By Mary E. Vandenack

The Tax Cuts and Jobs Act of 2017 included a 20% deduction for “pass-through” businesses. This deduction was intended to provide a benefit to owners of flow-through entities that has an impact similar to the reduction in tax rates for C corporations.

Section199A is an interesting maze of rules, definitions, and limitations. There are specific limitations with respect to service professionals. Law firms, solo and otherwise, should revisit tax status and entity structure early in 2018 to determine whether restructuring is in order to benefit from the new tax law.

IRC 199A – The Deduction Generally

The 199A deduction is available to individual taxpayers and trusts who own pass-through trades or businesses. The deduction reduces taxable income (not adjusted gross income).

The deduction is equal to the sum of:

• The lesser of:
  • Combined qualified business income amount of the taxpayer, or
  • The amount equal to 20% of the excess of
    • The taxable income of the taxpayer for the taxable year, over
    • Net capital gain
  • The lesser of:
    • 20% of the aggregate amount of qualified cooperative dividends
    • Taxable income (reduce by net capital gain) of the taxpayer.

The “combined qualified business income” of a taxpayer is determined for a taxable year. Such amount is determined by combining the amounts of the deduction for each qualified business of the taxpayer. If a taxpayer has qualified REIT dividends, 20% of such dividends, and any qualified publicly traded partnership income is added.

To determine the deductible amount for each trade or business the calculation is:

• The lesser of:
  • 20% of taxpayer’s qualified business income with respect to the qualified trade or business
  • The greater of:
    • 50% of W-2 wages with respect to the qualified trade or business, or
    • The sum of 25% of W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis of all qualified property.

The wages calculation will not come into play for most law firms. To the extent that the calculation does come into play (or can be used as a strategy by separating income from other than services, the wages must be W-2 wages. Independent contractor payments do not count. Guaranteed payments to partners are not W-2 wages.

If the qualified property test comes into play (unlikely for most law firms but possible for related businesses or entities owning real estate), the property must be tangible property subject to depreciation under IRC Section 167. The property must be held by and available for use by close of taxable year and must be used during the taxable year for the production of qualified business income.

What Businesses Are Qualified Trades or Businesses?

Pass-through businesses are eligible. “Pass-through” for this purpose includes Includes partnerships, S corporations, disregarded entities, sole proprietorships. If an LLC elects C corporation tax status, such entity will not be a qualified trade or business. There are limitations that apply to “Specified Service Trade or Business”. Most law firms will be a Specified Service Trade or Business. To the extent a pass-through entity is a Specified Service Trade or Business, the deduction for the owners of the entity will be phased out.

Specified Service Trade or Business is defined by reference to IRC Section 1202(e)(3)(A) except that engineering or architecture are excluded. Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services are considered Specified Service Trade or Businesses. The term is additionally defined as any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.

Limitation When Specified Service Trade or Business

For an owner of a Specified Service Trade or Business, if the taxable income of an owner is less than $157,500 for a single taxpayer or less than $315,000 for a married taxpayer, the limitation does not apply and taxpayer’s trade or business will be treated as a qualified trade or business. If the taxable income of a business owner who is a single taxpayer is greater than $157,500 but less than $207,500, a phase-out of the deduction shall apply. If the taxable income of married taxpayer is greater than $315,000 but less than $415,000, a phase-out shall apply.

Separate Limitation Based on Taxable Income

Even if a business is qualified trade or business (and not a specified service trade or business), various limitations apply if taxpayer income exceeds $157,500 for a single taxpayer and $315,000 for a married taxpayer. When a business owner’s income exceeds the threshold amounts, limitations apply based on the amount of W-2 wages paid and the amount of qualified property owned by a qualified trade or business.

How Does 199A apply to Law Firms – Examples

Example 1.

Married Lawyer has $200,000 of flow through income from law firm and taxable income of $250,000. Lawyer has no other flow through income. Lawyer will have a pass-through deduction of $40,000 ($200,000 * .20). The limitation regarding specified trade or service business does not apply because the lawyer’s taxable income is below the phase-out threshold.

Example 2.

Single lawyer has $180,000 of flow through income from law firm and taxable income of $180,000. Lawyer has no other flow through income. Lawyer will have a pass-through deduction of $10,890 rather than $36,000 because Lawyer is subject to the phase-out. The calculation is as follows:

• 180,000 – 157,500 = 22,500
• 22,500/50,000 = .45
• 1-.45 = .55
• Applicable % = $99,000 QBI; $19,800 (20% deduction), $0 W-2 and Qualified Property.
• 19,800-0 = $19,800
• .45 * $19,800 = $8,910
• 19,800-8,910 = $10,890

Example 3.

Assume the same facts as Example 2 but single lawyer employs a paralegal, who was paid $30,000 in W-2 wages. Lawyer will have a pass-through deduction of $14,602.50. The calculation is as follows:

• 180,000 – 157,500 = 22,500
• 22,500/50,000 = .45
• 1-.45 = .55
• Applicable % = $99,000 QBI, $16,500 W-2; $19,800 or $8,250
• 19,800 – 8,250 = $11,250
• 11,250*.45 = $5,197.50
• 19,800-5,197.50 = $14,602.50

Example 4.

Married lawyer has $425,000 of flow-through income from his law practice. Married lawyer has taxable income of $450,000. Married lawyer will receive no pass-through deduction.

A Law Firm Challenge in Dealing with the Rules – Owners are Impacted Differently

When applying strategies to seek the benefit of the pass-through deduction, taxable income of each law firm owner must be considered and each law firm owner will be impacted differently.

Assume a two partner law firm. One partner is married with a stay at home spouse. The other partner is single. Both partners contribute equally to law firm revenues and share expenses. Assume income for Year 1 that the law firm has $450,000 of income and that such income will be split equally.  The single partner receives $225,000 and gets no pass-through deduction.  The married partner receives $225,000 and receives a $45,000 deduction.

A similar disparity could occur if both partners are married and one has a spouse with no income and the other has a spouse with income. Assume that the first married partner has $225,000 of income from her law firm and that her spouse has no income. The married partner will have a $45,000 deduction. Assume the second married partner has a spouse with $300,000 income. The second married partner will have no pass-through deduction.

Some Planning Thoughts For Law Firms

Managing law firm income becomes paramount. To the extent law firms have partners who might be impacted by phase-outs, consider increased contributions to retirement and benefit plans. To deal with the disparities for partners who are differently situated, consider a plan type that allows differing types of contributions.

Use Section 179 and bonus depreciation with care. Consider the level of deduction that will be most beneficial to assist as many partners as possible in being able to take advantage of the pass-through deduction. While it may be tempting to take as much depreciation as possible in a year, it might be more beneficial to spread out deductions. Do a five year analysis.

Consider electing C corporation tax status. Law firms operated as C corporations will receive the benefit of the 21% tax rate on C corporation income and may elect a fiscal year other than December 31. Law firms that distribute most of firm income may not see benefits from this approach. Additionally, if income is retained in the C corporation, such income will be subject to a double tax when distributed.

Move income streams to a C corporation or to a different flow-through entity to which limitations do not apply. For example, if law practice owns a building, move building to a separate entity and pay rent to the separate entity. Alternatively, if a law firm offers web-based products for clients, revenue from such products can likely be treated differently than revenue from traditional legal services. The definition of specified services includes that the principal asset is the reputation or skill of one or more employees. Consider moving any revenue stream that does not meet that definition to a different entity.