). As for the question of feasibility, I am not sure at this time. If their allocable share of the income is below the thresholds mentioned above, it would not be necessary. In some circumstances, I could envision that a revised entity structure would be beneficial. In my view, it would be wise to see what guidance the IRS will be giving before getting carried away with committing to a scheme that will add compliance costs for an unclear result.
BKA: A variety of tax structures could potentially result in an effective lower rate. However, since there is no regulatory guidance for the newly established pass-through rate deduction, I feel it’s too early at this time to recommend significant changes such as spinning off associate attorneys solely based on the anticipated tax benefits.
Finally, the IRS is expected to issue additional regulations and guidance on the IRC Section 199A pass-through deduction; this could affect professional service providers contemplating free-standing entities. Many people will be looking for ways to best structure entities. While doing so, they should keep in mind the IRS’s recently departed Dana Trier, former deputy assistant secretary of tax policy, who said regarding loopholes in the new law, “Those games that people play, were games that I played.”
BA: This is one of many ideas that have been floated for taking advantage of the pass-through deduction for partnerships. Since W-2 wages, as well as guaranteed payments, are not “qualified income” for the pass-through deduction, the firms who have partners who receive their compensation through guaranteed payments have a similar dilemma. How can their compensation be restructured to take advantage of the pass-through deduction? Frankly, a number of much more “interesting” and creative ideas have been discussed on creating new entities to take advantage of the pass-through deduction. I refer you back to my earlier answer, that patience and waiting on further guidance is still probably the best approach. We are discussing a number of these concepts with our clients, but we are advising them that 2018 may not be the time to take advantage of them. My thought is that we should wait for more guidance and be prepared to move forward with concepts that will work once we receive more guidance. Most law firms that we deal with are not interested in being the test case.