Taxing Questions for Law Firms Looking to Benefit in the New Regime

Like every other business these days, law firms are trying to figure out how to take advantage of the new tax law.

Even if there's still plenty of uncertainty, “the gains are just too large” for firms not to explore tax-saving tricks, says New York University tax professor Daniel Shaviro. “Anyone who can afford the legal advice and has enough money at stake would be insane not to give [them] very serious thought,” he adds.

The new law offers two obvious potential benefits: a 20% deduction for pass-through entities such as partnerships, and a 21% tax on corporations — down sharply from the former 35% corporate rate. Meanwhile, with the top individual income tax rate cut from 39.6% to 37%, this is the first time the corporate rate has been significantly lower than the individual rate since President Ronald Reagan's 1986 tax overhaul.

Partners and associates both typically pay income tax at the individual rate, since most law firms are structured as pass-through entities — LLPs, LLCs, S corps or sole proprietorships — that distribute the profit to the owners. The new law's 20% deduction for pass-through income reduces the top individual rate to 29.6%, says Michael Gillen, a CPA who heads Duane Morris' tax accounting group.

But there's a big catch. Congress capped the income eligible for the 20% deduction on pass-through income from most types of professional services firms, including law firms, at $157,500 for single-filers, and $315,000 for married, joint filers.

That means firms with high-income partners — pretty much the entire Am Law 100 — likely won't benefit, Gillen says. “This is a costly problem and lawyers are paying careful attention to any solutions,” he says.

Several tax lawyers say they are working on a range of innovative tax planning strategies.

The new 21% rate for C corps looks attractive. “It would almost be negligence not to consider,” Shaviro says. But, again, it comes with a catch: a double-tax. Shareholder dividends are taxed at 20%, for a total tax of 36.8%. “The only problem is getting the money out,” Shaviro acknowledges.

He and other tax experts agree that a C corp is likely not feasible for a big national firm. Too many operational problems arise: How does a firm handle profit distributions? And how does it deal with shareholders who come and go, in some cases frequently? What's more, there are state law issues — and it's not clear whether state bars allow law firms to be corporations.

Forming an individual C corp to capture the 21% tax rate could work for lawyers who don't need to live on their annual compensation, says David Miller, a tax partner at Proskauer Rose in New York. The idea is to reinvest the money to avoid getting taxed on dividends.

“The corporation becomes an incorporated pocketbook,” says Alex Raskolnikov, a tax law professor at Columbia University. Lawyers could use their C corp to buy a second home or invest in real estate and commodities, he suggests.

What's more, C corps can deduct state and local taxes, while Congress has capped those deductions at $10,000 for individual income.

That said, an individual C corp can't run afoul of anti-abuse rules in the federal tax code. The corporation must pay its employees — in this case, the lawyer — a “reasonable salary,” Miller says, which is taxed at the individual rate. “I think it could be less than what the partner receives from the firm,” he says. “That would have to be developed.”

A C corp is also subject to a 37% penalty under the Personal Holding Company Rule if 60% of its income is passive, for instance from dividends and capital gains.

“If the only thing my new corporation does is receive distributions from the law firm partnership, it won't work,” Raskolnikov says. He suggests broadening the C corp's “principal purpose” by using it to trade in securities or real estate.

“Good luck on the IRS litigating any of this,” Raskolnikov adds, noting that the IRS is underfunded and understaffed.

Lower-income earners who want to access all of their compensation might try a different strategy to capture the 20% pass-through deduction for partnerships. Miller proposes that firms organize all of their associates with salaries below the $157,500 individual and $315,000 joint-filing caps on income into a mini-partnership.

An associate earning the top amount would save $14,664 in taxes, Miller has calculated: “For a big firm with lots of associates, that could very well be worthwhile.”

But, again, complexities arise. What about health insurance, retirement and other employee benefits, including the firm's payment of half their FICA taxes? If associates belong to a separate partnership that contracts with the firm, how does it keep from running afoul of federal employment law mandating that an employer cannot exercise control over its independent contractors? Who is liable if an associate makes an error on a case?

Raskolnikov argues that not enough associates would benefit to make it worth the trouble. The $157,500 individual income cap is less than a first-year's $180,000 salary at a big New York or California firm, he points out. But the median salary nationally for fourth-year associates is $155,000, according to NALP, so proponents argue that this strategy could make sense in regional markets where associates make less money.

Raskolnikov suggests another way law firms might take advantage of the 20% pass-through deduction: a separate partnership whose sole asset is the firm's name. “The idea is for law firms to do the same kind of trick that Apple and Starbucks and Amazon have been doing internationally,” he says.

The new partnership would own the firm's name — Cravath, Swaine & Moore, for instance — and license it to the operating partnership for a fee, Raskolnikov explains. This partnership would qualify for the 20% deduction because its income is not from professional services, he says.

One Atlanta CPA, Clay David of Cain & David, foresees problems with a partnership whose only asset is a firm's name. “What is the business purpose? If it's only the avoidance of tax, it's not usually looked at favorably by the IRS,” says David, who advises law firms ranging from solos to regional 90-partner firms.

He warns firms against the urge to game the new tax regime: “People are making herculean efforts to minimize the tax impact that they don't really understand. That tends not to end well.”

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Meredith Hobbs writes about the Atlanta legal community and the business of law for ALM. Contact her at [email protected] and on Twitter @MeredithHobbs. This article also appeared in The American Lawyer.