Impact of the Tax Cuts and Jobs Act on Law Firms

This article describes the provisions of the Act most likely to impact law firms.

The New Flow-Through Tax Rate

The Act would significantly alter the taxation of pass-through income. For 2017, pass-through income from sole proprietorships, partnerships and S corporations is taxed based on the owner's graduated individual tax rates, which top out at 39.6%. Under the new law, these types of income would continue to be taxed at individual tax rates, but a new 20% deduction applies for qualifying taxpayers. Unfortunately, if you're an attorney, you may not be one of them. The Act employs a complex formula for determining how much of a deduction an attorney is allowed. The threshold amount, which is indexed for inflation, starts out at $157,500 ($315,000 in the case of a joint return). The deduction is fully phased out for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return).

Therefore, for an attorney filing jointly with income outside of the “phase-in range” (i.e., with taxable income in excess of $415,000), the deduction is zero.

The Act, however, lowers individual tax rates from 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% to 10%, 12%, 22%, 24%, 32%, 35% and 37%.

Corporate Tax Rates

At the heart of the recently enacted tax reform act is the reduction of the top corporate tax rate from 35% to 21%. Currently, law firms that do business through a regular corporation must pay tax on net income at the personal service corporation (PSC) flat rate of 35%. The Act would eliminate the PSC designation, allowing incorporated law firms to pay tax at the flat rate of 21%. Because of the tax rate difference that would apply between earnings from a pass-through entity and those in a regular corporation, some law firms may ponder whether converting to a regular corporation makes sense. Those who do should proceed with caution. It is important to remember that earnings distributed from a regular corporation are subject to double taxation. Moreover, the Act retains Internal Revenue Code Section 533(a), imposing an accumulated earnings tax on profits retained in a corporation beyond a law firm's reasonable needs.

Interest Deductions

The Act reduces the tax benefits of a law firm relying on debt. Generally, the Act limits the deduction for interest expense to 30% of a business's earnings. For tax years beginning after Dec. 31, 2017 to Jan. 1, 2022, earnings are computed without regard for depreciation, amortization and depletion. Any disallowed deduction can be carried over indefinitely. Law firms with less than $25 million in annual gross receipts are exempt from this limitation. Now that the Act has become law, some law firms may want to consider adjusting their capital structure to rely less on borrowing.

Conclusion

What lies ahead for the Tax Cuts and Jobs Act? Most of the provisions of the law have become effective on Jan. 1, 2018. Now the U.S. Department of the Treasury must pass interpretive regulations for the Act.

***** Marcus Dyer is a tax manager at Withum with over 10 years' experience of providing tax and business advisory services. He has experience in representing clients in commercial and tax disputes before state courts, Federal District Court and the United States Tax Court.