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Law firms are often structured as pass-through entities (e.g., partnerships, LLCs, S-Corporations) due to traditional prohibitions against practicing law in corporate form. As such, in states that conform to the federal income tax treatment of pass-through entities, law firms are not subject to state income taxes — law firm owners (e.g., partners, members, shareholders) are subject to state income tax on their respective distributive shares of the firm's income.
The Tax Cuts & Jobs Act of 2017 (TCJA) included a $10,000 cap on state and local tax deductions. As a result, the owners of pass-through entities are limited in the amount of state and local taxes they can deduct on their Federal income tax return. In response, over 25 states have enacted pass-through entity taxes. These pass-through entity tax regimes allow the owners of law firms to preserve their state and local tax deduction on their income from the law firm.
Generally, pass-through entity taxes operate by creating an entity level tax on the law firm. The firm then claims an ordinary and necessary business expense deduction for the entity level state income tax. As such, the state income taxes are essentially paid on a "pre-tax" basis. In order to prevent double taxation, states either provide:
While state pass-through entity tax regimes may provide substantial benefit for law firm owners who pay more than $10,000 in state and local income taxes on their law firm income, there are many pitfalls to be considered before making a pass-through entity tax election. Considerations include (but are not limited to):
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