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Friday, February 9, 2018

Analyzing the Impact of Tax Reform on Your Law Firm


The dust hasn’t settled yet on the new Tax Cuts and Jobs Act of 2017, but law firms are already scrambling to decode the meaning of the changes and identify the impact. Many are considering whether to remain partnerships for tax purposes or restructure into a different corporate entity.

However, analyzing the impact of the tax reform legislation goes beyond the central question of whether to take advantage of the corporate tax rate reduction (which was reduced to 21%) or opt for remaining a pass-through business. There are many business factors to consider, as well as other tax changes that potentially impact your firm. These changes include:

  • Employee parking and other transportation fringe benefit deductions: The tax reform act disallows a deduction for qualified transportation fringe benefits, as defined in Code Sec. 132(f), provided to an employee of the taxpayer (which includes parking on or near the firm’s premises paid for by the firm on behalf of employees), except in the case of qualified bicycle commuting reimbursements, which may no longer be excluded from an employee’s income.

    This disallowed deduction could significantly increase an individual partner’s taxable income (without increasing the amount of cash they receive). The only way to make this a deductible expense to the firm is to put the amount paid for parking for the individual employee on the employee’s W-2 (making it taxable compensation to the employee).

  • Deductions for entertainment expenses: Deductions for entertainment expenses are no longer allowed. This means any type of entertainment paid by the law firm is now 100% non-deductible―sporting events, plays, movies, concerts, golf, Las Vegas shows, etc. Calling this something else, like business promotion or marketing, does not make it deductible.

  • Deduction for meals: The current 50% limit on the deductibility of business meals associated with operating a business is expanded to meals provided through an in-house cafeteria or otherwise on the premises of the employer. Such expenses generally for the convenience of the employer were previously 100% deductible.

  • Code Section 179 fixed asset expensing: For property placed in service in tax years beginning after December 31, 2017, the maximum amount a taxpayer may expense under Code Sec. 179 is increased from $500,000 to $1 million, and the phase-out threshold amount is increased to $2.5 million.

  • Temporary 100% cost recovery for qualifying assets: For qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023, a 100% first-year deduction for the adjusted basis is allowed.

  • New credit for employer-paid family and medical leave: Businesses can claim a general business credit equal to 12.5% of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave (FMLA) if the rate of payment is 50% of the wages normally paid to an employee.

  • Net operating loss (NOL) deduction: For NOLs arising in tax years ending after December 31, 2017, the two-year carryback provision is repealed. For losses arising in tax years beginning after December 31, 2017, the NOL deduction is limited to 80% of taxable income (which is determined without regard to the deduction).

  • Corporate alternative minimum tax (AMT): The Tax Cuts and Jobs Act of 2017 repeals corporate AMT. This may not affect many law firms, but it is still good news in a sea of mostly bad news.
Become a C corporation or remain a pass-through entity?

The centerpiece of the tax reform act is the reduction of the top corporate tax rate to 21% from 35%. At the same time, the legislation changes the way income from pass-through companies such as LLPs, LLCs, sole proprietorships, and S corporations is treated, with a 20% deduction on a partner’s or shareholder’s individual tax return based on business-related income. But, many owners of personal service businesses—law firms, accounting firms and others—are excluded from the deduction once their income surpasses certain limits (starting at $315,000 for a married taxpayer and completely phased out once you reach $415,000).

With these changes, some law firms may be wondering whether converting to a C corporation might make sense. However, it’s important to remember that most firms distribute substantially all earnings, so any tax savings may be limited to the tax on non-deductible expenses and other tax adjustments. Retaining income in a C corporation also comes with pitfalls. For instance, earnings distributed from a C corporation are still subject to double taxation. In addition, the tax reform act retains Internal Revenue Code Section 533(a), which imposes an accumulated earnings tax on profits retained in a corporation beyond a law firm’s reasonable needs.

With all this said, individual partners in a law firm partnership will want to consider what is the best choice of entity (individual, S corporation, C corporation) for them personally.

Analyze your options

Our advice for managing partners and other firm executives is to proceed with extreme caution. Don’t rush into decisions about restructuring and other tax strategies without taking the time to fully analyze the impact of the tax law changes to the firm. Talk to a tax professional with legal industry expertise who can model the various scenarios available for your firm, to help you determine the best strategy for optimizing your firm’s and your partners’ tax positions.

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