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Should Law Firms Make Pass-Through Entity Tax Elections?
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:
- A credit to the owners on their personal income tax return for their share of the tax paid by the law firm; or,
- A subtraction from state taxable income for income subject to the state's pass-through entity tax
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):
- Does the state offer a fully refundable credit, or is any unused credit limited to a carryforward to subsequent tax years?
- Is the credit available to the owner equal to their share of the tax paid at the entity level?
- Will a resident state allow a credit for taxes paid to a nonresident state's pass-through entity tax?
- Will a tax-benefit rule apply to state income tax refunds?
- Is the pass-through entity tax election made on an "all-or-nothing" basis, or can individual partners elect in or out of the pass-through entity tax based on their specific facts and circumstances?
- Is the pass-through entity tax base on the law firm owner's entire income from the law firm, or only income derived from sources within that particular state?
- When do estimated payments need to be made under a pass-through entity tax election, and when are those payments deductible?
- What is the process for making the election, what are the applicable deadlines, and is the election revocable?
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