Big Trouble For Biglaw Partners From 'Tax Reform'

The proposed tax bill hurts partners and helps associates -- who'd have thunk it?

The other day, on my way into the office, I bumped into a friend who’s a Biglaw partner here in New York — and who’s very, very upset. The cause of his ire? So-called “tax reform.”

The conventional wisdom about the Republican tax plan that was released tonight in final form and likely to get passed by Congress next week is that it’s “regressive” — i.e., that it benefits the rich more than the less rich. And that’s generally true, but with some important caveats — especially for Biglaw partners.

On the whole, partners of large law firms are pretty rich. In 2016, the average profits per partner at an Am Law 100 firm hit almost $1.7 million, and average PPP for “Second Hundred” firms, those ranked #101-#200 by revenue, clocked in at almost $750,000. Reasonable minds can disagree over what constitutes rich, but most folks — especially “ordinary Americans” — would view someone earning $750,000 or more as “rich.”

Some provisions will benefit Biglaw partners as a group, such as the lowering of the top personal tax rate from 39.6 to 37 percent and the reduction of the corporate tax rate from 35 to 21 percent (which will benefit investors in corporations — and most partners have lots of money invested in companies, through retirement plans or otherwise). But two provisions are problematic for Biglaw partners.

The first problem is the capping of the state and local tax deduction (“SALT deduction”) at $10,000. Under current law, the SALT deduction allows taxpayers who itemize their taxes to deduct state and local taxes — including property and real estate taxes, state and local income taxes, and sales taxes — on their federal returns. For Biglaw partners who live in high-tax states or whose firms generate lots of income in high-tax states (remember that partners must file tax returns in every jurisdiction where their firm operates), the capping of the SALT deduction could lead to a much, much bigger tax bill.

Take a partner based in New York or California who earns $2 million or more and owns a nice house or apartment, a pretty typical situation. After losing generous deductions for (rather high) state income and property taxes, that partner could be looking at an increase in tax liability in the six figures. (And that’s just based on the capping of the SALT deduction; if this partner buys an expensive new home, her mortgage-interest deduction is capped at $750,000. (Current homeowners are not affected.))

The second problem is the tax treatment of “pass-through” businesses, i.e., businesses whose income “passes through” to the owners’ individual returns, where it then gets taxed at ordinary income tax rates. Because law firms are pass-through businesses, and because cutting taxes on income from pass-through businesses has long been a hallmark of the Republican tax plans, earlier in the year it looked like law firms would be big winners under tax reform.

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Alas, Congress ultimately decided to stick it to the lawyers. As explained by the ABA Journal, describing the House and Senate bills that gave rise to the bill unveiled this evening (emphases added):

The House bill lowers the tax rate to a maximum of 25 percent on qualified business income for many pass-through businesses, and a phased-in 9 percent rate for small pass-through entities. However, the pass-through rate reduction would generally not apply to law firms and many other types of professional service businesses.

The Senate bill applies to all types of pass-through businesses, including law firms and other professional service businesses. It continues to tax pass-throughs at ordinary rates, but it creates a 23 percent deduction for the nonwage portion of pass-through income. The deduction is not allowed, however, for professional service providers whose taxable income exceeds $500,000 for married individuals filing jointly or $250,000 for individuals.

The final bill comes closer to the Senate version. It gives owners of pass-through businesses a 20 percent deduction on the profits they earn, but the deduction phases out starting at $315,000 of income for couples. It allows law firms and other professional-services firms to benefit from the deduction — following the Senate approach, rejecting the House approach — but still subject to the $315,000 cap. So Biglaw partners, who pretty much all earn more than $315,000, can’t join in the reindeer games.

Now, a Biglaw partner earning a few million who will have to pay a hundred grand or more in extra taxes might not be the most sympathetic figure. Will she have to buy a smaller boat, or postpone the renovations on the Hamptons house? But one can still see why they’d be upset: many of them are getting treated worse than both people who earn more and people who earn less.

Speaking of people who earn less… interestingly enough, because Biglaw associates generally earn under $315,000, they could wind up making out better than Biglaw partners under the new tax proposal. From a great paper by 13 leading tax-law professors, The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation, which identifies numerous loopholes, perversities, and other problems in the proposed tax reform:

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[T]axpayers may be able to game the pass-through provisions through the following strategies, each of which is described in greater detail in the Appendix:

Law firm associates, LLC. Under the Senate bill, there is potentially a major problem as drafted: Employees may be able to benefit from the pass-through provision by forming a pass-through of which they are an owner. To achieve the tax savings, no longer be an employee (who cannot benefit from the provision); instead be an owner (who can benefit from the provision). For example, law firm associates (and other employees of the firm) should no longer be mere associates. They should instead be partners in Associates, LLC—a separate partnership paid to provide services to the original firm. Their “profit share”—in lieu of salary—from Associates, LLC would then be given the special low pass-through rate. There are restrictions on lawyers—since they provide a personal service, which is disfavored in the bill—from benefiting from the special pass-through rate, but those restrictions would not apply to these associates. So long as the associate (or really partner in Associates, LLC) makes less than $500,000 in taxable income (for a married couple) or $250,000 (for a single individual), they would be fully eligible. And that covers a lot of law firm associates, not to mention many other people who are now employees—but who may not be for long. [Ed. note: This discussion pertains to the Senate bill, but just change the $500,000 limit to $315,000 and it’s accurate as to the final bill.]

The appendix identifies one possible hitch, but a hitch that’s easily overcome:

The associates couldn’t be given a “guaranteed payment” — i.e. a guaranteed amount each year. Instead, compensation would have to depend in some way on the profits of Law Firm Associates LLC. But, associates shouldn’t be too worried. The partners in the original firm can simply contract with Associates LLC to provide a steady stream of income.

The prohibition on “guaranteed payment” is designed to block schemes to turn wage earners into business owners (schemes like, well, Associates, LLC). But there’s a good amount of wiggle room in associate compensation — think about how bonuses vary from year to year, depending on the law firm’s performance, and how many firms do individualized bonuses, depending on the associate’s performance — so it would be easy to come up with a system for distributing the profits from Associates, LLC in a way that both avoids the “guaranteed payment” problem but also gives associates compensation that reflects the factors currently used in setting associate pay, such as seniority and performance.

So, at least as of now, here’s the tax-reform scoreboard for Biglaw: associates 1, partners 0.

Or, in the words of the Notorious B.I.G.:

ABA asks Congress to include law firms in pass-through tax relief [ABA Journal]
The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation [SSRN]
For Pass-Through Businesses, Let The (Tax) Games Begin [TaxProf Blog]


DBL square headshotDavid Lat is editor at large and founding editor of Above the Law, as well as the author of Supreme Ambitions: A Novel. He previously worked as a federal prosecutor in Newark, New Jersey; a litigation associate at Wachtell, Lipton, Rosen & Katz; and a law clerk to Judge Diarmuid F. O’Scannlain of the U.S. Court of Appeals for the Ninth Circuit. You can connect with David on Twitter (@DavidLat), LinkedIn, and Facebook, and you can reach him by email at dlat@abovethelaw.com.