Let’s give a big cheer! President Trump and members of Congress have delivered on their promise to give all Americans (or at least most of us) a tax cut this year.
On November 16, the United States House of Representatives did its part. By a vote of 227 to 205, the lower chamber passed the most sweeping tax legislation we’ve seen in the past 30 years, the Tax Cuts and Jobs Act of 2017. After a frenzied round of deal-making, the Senate passed a tax reform bill on December 2. Majorities in both the House and the Senate voted in favor of a conference bill on December 19. The President signed the bill into law on December 22. They say they desire to lower business and individual tax rates, modernize U.S. international tax rules and simplify the tax code. The Act does not treat taxpayers in all industries identically, however. That said, if you are an attorney, you may be wondering if a tax cut lies ahead for you in 2018. This article describes the provisions of the Act most likely to impact law firms.
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 a 39.6%. Under the new law, these types of income would continue to be taxed at individual rates, but a new 20% deduction also applies for qualifying taxpayers. Unfortunately, if you are an attorney, you may not be one of them. The act employes 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 conference bill would, however, lower individual tax rates from 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% to 10%, 12%, 22%, 24%, 32%, 35% and 37%.
At the heart of the recently passed 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 21% rate.
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.
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 December 31, 2017 to January 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.
What lies ahead for the Tax Cuts and Jobs Act? Most of the provisions of the law have become effective as of January 1, 2018. Now, the U.S. Department of the Treasury must pass interpretive regulations for the Act.
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