IT’S TAXING

How Will the New Tax Law Affect Lawyers and Law Firms?

In December, Congress passed the most comprehensive tax bill since 1986, the Tax Cuts and Jobs Act. The sweeping Act promises to impact individuals, businesses, trusts and estates, and financial institutions — and even the craft beer industry (seriously…). While there is certainly no shortage of opinion regarding the effects of the law, considerably less press has been focused on the law’s direct impact on the income taxes paid by lawyers. The new law will have a significant and direct impact on income taxes paid by many lawyers and their law firms, not just the income taxes paid by their clients.

Tax Relief for Pass-Through Entities

The first way the Act will impact lawyers is by lowering their marginal income tax rates, as it does for all taxpayers. But more specific to lawyers, the Act could have a significant impact through a new deduction. Under the Act, individual owners of pass-through entities will be allowed to deduct 20 percent of the “qualified business income” they receive from the entity. Pass-through entities include entities taxed as partnerships or S corporations. A “pass-through entity” does not pay income taxes. Instead, the owners do. This simply means that the firm’s profits are not taxed at the entity level, but are instead taxed at the individual owner level. In turn, the law firm’s owners, i.e., the equity partners in a partnership, could reap the benefits of this pass-through deduction. As a result of this deduction, the owners or partners may wind up paying significantly less income tax than they otherwise would.

Resources

In the coming months as everyone has time to evaluate the details of this massive new law, there will be more in-depth analysis in these pages and online. Here are some resources available now:

CLE

How New Tax Laws Impact Lawyers  
This one-hour Tennessee Bar Association webcast reviews the impact of the new tax laws on lawyers who operate as sole practitioners, partnerships, limited liability companies or corporations. For some, a change in organizational structure may be the best way to take advantage of the new legislation.

Originally aired Jan. 30, it is available for replay at https://cle.tba.org/catalog/course/4428.

Coming September 2018

The TBA Tax Law Section will analyze the new law in a comprehensive continuing legal education program.

Online Information

“Consensus tax bill includes law firms
in pass-through tax relief, with limits,” ABA Journal, Dec. 18, 2017, http://www.abajournal.com/
news/article/consensus_tax_bill_includes_law_
firms_in_pass_through_tax_relief_with_limit


Watch the TBA’s daily newsletter, TBAToday, for upcoming resources and more information as it develops.

As a simple illustration, suppose the firm has $100 of income. Assume the $100 is taxed at a 25 percent rate, which means $25 is paid in tax, netting the owners $75. However, if 20 percent of that initial $100 is deductible as “qualified business income,” then the 25 percent tax rate is only applied to $80 worth of income, and the result is only $20 in tax, netting the owners $80.

Of course the rates in this example are overly simplified for illustrative purposes.

But before anyone gets carried away, it is not a foregone conclusion that all partners will be able to claim their income is “qualified business income,” nor is it clear that those who will be able to make the deduction will be eligible for the full 20 percent. First, both “wages” and “guaranteed payments” are excluded from the definition of “qualified business income.” As such, under many common partnership compensation structures, “income partners” or junior partners will be unable to claim any deduction because their income is either wages or a guaranteed payment. Second, the IRS will more than likely set some minimum threshold of “reasonable” compensation with respect to the partnership, and require anyone claiming “qualified business income” in excess of that threshold to provide additional supporting documentation.

Thus, it may be difficult, if not impossible, even for equity partners to have “qualified business income.”

In addition, the deductibility of qualified business income begins to phase out for service providers like lawyers when the lawyer’s taxable income from all sources exceeds $157,500 ($315,000 for a joint return).

And of course, in the end, lawyers and law firms will still have to get individualized tax advice geared to their particular circumstances. But the point remains: Many law firm equity partners could see significant savings under the new law — even more so than the general public.

Exclusions

Another important aspect of the Act is what it did not do, or more specifically, what it almost did. For one, in early drafts of the bill, lawyers and law firms were very nearly precluded from being eligible for a special tax rate on “pass-through” income. In addition, there were several other key provisions that did not make it into the bill:

Deductibility of Student Loan Interest

If there is one thing all too many lawyers are intimately familiar with, it is student loans. Under current law, certain individuals may deduct up to $2,500 of interest, subject to income limits, that has been paid on qualified education loans. In general terms, this deduction provides relief to recent graduates who are burdened with student loan debt. But in addition to its general applicability, this student loan interest deduction also provides a financial incentive to recent law school graduates to enter public service jobs, which are a critical function of our society, but generally lower paying.

The initial version of the tax reform bill that was introduced by the House would have repealed this deduction entirely. However, the deduction was preserved in the final version of the law, largely in part because of efforts of the American Bar Association.

Mandatory Accrual Accounting for Law Firms

The initial version of the bill also contained provisions that would have precluded law firms from using the cash-basis method of accounting. If these proposals had been included, many law firms would have been forced to switch from cash to accrual accounting, and thus be required to pay taxes on billings, sometimes long before payment is actually received from clients.

Conclusions

The new tax bill could have a profound impact on the legal industry generally and on lawyers individually. There are some questions that will need to be answered before we know the full extent of the impact, but there will almost certainly be some large changes in the coming months.
 


Rob Breunig ROB BREUNIG is an associate in the Nashville office of Adams and Reese LLP, and represents clients on tax, corporate and employee benefit matters. He earned his law degree and his LLM in taxation at the University of San Diego School of Law, and is a member of the Tennessee Bar Association’s Tax Law Section Executive Council.

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