Originally published by GP Solo Magazine for the American Bar Association.
Written by Lauren Suarez and Allison D.H. Soares.
April 15 symbolizes a lot of things to various lawyers, depending on whether you are a solo practitioner, a midsize firm, a partner in a large, national firm, or merely an individual just coming out of law school trying to decide whether to incorporate and hang your own shingle.
As we look back at the impact the previous presidential administration had on the profession of law as a whole, one of the most crucial pieces of legislation of the Trump presidency was the Tax Cuts and Jobs Act of 2017(TCJA). When the TCJA was passed, it was difficult to predict whether our businesses would suffer, stay stagnant, or prosper under the new legislation. Additionally, only a handful of the TCJA adjustments were created to be permanent past 2025. As a result, many of those adjustments are set to expire in 2025 and leave us wondering where our next tax adjustments will take us.
The TCJA is complicated enough for those who have entered into the world of tax either through preparation or controversy. In an attempt to make this area a bit easier to digest, we have provided a brief summary of the individual and business highlights of the TCJA and a synopsis of how law firms have been impacted over the last three years.
With the passing of the TCJA, one of the biggest and most con-fusing additions was the qualified business income (QBI) deduction and how it affects flow-through entities and their partners/shareholders. A majority of law firms are established as a flow-through entity, whether this is a limited liability partnership (LLP) or an S corporation, and the partners of the firms end up carrying the tax liability burden.
The TCJA affected various other business aspects such as depreciation, the ability of an S corporation to convert to a C corporation, employer tax credits for paid family and medical leave, business interest expense, and limitations on losses. All of these have played out in different ways for firms and individuals over the last three years. To tackle all these adjustments would take more time than we have, but we will briefly touch on those that we feel are the most important for the law profession today.
FLOW-THROUGH LAW FIRMS
A majority of law firms are set up as an LLP, in which the income is passed through to the individual partners of the firm. There is no tax paid at the partnership level. Each individual partner reports and pays income tax on their personal return.
The QBI deduction was not created to act as a deduction to the gross income or a firm expense. It was created to reduce the taxable income by a maximum of 20 percent. There were limitations built into the QBI deduction based on the taxable income of the individual as well as the field in which the business is engaged. Law firms are not included in the definition of a “qualified business” and therefore do not qualify for the20 percent deduction. The practice of law falls into the category of “specified service business,” which includes professionals involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. However, a loophole was created that still allows firm partners to take advantage of the 20 percent QBI deduction if they have taxable income from other sources outside their practice. The QBIdeduction has a limitation based on taxable income and filing status that creates a sliding scale of$157,500 to $207,500 for single filers and $315,000 to $415,00for joint filers. The deduction is not available if the filer exceeds the maximum taxable income threshold.
Additionally, guaranteed part-ner payments do not qualify for the deduction as an alternative to wages related to “specified service business.” Thus, the QBI deduction ultimately makes firms review how they categorize their partner payments for the year and still keep their allocated shares.
Here are a few examples to explain this concept. A husband and wife file a joint tax return and earn $800,000. The wife, Wendy, has worked at a law firm for years and has finally become a partner. The husband, Henry, has $100,000 of taxable income. Wendy’s portion of her law firm income (which is considered qualified business income) is$700,000. Unfortunately, Wendy and Henry are not entitled to a20 percent deduction because, as mentioned above, the practice of law is a specified service business and they earned more than$415,000.
Now consider the same facts, but with Wendy’s income reduced to $260,000; her portion of the law firm profit income is $200,000 and her W-2 wages are $60,000. (W-2 wages are the total wages paid by the firm with respect to the employment of its employees during the calendar year.) Wendy and Henry may qualify to take a 20 percent deduction because Wendy’s taxable income is below $315,000.Wendy could take a 20 percent deduction of the $200,000 of her share of the law firm income, which would be $40,000.
Where this example gets complicated is when joint filers earn and have taxable income between$315,000 and $415,000. The deduction would then be limited to the lesser of 20 percent of business income or a “W-2 limitation” based on wages or wages. One of the biggest and most confusing additions in the TCJA is the qualified business income (QBI) deduction. plus a capital element. The W-2 limitation equals the greater of 50 percent of W-2 wages paid by the business, or 25 percent of wages paid by the business plus 2.5 percent of the unadjusted basis of“qualified property.”
At the end of the day, if you are an attorney with a flow-through entity and your pass-through income is below $315,000 for joint filers and $157,500 for other filers, you may be entitled to take the full 20 percent deduction on your personal Form 1040 tax return. If your taxable income is more than $415,000 for joint filers or $207,500 for single filers, you will not be entitled to a deduction. If your taxable income is between those two thresholds amounts from $315,000/$157,500and $415,000/$207,500, you may get a partial deduction that is phased out as you reach the maximum amount.
Though a majority of law firms are incorporated as flow-through entities, there are a number of individuals who decided to incorporate as a C corporation. If the firm is incorporated as a C corporation, the QBI deduction does not allow you to take advantage of the 20 percent flow-through deduction to your taxable income. C corporations are double-taxation entities; thus, there is no flow-through because there is taxation at both the entity and individual levels. However, you will have noticed a significant tax reduction on the overall net income of the business.
Prior to the TCJA, personal service corporations were taxed at a flat 35 percent. That figure was reduced to 21 percent with the TCJA. However, a C corporation will still be subject to double-taxation, which, depending on the individual’s tax bracket, could be good or bad. Interestingly enough, due to the inability of many partners to take advantage of the QBI deduction, either due to their choice of incorporation or has phased out of the income thresholds, a large number of firms either remained as C corporations or converted from a pass-through entity in order to take advantage of having dividends taxed at 23.8 percent at the individual partner level. Although the QBI deduction was one of the largest overall changes to affect the firms and partners, all firms and partners also saw changes to their ability to take unreimbursed business expenses, meals, and entertainment.
IMPACT ON ALL BUSINESSES AND TAXPAYERS
The meals and entertainment deduction was an unexpected change in the TCJA. Prior to the TCJA, when a business had a meal or entertainment expense, the business was allowed to take50 percent of the cost as a deduction on its tax return. However, the TCJA has now disallowed all entertainment expenses and has restricted the types of meals that a business is allowed to deduct. For example, a business is no longer allowed a 100 percent deduction for meals provided on the business premises.
The TCJA also limited the commuting and parking expenses that employers would incur on behalf of their employees. In larger cities, this is a benefit that had been offered to many employees and can be extremely expensive. However, over the years, many employers have taken this expense and moved it to an amount tied to their lease and taken it as a rental expense.
CHANGES THAT IMPACTED ALL INDIVIDUAL TAXPAYERS
There are many good changes that came from the TCJA, including lower tax brackets. For example, the tax bracket for individuals was reduced from 39.6 to37 percent. Attorneys, whether they are single, married, or head of household, can have an impact on the potential 10 percent to 12 percent reduction toward their overall tax liability because their income will be taxed at a lower rate on their individual returns. Those lower tax brackets, however, impacted other areas that traditionally lowered one’s tax liability. For example, charitable contributions were impacted because taxpayers had less of a need for itemized deductions. Taxpayers may also want to consider accelerating any potential medical procedures because the total threshold will increase to the meals and entertainment deduction was an unexpected change in the 10 percent this year.
However, there are many items that put many taxpayers at a disadvantage. The state and local tax (SALT) deduction is one of those areas. The SALT deduction has been quite lucrative for many taxpayers throughout the years, particularly for those who live in high-tax states such as New York, New Jersey, and California. This deduction includes state and local property taxes paid, as well as either state and local income taxes or sales taxes. It also became one of the most contentious parts of the tax reform process. Many Republicans wanted to do away with the deduction entirely. But after some compromise, the SALT deduction survived. The TCJA created a $10,000 annual cap on the SALT deduction. This was a big disappointment to taxpayers in high-tax areas. For example, the average SALT deduction taken in New York was more than $21,000 in a recent tax year. Therefore, the average New York taxpayer, who historically claimed the SALT deduction, would see their deductible amount cut by more than half. The $10,000 cap is not in effect for Schedule E or C properties. Now, taxpayers need to plan at the beginning of the year for itemized deductions, considering the cap on SALT, mortgage interest, medical expenses, and charitable contributions.
Additionally, between December 31, 2017, and January 1, 2026, business losses are also limited for non-corporate taxpayers. Taxpayers are limited to a business loss equal to the business gains plus $250,000 if single and plus $500,000 if filing jointly. If a taxpayer has losses that exceed those limitations, they will be carried forward to a subsequent tax year for use.
Now that we are three years into the TCJA, attorneys are starting to see the results of this legislation on their personal and business taxes, and many are already aware of how their business and personal finances have been affected by the TCJA. As tax controversy attorneys, we are starting to see these issues come up during tax audits. So far, the most prominent issue that has been audited is the QBI deduction for individuals and businesses. Auditors want to confirm wages paid, the number of employees, and that the assets used to calculate the unadjusted basis of the business are all related to the necessary business operations. Some QBI deductions can be significant depending on the size of the business, and the Internal Revenue Service (IRS) is definitely going to look closer at something new and unknown.
Deductions such as SALT, meals and entertainment, unreimbursed employee expenses, charitable contributions, and employee transportation are appearing differently in IRS audits. These transactions are typically caught by accident as an auditor reviews other income and expense items on the personal or business audit side. As the returns filed during the TCJA time period begin to come up within the audit win-dow, always keep your records on hand and have a clear delineation between business and personal income and expenses.
As a final thought, we now have a Democratic presidential administration and a Democratic majority in Congress (at least for two years). They will likely reexamine and make substantial changes to the TCJA. The Biden administration has already made some predeterminations as to how they intend to dismantle the TCJA. Whether that comes to fruition or not remains to be seen.
PUBLISHED IN GPSOLO, VOLUME 38, NUMBER 3, MAY/JUNE 2021 ©2021 BY THE AMERICAN BAR ASSOCIATION. REPRODUCED WITH PERMISSION. ALL RIGHTS RESERVED. THIS INFORMATION OR ANY PORTION THEREOF MAY NOT BE COPIED OR DISSEMINATED IN ANY FORM OR BY ANY MEANS OR STORED IN AN ELECTRONIC DATABASE OR RETRIEVAL SYSTEM WITHOUT THE EXPRESS WRITTEN CONSENT OF THE AMERICAN BAR ASSOCIATION