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When determining whether your workers should be classified as employees or independent contractors, it’s critical to ensure that you are closely following the Employment Development Department’s (EDD) strict guidelines.
On the simplest level, proper classification is determined by whether or not the principal, or employer, holds the “right of control.”
What is “Right of Control?”
Right of control is determined by who holds the “right to control the manner and means” by which work is performed.
A corporate administrative assistant, for example, reports directly to an executive who manages their work. Likely they work a classic Monday through Friday, 9 to 5 schedule. When they want to go on vacation, they have to request time off or let their manager know in advance.
Now consider an app-based rideshare driver. When they’re available to work, they log into the app and begin work. Perhaps after a couple of hours, they decide they need a break, they disable the app and log off for a break. While they are required to abide by the rules and regulations set in place by the company that they work for, their hours and responsibilities are not deliberately determined by the company overall.
How does EDD determine 1099 status?
EDD utilizes the right of control as an initial way to classify workers. They take things one step further by providing a worksheet that employers can utilize to help clarify discrepancies.
Since January 2020 the new ABCs of worker classification has been implemented to try to simplify the process of determining worker classification. Under the ABC test, a worker is considered an employee and not an independent contractor, unless the hiring entity satisfies all three of the following conditions:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Since the passing of the AB_5 gig worker bill, there have been multiple rounds of exceptions, exclusions, and widespread confusion about how the rules affect real-life business scenarios. In cases of confusion, the original 13 point Borello test is still the fallback.
The questions posed in the EDD Borello criteria include the following 13 elements to provide additional support in determining workers’ proper classification. They include the following:
- Do you instruct or supervise the person while he or she is working?
- Can the worker quit or be discharged (fired) at any time?
- Is the work being performed part of your regular business?
- Does the worker have a separately established business?
- Is the worker free to make business decisions that affect his or her ability to profit from the work?
- Does the individual have a substantial investment in their job which would subject him or her to the financial risk of loss?
- Do you have employees who do the same type of work?
- Do you furnish the tools, equipment, or supplies used to perform the work?
- Is the work considered unskilled or semi-skilled labor?
- Do you provide training for the worker?
- Is the worker paid a fixed salary, an hourly wage, or based on a piece-rate basis?
- Did the worker previously perform the same or similar services for you as an employee?
- Does the worker believe that he or she is an employee?
Answering “yes” to questions 1-3 would provide a strong indication that the worker is an employee. Answering “no” to questions 4-6 would indicate that a worker is not in business for themselves and would likely classify as an employee. Questions 7-13 may indicate important factors to be considered. While answering “yes” to any one of them may indicate that a worker should be classified as an employee, no single factor is enough to determine so independently.
The full worksheet provided by EDD provides further clarification on certain factors and circumstances. If completing the provided worksheet does not provide sufficient clarification for employers, EDD offers the ability to request a written ruling by completing a Determination of Employment Work Status.
In cases where EDD initiates a worker classification audit, employers can be required to retroactively prove that their workers were correctly classified at 1099 contractors vs W-2 employees. At Milikowsky Tax Law we are experts in EDD audit defense. Our team works with you to ensure that your audit does not spread to other areas, that EDD understands the scope and function of your unique business and that you are only liable for back fines and fees on those workers who are indisputably misclassified.
We have represented hundreds of businesses and individuals audited by EDD, CSLB, CFTB, and IRS. Our team is dedicated to ensuring you get the best result and that your audit does not permanently negatively impact your business or your life. Reach out to our team for more information.
On January 24th, the Internal Revenue Service (IRS) announced the start of tax season. Now, the agency can accept federal income tax returns for 2021. With tax season officially in progress, the April deadline is quickly approaching. Organizing tax filing information well in advance, and understanding any tax changes for filing this year sets you and your business up for success. Avoid filing taxes last minute as you may make errors that can flag your business for an Internal Revenue Service (IRS) audit.
Before filling out your business’ tax return, we’ve put together tips to help you successfully file this year.
Tax Return Due Date
Each year, taxes are due April 15th. The date is unflinching unless it falls on a weekend. This year, the deadline is extended to April 18th for the majority of taxpayers because the 15th lands on Emancipation Day celebrated in Washington D.C. However, we do not recommend waiting until then to start assembling and filing your taxes.
The following are the approved extensions to the April 18th deadline:
- April 19th for taxpayers in Main and Massachusetts to observe Patriots’ Day
- May 16th for the victims of tornados in Illinois, Tennessee, and Kentucky
- May 16th for the victims of wildfires in Colorado
- October 17th for taxpayers requesting an extension
PPP Loan Deductibles
Small business owners who applied for PPP loan forgiveness may need to look into different tax deduction strategies. Claiming PPP funds depends on if they were forgiven or not. Businesses that had PPP loans forgiven are not eligible to claim deductibles on their taxes because it is essentially “double-dipping.” However, businesses that did not have PPP loans forgiven can claim the expenses on their tax forms this year.
Claim All Reported Income
When reviewing your business’ tax returns, IRS matches what you reported as income to the 1099 – MISC forms your independent contractors fill out. IRS has a copy of the 1099-MISC forms your business receives and will cross check accurate reporting is made. If they find an error between the filings, the agency may flag you for an audit.
Taxable and Nontaxable Employee Benefits
Some employee benefits that employers give are considered taxable while others are considered non taxable benefits. All help retain top talent but come tax season, providing benefits that don’t cost your employees more when filing is a financially beneficial opportunity.
IRS considers taxable benefits as:
- Vacation expenses
Non-taxable benefits include:
- Accident and health benefits
- Educational assistants
- Employee discounts
Classify your business correctly
The various business classifications are taxed differently. Misclassifying your own business can lead to overpaying, or underpaying taxes. If the agency finds an underpayment of taxes, they will most likely open up an audit against your business.
Different business classifications include:
- Sole proprietorships
- S Corporations
- Limited Liability Company (LLC)
Businesses that give charitable donations help the community and can use their contributions towards tax deductions. The size of your business determines how much in charitable deductions you’re able to file.
Qualified Business Income Deductions
After 2017, IRS implemented the qualified business income deduction. This deduction states, “many owners of sole proprietorships, partnerships, S corporations and some trusts and estates may be eligible for a qualified business income (QBI) deduction.”
Through this change, certain business entities can deduct up to 20% of business income along with 20% for qualified real estate investments on filings.
Businesses who use company car vehicles can use it as a deduction as well. If the vehicle is solely used as a company car, the entire cost can be used towards deductions. However, if the vehicle is split between personal use and business use, only the business use can be deducted.
Deductions can be calculated through:
- Standard Mileage Rate
- Actual expenses
Keep Organized Records
Having the receipts for business expenses makes claiming it as a deduction a smoother process. Not every expense claimed as a deduction needs the receipt to back it up, but it helps, especially if IRS decides to open up an audit against your business.
Tips to Make Filing Easier This Year
Staying up to date on new tax updates is a great starting point to making filing easier this year. Another way you can make filing taxes as streamlined as possible is this year is to:
- Gather and organize your tax records ahead of time
- Accurately report income and expenses
- Make sure you’ve withheld enough
Planning for tax season ahead of time gives you the opportunity to file the most accurate returns possible. In doing so, you avoid triggering an IRS audit. If you are worried about flagging an IRS audit when submitting your business’s tax returns, read our article on six triggers of an IRS audit here.
Anytime you file taxes, there is a chance that your tax return might be audited by the Internal Revenue Service (IRS). The agency conducts standard procedures to find any errors or discrepancies among taxpayers. The audit process is meticulous and, should you find yourself under the scrutiny of IRS, will require detailed information from you.
In the article below, you’ll learn about the audit process and frequently asked questions surrounding IRS audits.
Why was I selected for an Audit?
There are different reasons you may be flagged for IRS audits. Some are due to random checks; however, you have a low chance of being audited this way. Most taxpayers have less than a 0.6% chance of receiving a random audit check.
IRS runs tax returns through their Discriminant Information Function (DIF) system to continually update their database and make sure they are tracking industry benchmarks for each industry and tax bracket.
The DIF system also checks for incorrect tax filing information. Any discrepancies in tax forms, such as an imbalance of tax returns, a discrepancy between reported earnings and employer filings, or unreported cash transactions by one member of a transactional party, will trigger DIF to send your return to an IRS audit officer.
People are more susceptible to an audit if they:
- Earn less than $25,000 or more than $500,000
- File incorrect or incomplete returns
- Have large numbers of cash transactions
- Claim a disproportionate number of deductions
- Are self-employed
- Have a home-based business
- Have a cash business
- Have foreign assets
Sometimes you can be audited as a result of your business partners or investors going through an audit.
How Will I Know If I am Selected for an Audit?
You will know if you are selected for an audit if you receive a verified letter in the mail from IRS. They do not call to notify you about your audit.
What Do I Do If I’m selected for an Audit?
If you or your business are selected for an audit, make sure you read all of the information sent to you in your audit notification letter. The letter and accompanying information request packet will notify you as to what entity is being audited (business or personal) what year(s) are under review and who your auditor is. Once you know what IRS needs, make sure you collect all of the records and supporting documentation requested (but nothing additional). You will need to submit records from banks, vendors, and businesses you have worked with, invoices and pay stubs, payroll records, and medical expenses among other information.
Should I Hire an IRS Tax Attorney to Help Me?
We suggest contacting a qualified tax attorney to help guide you through your audit, to ensure you are timely, responsive, compliant, and do not unintentionally increase the scope of your audit to other areas of your business or personal finances that would otherwise remain unscrutinized.. There is little to no margin for error during an audit, a tight timetable, and potentially severe consequences to a poorly handled interaction with IRS. Unlike CPAs who do not have attorney-client privilege, attorneys are able to speak with your IRS officer on your behalf without risk of subpoena or summons of records discussed. A qualified attorney can, review your documents with an expert eye, create the right strategy for you, represent you or your business, and provide valuable advice and guidance.
How long do I have to reply to an IRS audit?
You have 30 days to reply to the initial audit letter. Do not hesitate, and make sure you take the appropriate steps early on. IRS is not likely to provide extensions unless you have a good reason. Your attorney can help by advocating for more time with the IRS agent. A good attorney will know many of your local IRS auditors and have strong relationships built on well-structured prior cases and mutual respect.
How Long Do Audits Take?
The time it takes to conduct an audit depends on the case. It fluctuates depending on:
- The seriousness of the tax reporting error
- When and whether the right information is provided to IRS
- Communication between the person being audited and IRS officer
How Many Years of Tax Returns Can IRS audit?
IRS audits tax returns from the past three years; however, most are from the past two years. Only when IRS agents find discrepancies within the audit they are conducting do they dig for information older than three years. Most audits do not look for information past six years. Though in cases of criminal audits IRS can look back 9 years and longer.
If you or someone you know received an audit letter from IRS, reach out to our expert team at Milikowsky Tax Law. We have over a decade of experience working with IRS and tax audits and are experts in defending business owners in the face of IRS or other government agency audits.
In mid-May, the U.S Treasury Department announced that they would require any transfer of $10,000 or more to be reported to the Internal Revenue Service (IRS). This update comes in response to growing concerns with regard to cryptocurrency compliance.
While many forms of crypto trading were designed to be hidden or virtually invisible, IRS is far from blind to these transactions. It is suspected that a significant amount of money is laundered through crypto transactions and tax evasion occurs through illegal crypto investing and trading.
IRS’s initial response to the rise in the use of cryptocurrencies includes training and developing their internal investigative teams to utilize data analytics to trace, identify, and audit suspicious crypto transactions.
This recent shift in focus towards cryptocurrency violations brings up questions of, “why now?” given that IRS has been defunded and has experienced years of employment shortages, and is currently in a stage of increased recruitment efforts. Data analytics is hardly a new venture for IRS, it has long been a staple in tracing and audits. While the blockchain is opaque and there will be elevated challenges around information-gathering, the use of data analytics is the IRS’ best path forward in combating crypto-fraud.
IRS’s decision to increase its utilization of data analytics tactics comes as an approach to sift through billions of transactions with greater efficiency and ease than they have in the past. This is an ideal response given the previously mentioned employment shortages currently being experienced by IRS.
Cryptocurrency continues to grow at an exponential rate. IRS has experienced challenges in keeping up with how quickly the unique industry has grown and evolved over recent years. The implementation of data analytics is a step towards being able to keep up with digital currency, in a way that they have not been able to previously.
As IRS adjusts to these new processes for tracing and auditing cryptocurrency exchanges, it is predicted that they will be able to increase their success in regulating and addressing the potential of tax evasion.
Jeffrey Cooper, former executive director of international operations at IRS Criminal Investigation told Accounting Today that it’s a process of ‘follow the money.’ He explained that once money goes into the exchange, they’re able to trace it through data analytics.
The American Family Plan, put in place by the Biden administration, also helps deal with potential tax compliance issues with cryptocurrency by implementing a new reporting threshold of $10,000. The new reporting requirements will ensure that whatever crypto traders are doing, there will be a clear trail of traceable data to accompany it.
According to IRS estimates, in 2019 there was a discrepancy of over $600 billion between taxes owed and taxes collected by the agency.
Changes in the process of implementation are likely to induce upset among crypto investors. That being said, politicians across the board have prioritized crypto regulation among concerns of market manipulation and uninformed retail investments.
For business owners who have thought that crypto is a way to avoid (or evade) tax liability, to move money undetected, or otherwise skirt regulations, the recent rise in interest by IRS and other government entities in regulating the industry should come as a warning. There are two things that we all can’t avoid…. And one of them is taxes.
In early May of this year, the Biden Administration officially made the decision to revoke the previously adjusted Trump era ruling on independent contractor classification.
Earlier this year, in January 2021, the Trump administration took advantage of the opportunity to implement final changes to the Department of Labor (DOL) before leaving office. The “final rule” that they implemented stood largely unchanged from the original ruling which established a tiered test to determine employee versus contractor status as part of the Fair Labor and Standards Act (FLSA).
The updated proposal established a two-part analysis to determine whether a worker’s correct status is that of an independent contractor or employee. The “core factors” stated are as follows:
- The nature and degree of control over the work.
- The worker’s opportunity for profit or loss based on initiative and/or investment.
In addition to the previously mentioned “core factors,” the DOL also listed three other factors to support the analysis. These factors are:
- The amount of skill required for the work.
- The degree of permanence of the working relationship between the worker and the potential employer.
- Whether the work is part of an integrated unit of production.
Following the ending of Trump’s presidency, the DOL has announced that the ruling determined by the Trump administration was inconsistent with FLSA and was thought to have a negative impact on both workers and businesses.
As such, the previously implemented “final rule” was rescinded under the current Biden Administration.
Going forward, companies will be responsible for judging their workers based on the existing “economic reality” test until another proposal can be made by the Biden administration.
It should be noted that throughout President Biden’s campaigns, he spoke of his intentions to promote a federal standard for independent contractor classification in alignment with the existing method utilized in California.
This method includes the use of the multifactor “ABC” test. Under the ABC test a worker is classified as an employee unless they meet all three of the following criteria:
- The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
- The person performs work that is outside the usual course of the hiring entity’s business.
- The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Until further decisions are made, this test will remain the federal determination with regard to independent contractor classification.
For more information or guidance on the proper status of your business’s workers, call or contact our team of tax professionals at Milikosowsky Tax Law.
Over the past year businesses flocked to the Small Business Administration (SBA) to submit applications to receive their share of the federally allocated Paycheck Protection Program funding.
PPP loans were distributed to businesses struck hard by the ongoing coronavirus pandemic. Their intended use was to help keep workers employed by providing funding to support their ongoing paychecks following mass layoffs at the forefront of the pandemic.
Since their initial rollout, it has been discovered that many businesses wrongly claimed PPP loans, resulting in millions of dollars of fraudulent claims.
As of May 31, SBA has since closed the application for PPP loans. Despite being renewed by the federal government numerous times in both 2020 and 2021, businesses are no longer able to submit new requests for funding.
As of May 23, SBA had approved over 11.6 million loans, totaling approximately $796 billion.
Even since the program application portal has been shut down, SBA will take approximately one month to process all existing applications submitted prior to the closure.
While the initial rollout of the PPP loan distribution process brought with it thousands of fraudulent claims, it’s now expected that the program overall served as a starting point for SBA to continue serving small businesses into the future.
While the general PPP loan applications have been closed at this time, SBA has been granted an additional $100 million to fund a pilot program providing support to underserved small businesses. This comes after speculation that despite the hundreds of billions of dollars in loans distributed over the past year, some of the neediest businesses were not able to receive the support they desperately needed.
Additionally, Congress has recently granted SBA the responsibility to take charge of new relief programs for businesses in the restaurant and live-events industries, two industries that are returning to their former glory.
The discovery of such a large number of fraudulent PPP claims has left all recipients at risk of an audit. While all loans disbursed of $2 million or more are guaranteed to be audited by SBA, all recipients, regardless of loan size are at risk of a potential audit.
While SBA is auditing a large number of loans that were dispersed as part of the Paycheck Protection Program, those that are found to have been spent as they were intended have the opportunity to be forgiven entirely.
If your business received a PPP loan and is confident that you utilized your funding for its intended purposes, there may not be a significant reason to be concerned in the event of an audit. However, in the event that you are the subject of an SBA audit, it’s imperative that you maintain ample records and documentation of all expenditures related to your receipt of a PPP loan.
Another aspect of SBA audits to be concerned about is SBA’s relationship with other government agencies including EDD and IRS. In the event that your business is audited as a recipient of a PPP loan, there is the potential that SBA may uncover information in their audit that may lead them to involve additional government agencies to conduct further audits of your business.
EDD and IRS audits hold significantly more complex potential outcomes and should not be considered lightly. While your business may not have otherwise triggered an IRS or EDD audit, SBA has the simple ability to pinpoint businesses for them to investigate further.
If your business is the subject of an SBA, EDD, or IRS audit, the best practice is to reach out to an experienced tax attorney immediately. Making the wrong choices in the event of an audit has the potential to further incriminate you without your intention of doing so. An experienced tax attorney such as those on our team at Milikowsky Tax Law can support you through the complicated process of an audit and do our best to support the best possible outcome for you and your business.
To get started working with our team, call or contact us today. At Milikowsky Tax Law, we keep businesses in business.
While nobody wants to be responsible for paying any more taxes than is absolutely necessary, it’s critical to remain aware of the fine line between getting creative with your tax responsibilities in a legal way, and taking it too far into tax evasion or avoidance. The latter should be avoided if you don’t want to land yourself as the subject of a government audit, or even in prison.
In 2019, IRS declared a tax gap of $441 billion, representing the difference between the amount of taxes that should have been collected, and how much was collected.
Despite this significant total of uncollected taxes, the same year, IRS audited only 0.4% of individual taxpayers in 2019, and only 6.2% of corporations.
While there are certain behaviors and triggers that may result in IRS auditing your business, it is clear that they are incapable of fully keeping up with the full amount of audits needed to regulate all taxpayers.
What is tax evasion?
Tax evasion is defined as “the use of illegal means to avoid paying taxes.” Some examples of actions that may be labeled as tax evasion include the following:
- Purposely underpaying your taxes
- Underreporting your annual income
- Claiming false deductions
- Hiding interest
- Falsifying records
What’s the difference between tax evasion and tax avoidance?
While tax evasion is an illegal practice, tax avoidance is the act of legal strategic tax planning. While the actions listed above are unlawful and enlist deceitful and dishonest tactics to avoid paying the funds for which they were responsible, tax avoidance involves simply reworking their options to minimize the total amount that they are responsible for paying.
Some examples may include the use of tax-advantaged savings accounts (such as those for retirement or educational purposes), contributing to charitable organizations, or avoiding realized capital gains.
The point in which tax avoidance transitions to tax evasion is a gray area. Oftentimes the average taxpayer may not be equipped to determine at what point this line is crossed. As such, the best practice is to consult with a tax attorney or tax law professional to ensure that your actions do not lead to potential consequences including those mentioned below.
Potentially penalties for tax evasion
Tax evasion is a criminal offense and has the potential to lead to jail time.
The average jail time for tax evasion ranges between three to five years. It varies on a case-by-case basis, but jail time for tax evasion occurs more often than one would think. What other penalties exist for tax evasion?
According to Internal Revenue Code, “Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.”
Needless to say, IRS takes tax evasion seriously. With a 90.4% conviction rate on criminal cases, going up against the IRS criminal investigations department is not to be taken lightly.
You may be able to show that there was no intent to defraud the government if you are able to prove that there was a legitimate miscalculation of taxes. With proper guidance, it is possible to partake in tax resolution negotiations with IRS or state tax authorities. It is always advised that you receive counseling from an experienced tax attorney who can help in creating a defensive strategy to bolster your case.
The attorneys at Milikowsky Tax Law have extensive experience in dealing with tax evasion charges. Contact us today with further questions or to discuss your case.
In March 2021, the current administration and congress were able to enact the American Rescue Plan, the plan provides cash payments to individuals and included tax law changes benefitting lower-income individuals and families. The American Rescue Plan tax changes are temporary (expiring at the end of 2021) remedies targeted at those affected by the economic downturn caused by COVID-19.
- A child tax credit of $3,600 per child under age 6 and $3,000 per child ages 6 through 17 is fully refundable and payable in advance. It will revert for 2022 to $2,000 per child under age 17 unless extended by legislation.
- A child and dependent care tax credit maximum credit for one individual is $4,000 and $8,000 for two or more qualifying individuals and is refundable for some taxpayers.
- EITC extended to workers under age 25; and for 2021, individuals as young as age 19 are eligible.
- Premium reductions for ACA coverage for two years.
On the docket for enactment are other tax implication-filled plans such as The American Jobs Plan aims to achieve the following:
- Create new unionized jobs and train American workers for future jobs
- Invest in innovation by revitalizing American manufacturing
- Create caregiving jobs and raise wages of home caregivers
- Modernize homes, commercial buildings, schools, and federal buildings
- Upgrade highways and national infrastructure
- Update drinking water infrastructure and develop a new electrical grid
These intended projects are planned to be funded by the Made in America Tax Plan that the presidential administration has also proposed. Currently, this tax plan is projected to bring in a total of approximately $2 trillion to cover the costs of the projects mentioned above.
The intention of this proposed legislation is to ensure that large corporations and wealthy individuals will pay a higher rate to contribute to the national funding. As currently proposed, this plan will be funded over the coming 15 years, particularly concentrated over the next eight years.
The details of this proposed plan will implement substantial changes for many corporations across America. Additional details of the Made in America Tax Plan are:
- Increased Corporate Tax Rate
The Made in America Tax Plan proposed an increased corporate tax rate to 28%. These rates were previously cut down to 21% in 2017 as part of the Tax Cuts and Jobs Act enacted that year. Note that these proposed rates are still lower than the rates experienced prior to their lowering in 2017.
- Minimum Book Tax
President Biden’s proposed updates also include the implementation of a 15% minimum book tax on firms with $100 million or more in net income. Overall, this change is targeted at corporations that have significant annual income but pay little to no taxes.
- Clean Energy Incentives
President Biden’s plan mentioned both tax and non-tax incentives with relation to clean energy. While the details surrounding this aspect of his plan are still not entirely clear, it was noted that existing subsidies would be eliminated and not be expected to cause significant impacts on the price or security of energy for Americans.
It is also mentioned that Biden’s tax plan would advance existing clean energy production by extending existing production and investment tax credits for the next 10 years.
- Increased IRS Enforcement
Lastly, President Biden’s proposed plan calls for a significant strengthening of IRS enforcement. He aims to reach this goal by increasing funding to IRS to increase audits of international corporations that are not meeting their tax contributions.
In more recent news, Biden has claimed he expects that increasing IRS enforcement will bring in an additional $700 billion over the next decade. This result is expected should the administration obtain the $80 million budget from Congress.
While the administration’s proposed plans are just that, proposed, it should be noted what intended actions might mean for businesses in the near future. The likelihood that these plans will see further edits and adjustments from Congress before being approved is high.
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