How The New Tax Laws Will Affect Smaller Law Firms

Unfortunately, the changes don't look promising.

Understanding the new tax law is daunting. There have been changes on the individual and corporate level. We have heard about the elimination of the personal exemption and the elimination or reduction of many popular itemized deductions such as mortgage interest and state and local taxes. But there have also been some changes to how businesses are taxed. Below are some of the changes that are relevant to smaller law firms. Unfortunately, they don’t look promising.

The 20% qualified business income deduction rules are stricter for lawyers.

One highlight of the tax reform bill is the 20% reduction from taxable income that is “qualified business income” (QBI). But for lawyers, the deduction is severely limited. First, we get the full 20% deduction only if our business income is under the threshold amount of $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly.

Once the income exceeds the threshold, the deduction starts to phase out until the taxable income reaches $207,500 for singles and $415,000 for married couples at which point the deduction is gone and we are taxed at the regular income tax rates.

Some lawyers might be tempted to try to get around this rule by setting up a hybrid business where they practice law and sell retail under the same roof. However, assuming the IRS allows this, this can create an additional layer of complexity because other businesses have different limitations on the 20% deduction if they exceed the threshold amount.

But wait, what about setting up a C Corporation so the law practice can be taxed at 21%? Well, about that…

Setting up a C-Corporation is probably not going to reduce taxes.

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The other highlight of the new tax law is the flat 21% corporate income tax rate. This applies to the traditional C-Corporations that many large companies use.

However, most solo practitioners and small firm owners do not have C-Corporations. They generally operate their business as a pass-through entity such as a sole proprietorship, an S-Corporation or some type of partnership entity such as a general partnership or an LLP. This means that the business income passes through to their individual tax returns and are thus subject to the personal income tax rate.

At some point, individuals will hit the newly created 22% bracket or higher. So it would sound tempting to set up a separate C-Corporation to lock in some of the business income at the flat 21% bracket.

Unfortunately, this tactic will not work for lawyers because of an exception for “personal service corporations” (PSC). A PSC is where the main activities of the corporation involve professional services, which includes law practice. The net business income of PSCs are subject to a flat 35% tax rate. That’s quite the buzz-killer.

If you are fortunate enough to pay the top individual tax rate of 37%, the C-Corporation — even though taxed as a PSC — may work if that 2% difference is a lot of money. But you and your tax professional should also know how to deal with the 20% “accumulated earnings tax”. To understand this tax, it helps to understand why C-Corporations exist: the infamous double taxation rule. The corporation pays corporate tax on the profits and issues dividends to shareholders who themselves pay taxes on the dividend income. Now if you are setting up a corporation primarily to shelter taxes, you don’t want the corporation to be paying dividends at all. You’re just going to pay the tax once and retain the earnings in the corporation.

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Congress was aware of this tactic and gave the IRS the power to determine whether a C-Corporation’s retained earnings for the year are excessive and should have been distributed to the shareholders as dividends. If it is, then the excess earning amount will be subject to an additional 20% tax.

And of course, there are the usual fees of maintaining the corporation – the annual fees, tax return preparation, payroll, etc. All of these additional expenses could negate the tax savings.

So don’t set up a separate C-corporation on a whim. The top 1% will save 2% at most. For remaining 99%, the tax savings is LOL%.

Business related entertainment expenses are no longer tax-deductible.

In the past, business related entertainment expenses were 50% deductible as a business expense. But no longer. However, business related dining expenses are still 50% deductible. So you may want to hold off on purchasing the Mets tickets and go to the sports bar instead.

The truth is, this is not that big of a deal for most established law firms as they will likely just pay the extra tax. But the repeal will hurt startup companies the most as they little startup capital and need to develop a relationship with potential clients. And what better way to establish rapport and trust by having a good time outside of the conference room?

I suspect that starting in the next few months, restaurants and bars will take advantage of this rule change by hosting more pay-per-view events and setting up upscale dining rooms so their customers can discuss business while eating two-year dry aged steak.

Net operating loss carrybacks have been eliminated.

In the past, businesses who report a net operating loss on their tax return can elect to carry back the loss to the last three years, usually to get a refund. When a business had a really bad year, the tax refund from the carryback could have been used to get a much needed cash infusion.

Now, the losses can only be carried forward for up to twenty years. So you have one more reason to save some money for the upcoming recession.

Home equity loan interest payments are no longer tax deductible.

Interest paid on a home equity line of credit (HELOC) was tax deductible under the old law. This made it an attractive way to refinance student loans (and possibly eliminate its nondischargeability.)  Also, the HELOC could have been used to pay business expenses, usually litigation costs on contingency matters.

Now, the HELOC is no longer tax deductible but only as a Schedule A itemized expense. If the loan is used for business purposes, the interest paid can be deductible as business related interest payments.

As I wrote the above, I felt sad to see that small businesses with limited funds will have to deal with a labyrinth of complex tax laws and repeals of useful deductions. While large corporations that have the money to hire expensive tax professionals get a flat tax rate. But that’s the world we live in right now. There are likely to be some clarifications and regulations from the IRS in the future which will hopefully make things easier. But by staying on top of the tax law changes, you can make better plans to legally minimize the amount of tax you pay.


Shannon Achimalbe was a former solo practitioner for five years before deciding to sell out and get back on the corporate ladder. Shannon can be reached by email at sachimalbe@excite.com and via Twitter: @ShanonAchimalbe.