Tax Cuts for Law Firms

With the compromise-laden Federal tax cut now law, what if any are the implications for law firms? Members of this newsletter's Editorial Board and several other recent contributors were asked to address that question.

Consultant Ed Poll's view seems to represent a consensus: For individual attorneys the changes effected by this tax law may be significant, but for law firms themselves the overall importance of the tax cut is minor.

That said, several provisions of the tax law do offer firms opportunities to reduce taxable income and, in some circumstances, opportunities for reduced taxation on compensation. It also appears that some problems could result from misguided attempts to take advantage of the tax cuts.

In the edited digest that follows, the tips themselves are courtesy of our listed authors. Some added background details are based on information in a May 23, 2003 Ernst & Young client-alert memo provided by tax consultant Jake Weichholz, along with a Web advisory of the Research Institute of America Group (http://www.riag.com/) cited by consultant Ron Seigneur. Before taking action, be sure to run these ideas by your own tax advisor.

Accelerated Depreciation

CFO Jim Davidson suggests that unincorporated firms can benefit substantially by the increase from 30% to 50% in bonus first-year depreciation on qualified property acquisitions. (In calculating their income for the alternative minimum tax, partners do not need to add back their share of the 50% bonus depreciation.)

Small firms can also benefit from optional Section 179 deductions, the maximum for which rises from $25,000 to $100,000. The new deductibility maximum is subject to a dollar-for-dollar reduction if qualifying property placed in service during the tax year exceeds $400,000. That limit is itself a liberalization, since the reduction previously kicked in at $200,000.

An important scope change for Section 179 is that it now applies to off-the-shelf computer software. [Ed. Note: Organizations that have gone overboard trying to avoid the sales tax on software purchases now have a painless opportunity to be more supportive of their hard-pressed state and local governments while still saving on taxes.]

For all these tax changes, a variety of updated calendar restrictions specify when a 'qualifying' asset must be contracted for, manufactured, acquired, put into service, and/or retired.

Overall Compensation Strategy

If your incorporated law firm's compensation policy is currently effective with regard to salary vs. dividend, think carefully before changing it based on this tax cut.

Consultants Joe Altonji and Jim Cotterman point out that the change in dividend taxation is not even relevant to firms organized as partnerships or S Corporations. Altonji predicts that the desire to avoid double taxation on income will deter corporate-format firms from holding income at year-end ' which they are already disinclined to do.

Although paying a single rate will generally remain preferable to double taxation even after the dividend tax cut, managing partner Mike Mooney notes an exception. The (today rare) law practice that has accumulated earnings from prior years can now pay out those earnings as dividends and have the shareholders pay the lower rate on them. Previously, such a firm might have had to wait until liquidation to assure its shareholders a capital gains rate on the accumulated income.

Mooney remarks that the salary vs. dividend game has been around for quite a while due to the FICA tax, which remains a substantial consideration in tax calculations. Some shareholders attempt to minimize their salaries to avoid FICA tax, and the IRS and the courts have applied more or less a reverse reasonable-compensation standard to prevent abuse.

Retirement Plan Investments

Given the now reduced taxation rate on dividends, should law firm retirement plans invest in securities that pay high dividends? Mooney suggests perhaps not:

• To leverage the tax-exempt investments in my qualified plan as much as possible, maybe I'm better off keeping high-interest-yielding investments in the qualified plan (moving stocks to my personal portfolio).
• If I keep dividend-paying stocks in my qualified plan, any distribution of qualified plan assets attributable to dividends will be taxable at 35%, so I will effectively have paid 20 extra percentage points of tax just for the privilege of deferral.

Mooney cautions that these conclusions should not be extrapolated to justify reducing one's contribution to the qualified plan. 'If I have $30,000 available to put into my qualified plan, I would not put less into the plan ' and lose the current tax deduction ' just to be able to use some of that amount to buy dividend-paying stock outside the plan (eg, put $25,000 in the plan and buy $5,000 worth of stock). I'm still better off putting the full $30,000 into the plan, deducting the contribution and using all of the $30,000 to buy assets (whether stocks or bonds) inside the plan.'

Jim Davidson identifies a similar scenario that could be generated inadvertently. Consider an individual shareholder with low total compensation in a firm where the qualified retirement plan bases its maximum allowable contribution on salary. Increasing that shareholder's ratio of dividends to salary could actually reduce his or her salary component below the maximum allowable contribution to the plan. Even if the proposed salary-to-dividend shift passes muster with the IRS regarding FICA, the incremental tax saving would not normally justify reduced participation in the qualified retirement plan.

To some extent, this issue has been around before with capital gains in a qualified plan, where the benefit of deferring the whole amount of a contribution to the plan usually outweighs the 'conversion' to ordinary income on distribution.

Firm Structure Decisions

Finally, for those evaluating these tax cut implications in connection with a firm structure decision, Ron Seigneur reminds us that the tax cuts are temporary. He would discourage a firm from incurring the 35% tax on corporate profits just so it could pass through tax-free dividends to the owners. Jim Cotterman adds that the maximum federal corporate income tax is levied from the first dollar of profit for professional corporations. He also reminds planners that state and local tax laws (both corporate and individual) must be considered in calculating possible savings.

CONTRIBUTORS: Joseph B. Altonji; James D. Cotterman, Altman Weil, Inc.; James W. Davidson, Holland & Hart, LLP; Michael E. Mooney, Nutter, McClennen & Fish, LLP; Edward Poll, Edward Poll & Associates; Ronald L. Seigneur, Seigneur & Company, PC; Jacob Weichholz, Ernst & Young LLP.

With the compromise-laden Federal tax cut now law, what if any are the implications for law firms? Members of this newsletter's Editorial Board and several other recent contributors were asked to address that question.

Consultant Ed Poll's view seems to represent a consensus: For individual attorneys the changes effected by this tax law may be significant, but for law firms themselves the overall importance of the tax cut is minor.

That said, several provisions of the tax law do offer firms opportunities to reduce taxable income and, in some circumstances, opportunities for reduced taxation on compensation. It also appears that some problems could result from misguided attempts to take advantage of the tax cuts.

In the edited digest that follows, the tips themselves are courtesy of our listed authors. Some added background details are based on information in a May 23, 2003 Ernst & Young client-alert memo provided by tax consultant Jake Weichholz, along with a Web advisory of the Research Institute of America Group (http://www.riag.com/) cited by consultant Ron Seigneur. Before taking action, be sure to run these ideas by your own tax advisor.

Accelerated Depreciation

CFO Jim Davidson suggests that unincorporated firms can benefit substantially by the increase from 30% to 50% in bonus first-year depreciation on qualified property acquisitions. (In calculating their income for the alternative minimum tax, partners do not need to add back their share of the 50% bonus depreciation.)

Small firms can also benefit from optional Section 179 deductions, the maximum for which rises from $25,000 to $100,000. The new deductibility maximum is subject to a dollar-for-dollar reduction if qualifying property placed in service during the tax year exceeds $400,000. That limit is itself a liberalization, since the reduction previously kicked in at $200,000.

An important scope change for Section 179 is that it now applies to off-the-shelf computer software. [Ed. Note: Organizations that have gone overboard trying to avoid the sales tax on software purchases now have a painless opportunity to be more supportive of their hard-pressed state and local governments while still saving on taxes.]

For all these tax changes, a variety of updated calendar restrictions specify when a 'qualifying' asset must be contracted for, manufactured, acquired, put into service, and/or retired.

Overall Compensation Strategy

If your incorporated law firm's compensation policy is currently effective with regard to salary vs. dividend, think carefully before changing it based on this tax cut.

Consultants Joe Altonji and Jim Cotterman point out that the change in dividend taxation is not even relevant to firms organized as partnerships or S Corporations. Altonji predicts that the desire to avoid double taxation on income will deter corporate-format firms from holding income at year-end ' which they are already disinclined to do.

Although paying a single rate will generally remain preferable to double taxation even after the dividend tax cut, managing partner Mike Mooney notes an exception. The (today rare) law practice that has accumulated earnings from prior years can now pay out those earnings as dividends and have the shareholders pay the lower rate on them. Previously, such a firm might have had to wait until liquidation to assure its shareholders a capital gains rate on the accumulated income.

Mooney remarks that the salary vs. dividend game has been around for quite a while due to the FICA tax, which remains a substantial consideration in tax calculations. Some shareholders attempt to minimize their salaries to avoid FICA tax, and the IRS and the courts have applied more or less a reverse reasonable-compensation standard to prevent abuse.

Retirement Plan Investments

Given the now reduced taxation rate on dividends, should law firm retirement plans invest in securities that pay high dividends? Mooney suggests perhaps not:

• To leverage the tax-exempt investments in my qualified plan as much as possible, maybe I'm better off keeping high-interest-yielding investments in the qualified plan (moving stocks to my personal portfolio).
• If I keep dividend-paying stocks in my qualified plan, any distribution of qualified plan assets attributable to dividends will be taxable at 35%, so I will effectively have paid 20 extra percentage points of tax just for the privilege of deferral.

Mooney cautions that these conclusions should not be extrapolated to justify reducing one's contribution to the qualified plan. 'If I have $30,000 available to put into my qualified plan, I would not put less into the plan ' and lose the current tax deduction ' just to be able to use some of that amount to buy dividend-paying stock outside the plan (eg, put $25,000 in the plan and buy $5,000 worth of stock). I'm still better off putting the full $30,000 into the plan, deducting the contribution and using all of the $30,000 to buy assets (whether stocks or bonds) inside the plan.'

Jim Davidson identifies a similar scenario that could be generated inadvertently. Consider an individual shareholder with low total compensation in a firm where the qualified retirement plan bases its maximum allowable contribution on salary. Increasing that shareholder's ratio of dividends to salary could actually reduce his or her salary component below the maximum allowable contribution to the plan. Even if the proposed salary-to-dividend shift passes muster with the IRS regarding FICA, the incremental tax saving would not normally justify reduced participation in the qualified retirement plan.

To some extent, this issue has been around before with capital gains in a qualified plan, where the benefit of deferring the whole amount of a contribution to the plan usually outweighs the 'conversion' to ordinary income on distribution.

Firm Structure Decisions

Finally, for those evaluating these tax cut implications in connection with a firm structure decision, Ron Seigneur reminds us that the tax cuts are temporary. He would discourage a firm from incurring the 35% tax on corporate profits just so it could pass through tax-free dividends to the owners. Jim Cotterman adds that the maximum federal corporate income tax is levied from the first dollar of profit for professional corporations. He also reminds planners that state and local tax laws (both corporate and individual) must be considered in calculating possible savings.

CONTRIBUTORS: Joseph B. Altonji; James D. Cotterman, Altman Weil, Inc.; James W. Davidson, Holland & Hart, LLP; Michael E. Mooney, Nutter, McClennen & Fish, LLP; Edward Poll, Edward Poll & Associates; Ronald L. Seigneur, Seigneur & Company, PC; Jacob Weichholz, Ernst & Young LLP.