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How the New Qualified Business Income Tax Deduction Affects Attorneys

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How the New Qualified Business Income Tax Deduction Affects Attorneys

The New Law

The Tax Cut and Jobs Act (the “Act”) was signed into law by President Trump December 22, 2017.  One of the main objectives of the Act was to reduce the taxation of business income.  The qualified business income deduction can provide significant tax savings for some attorneys although there are limitations that apply to personal service business such as law firms.  These limitations do not apply to businesses that are not personal service businesses.

Taxation of Business Entities

Businesses (including law firms) typically operate as a “C” corporation, an “S” corporation, a partnership, a limited liability company or a sole proprietorship.  Of those five entities, only C corporations pay federal income tax.  The others are “pass through” entities that pay no income tax; their income is taxed once to their owners.

Before the Act, if a C corporation had taxable income, it paid up to a 35% federal income tax on that income.  If it distributed what was left to its shareholders, they paid tax on that amount at up to 23.8%.  This resulted in a combined “double tax” federal income tax rate of about 50.5%.

The income of a pass-through entity could be taxed to its owners at up to 39.6% (the highest individual tax bracket before the Act).  This is about 11% less than the double tax rate of 50.5% that was applicable to C corporations and their shareholders.

The Act reduced the tax rate on C corporations’ taxable income to a flat 21% (this applies to personal service C corporations, which includes law firms).  This reduces the double tax rate to about 39.8%.

Before the Act, using a pass-through entity to conduct business could result in up to an 11% lower tax bracket compared to a C corporation.  Having lowered the C corporation rate to 21%, if Congress did not lower the tax rate on a pass-through entity’s income, the difference would be only 2.8% (i.e., 39.8% double tax less than the Act’s 37% top individual tax bracket).  Congress tends to think of pass through entities as “small businesses” deserving of a lower tax rate than C corporations.  Thus, the Act created new Internal Revenue Code Section 199 A, which is designed to reduce the taxes on pass-through entity income.

Section 199A

Congress could have simply reduced the tax rate on a pass-through entities’ income, but it did not do that.  Instead, Section 199A allows owners of pass-through entities, in general terms, to reduce taxable income by 20% of its “qualified business income” (“QBI”).  This has the effect of reducing the top individual tax bracket from 39.6% to 29.6% (i.e., 37% less (20% x 37%)), thereby preserving the approximate 11% rate difference between C corporations and pass-through entities.  While there are restrictions on the deduction that is available to personal service businesses (like law firms) that do not apply to other businesses, the deduction can still significantly reduce income taxes for lawyers.

A word of caution.  The application of Section 199A to your practice is very fact sensitive.  This Article presents a general discussion of Section 199A.  Your specific facts would have to be analyzed to determine what, if any, planning opportunities are available.

Computing QBI

The first step is to compute the pass-through entity’s QBI for a law firm.  That would normally be receipts less normal operating deductions.  This is basically the same as computing your practice’s taxable income.  QBI does not include any wages the lawyer is paid by an S corporation or any guaranteed payments paid to its owners by a partnership or limited liability company.

Example 1

If S corporation had $1,000,000 of receipts, paid wages of $400,000 to its shareholders and had $400,000 of operating expenses (including wages of $100,000 paid to non-shareholders), QBI would be $200,000, which would then be allocated among the shareholders based on their percentage ownership of the corporation.  If X was a 50% shareholder, $100,000 of QBI would be allocated to him or her to be used in computing the deduction.

Computing the Deduction

An individual taxpayer’s deduction for a particular year is equal to the lesser of:

  • 20% of QBI or
  • The greater of
    • 50% of W-2 wages with respect to the businesses or
    • 25% of the W-2 wages with respect to the businesses plus 2.5% of the unadjusted basis of all “qualified property.”
  • 20% of taxable income of the business owner

There are additional items in the formula, but they are not likely to apply to law firms and are not discussed in this Article.

Qualified property is tangible property subject to depreciation (inventory is not included) used by the business at the end of the year in the production of QBI.  The depreciation period is the later of 10 years or the last day of the regular depreciation period.  This normally is not going to be a significant number for a law firm.

The W-2 wage limit is designed to prevent business owners from reducing W-2 salaries paid to themselves (which is not QBI) and replacing salaries with dividends or other distributions (which are QBI).  For example, if a shareholder in an S Corporation stopped taking salary and took out all earnings as a dividend, and assuming there were no other employees, W-2 wages would be zero so there would be no deductions.  Even without the wage limitation, the IRS could require that some or all of the dividends be recharacterized as wages, using an “unreasonably low compensation” argument.  This is discussed later.

The 2.5% of “qualified property” rule is designed to allow an owner of real estate that has no employees to benefit from the Act.  In very general terms, if an investor had rental income from a building but no employees, he or she would get no QBI deductions because wages would be zero.  For example, if X owns a building that produces QBI of $2,000,000 and has a cost basis of $8,000,000 (the unadjusted basis of the qualified property), but pays no W-2 wages, X would get no deductions.  But because of the 2.5% provision, X gets a deduction equal to $200,000 (2.5% x 8,000,000).

The W-2 limitations do not apply if a taxpayer’s taxable income is less than $315,000 if married filing jointly or $157,500 for all other taxpayers.  The limitation is phased in between $315,000 and $415,000 if married filing jointly or $157,500 and $207,500 for all other taxpayers.  The limitation applies in full after $415,000 if married filing jointly or $207,500 for all other taxpayers.

As noted, if a lawyer is a partner in a partnership, a member of a limited liability company or a shareholder in an S corporation, he or she takes into account his or her pro rata share of any items taken into account in computing the deduction.  This would normally be his or her percentage of ownership in the entity, although it could be more complicated in a partnership or a partnership or limited liability company where their governing agreements provide for special allocations.

Before getting into the special rules that apply to personal service businesses like law firms, here are several simple examples:

Example 2

X is the sole shareholder of an S corporation.  W-2 wages are $30,000.  S Corporation’s QBI is $100,000.  X’s spouse Y works and they file a joint return.  Their combined taxable income is $300,000.  Qualified business property is $0.

The deduction is the lesser of:

  • QBI x 20% = $20,000 (i.e., $100,000 x 20%) or
  • W-2 wages x 50% = $15,000 (i.e., 50% x $30,000)
  • Taxable income limitation = $60,000 (i.e., 20% x $300,000)

However, since taxable income of X and Y is less than $315,000, the W-2 wage limitation does not apply so X receives a deduction in computing X and Y’s income tax of $20,000.

Example 3

Assume the same facts as in Example 1 except taxable income is $375,000.  The W-2 wage limitation would be phased in since taxable income is between $315,000 and $415,000.  The excess taxable income is $60,000 (i.e., $375,000 – $315,000), which equals 60% of the difference between $415,000 and $315,000 (i.e., $60,000/$100,000).  The W-2 limitation would be $15,000 without the phase in, so X would have received a benefit of $5,000 (i.e. $20,000 – $15,000) if the limitation did not apply.  However, since 60% of the limitation is phased in, that benefit should be reduced by 60%, or $3,000 (i.e., $5,000 x 60%).  Thus, X’s deduction would be $17,000 (i.e., $20,000 – $3,000).  The taxable income limitation is $75,000 (i.e., $375,000 x 20%) and would not apply.

Example 4

Assume the same facts as in Example 1 except taxable income is $415,000.  The W-2 limit applies in full, so the deduction is $15,000.

Additional Limitations Applicable to Law Firms

To further complicate things, there are additional limitations for personal service businesses, which includes law firms.  Congress views personal service businesses as in reality receiving payment for services rendered, which are similar to payments received by employees for services rendered to his or her employer.  Accordingly, additional restrictions apply to personal service businesses that do not apply to other businesses.

If a taxpayer works in a personal service business and taxable income is less than $315,000 if married filing jointly ($157,500 for other taxpayers) there are no additional restrictions.

If a taxpayer married filing jointly working in a personal service business has taxable income of $415,000 or more ($207,500 for other taxpayers), he or she does not get any Section 199A deduction.  This does not apply to non-personal service businesses.

If a married taxpayer filing jointly has taxable income between $315,000 and $415,000 ($157,500 and $207,500 for other taxpayers) the taxpayer gets a pro rata deduction.

The W-2 wage limitations apply to a personal service business in the same manner of any other business.

If Taxable Income is Over the Threshold

Example 5

L is a 50% shareholder in S corporation law firm.  The taxable income on her joint return is $500,000.  L’s 50% share of the law firm’s QBI is $300,000, her 50% share of W-2 wages paid by the law firm is $100,000 and her share of the qualified unadjusted basis of assets used in the business is $50,000.  Since the law firm is a personal service business and L’s taxable income is in excess of $415,000, she is completely phased out of Section 199A and gets no deduction.  Note if the business was not a personal service business, L would have been entitled to a deduction of $50,000, computed as the lesser of:

  • QBI x 20% = $60,000 ($300,000 x 20%) or
  • The greater of W-2 x 50% = $50,000 (50% x $100,000) or

W-2 x 25% + 2.5% of qualified business property = $26,250 (i.e., 25% x $100,000) + (2.5% x $50,000)

  • 20% of taxable income = $100,000 (i.e., 20% x $500,000)

If Taxable Income is Under the Threshold

Example 6

L is a 50% shareholder in S corporation law firm.  L’s taxable income on her joint return is $300,000.  L’s share of law firm’s QBI is $250,000, her share of W-2 wages is $50,000 and her share of the unadjusted basis of qualified business assets used in the practice is $40,000.  Since taxable income is less than $315,000, L can take a deduction of 20% of $250,000 or $50,000.  The additional restrictions on personal service businesses and the W-2 limitation do not apply because taxable income is less than $315,000.  The taxable income limitations is $60,000 (i.e., $300,000 x 20%).

Taxable Income is in the Phase-Out Zone

Example 7

X and Y are married filing jointly.  X is a 50% partner in Law Firm LLC.  Her share of the practice’s QBI is $300,000.  Her share of W-2 wages paid is $80,000.  Her share of the unadjusted basis of qualified assets used in the business is $50,000.  Y earns $75,000 from his job.  Taxable income on the joint returns is $375,000.  Since the taxable income is between $315,000 and $415,000, Section 199A applies but there are various limitations.  The deduction is initially computed as the lesser of:

  1. 20% of $300,000 = $60,000 or
  2. The greater of:
    1. 50% W-2 wages = $40,000 or
    2. 25% of W-2 wages ($20,000) plus $1,250 (2.5% x $50,000) = $21,250

As noted in Example 5, if taxable income did not exceed $315,000, the QBI deduction would be $60,000 since the W-2 limitation would not apply.  However, $60,000 is reduced pro rata since taxable income is between $315,000 and $415,000.  Taxable income is $60,000 above the threshold, so the QBI deduction should be reduced by 60% ($60,000/$100,000) i.e., reduced by $36,000 ($60,000 x 60%).  The QBI deduction would therefore be $24,000 before the W-2 limitation ($60,000 – $36,000).

Since taxable income exceeds $315,000 by $60,000, the W-2 wage limitation is taken into account.  If there was no W-2 limit, the deduction would have been $24,000.  The initial W-2 wage limitation, if fully applied, is $40,000 ($80,000 x 50%).  However, since taxable income is $60,000 above the $315,000 threshold amount, the W-2 wage limitation is phased in (reduced).  Because $60,000 is 60% of the difference between $415,000 and $315,000 ($60,000/$100,000) 40% of the W-2 wage limitation, $16,000 should apply (i.e., $16,000 = $40,000 x 40%).  If the W-2 wage limitation did not apply the taxpayer would realize a benefit of $8,000 (i.e., $24,000 – $16,000).  However, since the W-2 wage limitation does apply, the $8,000 benefit is reduced by 60%, or $4,800 ($8,000 x 60%).  Therefore, the deduction is $19,200 (i.e. $24,000 – $4,800).

So much for the Act’s goal of simplifying the Internal Revenue Code!

Where is the Deduction Reported on Form 1040 U.S. Individual Income Tax Return?

The Section 199A is not an “above the line deduction” taken to arrive at adjusted gross income.  It is not an itemized deduction – you get the deduction even if you take the standard deduction.  It most likely will be taken on page 2 after adjusted gross income, similar to the standard deduction.  It is also allowed as a deduction in computing the alternate minimum tax.

Planning Opportunities

In general, it is best to keep W-2 wages as low as possible and QBI as high as possible.  For example, a sole practitioner using an S corporation would be better off taking no W-2 wages and having the S corporation distribute all the income as a dividend.  If taxable income is under the threshold, the W-2 limitation would not apply, so X would get a deduction equal to 20% of the firm’s income.  In addition, there would be no payroll taxes.  Not surprisingly, it is not that easy.  Taxpayers have been trying to do that for years in order to reduce payroll costs.  The IRS has successfully reclassified some or all of the dividends as wages and therefore subject to payroll taxes.  It can be expected the IRS will continue this approach where S corporations reduce shareholder’s salaries to increase QBI.

A sole proprietor does not pay a salary to him or herself, so all the QBI of the sole proprietor is QBI.  Assuming the lawyer’s taxable income is less than $315,000, if married filing jointly ($157,000 for other taxpayers), the Section 199A deduction is 20% of the QBI (the practice’s income).  The W-2 limitation does not apply.  The same result would apply if operating as a single member limited liability company.

If a sole practitioner is operating as an S corporation, he or she should consider changing to a single member LLC or a sole proprietorship.  This raises issues as to the tax consequences of the change, such as it being a taxable liquidation of the S corporation, but this risk is usually a manageable one.

An S corporation with more than one shareholders should consider changing to a partnership or limited liability company.  The tax consequences of the change are likely to be more complicated but depending on the facts may be manageable.

There is not a history of the IRS challenging the reasonableness of guaranteed payments paid by a partnership or limited liability company since all income (unlike S corporation dividends) is subject to self-employment taxes.  Thus, a partner or member before the Act would not benefit by reducing guaranteed payments.  However, under this Act there would be a benefit because doing so would increase QBI.  It can be expected the IRS will eventually try to establish “reasonable guaranteed payments” guidelines to prevent abuse in this area but in the meantime, a partnership or limited liability company may consider eliminating or reducing guaranteed payment.

Summary

  • If you are married filing jointly and your taxable income is $315,000 or less, you get a deduction equal to 20% of your share (based on percentages of ownership) of your firm’s QBI. The W-2 limitations do not apply.  For all other taxpayers the threshold amount is $175,500.
  • If you are married filing jointly and your taxable income is over $415,000, you do not get any deduction. For all other taxpayers, the threshold amount is $207,500.
  • If you are married filing jointly and your taxable income is between $315,000 and $415,000, you get a partial deduction. The threshold amounts are $157,500 and $207,500 for all other taxpayers.

In general, keep W-2 wages and guaranteed payments as low as possible in order to maximize the deduction.

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