It’s too early to know what the final tax changes will be as both the House and the Senate have released their versions of tax reform. While there’s a lot we don’t know, we’re starting to get an idea who the winners and losers might be. And law firms may not end up in the winning column as originally thought.
Most U.S. companies including law firms are organized as “pass through” entities – partnerships limited liability companies, S corporations and sole proprietorships – whose owners pay taxes through individual returns and individual rates rather than corporate rates.
Under the House plan, a portion of net income distributed by a pass-through entity to an owner/ shareholder may be treated as capital attributable to the business and subject to a maximum rate of 25%. The remaining portion of net business income would be subject to ordinary tax rates. To avoid abuse, owners can elect to apply a “capital percentage” of 30% to net income to determine the amount of business income eligible for the 25% rate. The remaining 70% would be characterized as earned income/compensation subject to ordinary individual tax rates. This has the effect of reducing the top rate on flow-through income from 39.6% to 35%.
The Senate version for pass-through businesses is dramatically different by focusing more on tax cuts. Its plan allows individual taxpayers to deduct 17.4% of “qualified business income”. This deduction is limited to 50% of wages paid to the owner by the business to discourage owners from not paying wages in favor of flow-through income taxed at a lower rate. This has the effect of reducing the top rate on flow-through income from 38.5% to 32%.
For both House and Senate plans, law firms formed as pass-through entities are out of luck because these tax breaks generally do not apply to owners of personal service firms such as law, medical, accounting, engineering and consulting. For the House bill, zero percent of professional service income gets the 25% rate. For the Senate bill, the 17.4% deduction is not available to professional service firms unless the owner’s income is less than $75,000 if single, $150,000 if married.
Also many law firms are organized as personal service corporations. Currently, any remaining profit in a personal service corporation is taxed at a flat rate of 35%. Under the House plan, the rate is 25%. The Senate bill also reduces the tax rate to 25% but would delay the cut to 2019. However, most C corporation law firms bonus out most firm profit as yearend bonuses rather pay corporate tax on retained earnings.
Also, both proposed bills eliminate the deduction for business entertainment. Currently businesses can deduct 50% of entertainment expenses.
Currently the top 39.6% tax bracket starts at $418,400 for singles and $470,700 for joint filers. Under both House and Senate bills, the top rate starts at $500,000 for singles and $1 MM for joint filers. So more income is taxed at the 35% tax bracket. Both bills eliminate the dreaded alternative minimum tax. No significant changes to capital gains and qualified dividends. No changes to retirement plans like 401ks except the Senate bill eliminates catch-up contributions for employees with wages of $500,000 or more. Also, both bills allow for immediate expensing under Section 179 for certain depreciable assets currently subject to annual cap of $500,000. The House bill raises the limit to $5 million and the Senate bill raises the cap to $1 million for the next five years. Currently the limit is $500,000.
So what should law firms do now to minimize 2017 taxes? The following are common tax planning strategies to consider:
With significant differences in the House and Senate bills, It’s too early to tell what the final tax bill will be especially since it needs to meet two standards to use the reconciliation process. The tax cuts over the first ten years can’t exceed $1.5 trillion, and it can’t add to the budget deficit beyond the ten year horizon. But it’s pretty clear that there will be no early Christmas gifts for law firm. However with careful planning, there are still some tax breaks firms can take advantage of this year to reduce 2017 taxes.