The sweeping changes that came with the overhaul of the federal tax system included a deduction for pass-through businesses, but attorneys and other professional service providers were brushed aside and likely will not be able to reap that tax break.
The Internal Revenue Service and the U.S. Treasury Department will probably offer guidance and Congress is expected to pass some technical corrections. All of this could impact how the Tax Cuts and Jobs Act of 2017 is implemented and interpreted, although lawyers still might not be able to take advantage of the pass-through deduction.
William Murphy, CPA and financial consultant for Mallor Grodner LLP, advised that attorneys wait until after April 15 and then take their accountants to lunch. They will need to discuss how the changes to the tax code will impact their practices and review their partnership agreements.
“They’re going to have to step back and look at everything, top to bottom,” Murphy said. He also advised they should keep a large bottle of aspirin handy.
Under the new tax law that for the most part took effect Jan. 1, 2018, owners and partners in qualifying pass-through businesses can deduct 20 percent of their income. However, married professionals such as attorneys, physicians and certified public accountants who file jointly and make more than $315,000 annually (or more than $175,000 for single filers) can forget about it. The deduction begins to phase out gradually as the income increases and is completely gone when the income reaches $415,000.
Consequently, these professionals would then be subject to the individual income tax rate which now tops out at 37 percent.
“It stinks,” said Jay Feller, CPA and principal with Somerset CPAs and Advisors. “But nobody’s crying over us not getting it.”
As frustrated as lawyers may be, it could have been worse.
The version that emerged from the House of Representatives mostly prevented law firms from taking advantage of the pass-through tax reductions. Conversely, the Senate version enabled professional service providers to claim the deduction and, while the deduction was capped, the taxable income limits were higher. The Senate’s proposal capped pass-through income at $500,000 for married professionals and at $250,000 for single professionals.
Once the two chambers began reconciling their individual bills, American Bar Association president Hiliarie Bass sent a letter trying to convince the conferees to adopt the Senate’s pass-through language.
The letter described the Senate version as fairer and promoting greater economic growth. It also asserted that professional service providers create a large number of good paying jobs not only in their respective firms but also in the larger local community by purchasing goods and services from other businesses.
Bass wrote, “professional service businesses provide just as many benefits to our economy and to society-at-large as other pass-through businesses.”
Because many law firms are organized as pass-through businesses, the provision will have wide impact. In addition, a sizable number of attorneys are expected to register incomes above the cap and will not qualify for the deduction.
Pass-through businesses, so named because the money coming into the entity passes through to the owners or partners, have been growing, according to a 2015 special report by the Tax Foundation. Spurred in part by the Tax Reform Act of 1986 that lowered individual income tax rates, pass-through businesses have become the most common business structure in the United States.
The net income of these kinds of businesses has ballooned as well, rising from $188 billion in 1980 to $1.3 trillion by 2011.
Feller is not surprised professional services are being treated differently. The government has always viewed the business of lawyers, physicians, accountants and other professionals differently because these entities, typically, do not have the inventory or make big investments in equipment that other kinds of pass-through companies do.
Disdain for lawyers
A report entitled “The Games They Will Play: An Update on the Conference Committee Tax Bill,” likewise faulted the tax reform legislation for favoring some taxpayers and activities over others for no apparent policy reason. The writers, who included David Gamage, professor at Indiana University Maurer School of Law, called the legislation “fundamentally unfair and inefficient and invites tax planning by sophisticated taxpayers to get within the preferred categories.”
Moreover, they predicted the complex rules in the pass-through provision, in particular, would bring plenty of opportunities to game the system.
For example, the disfavored professional service providers such as lawyers and doctors might try to get under the deduction cap by cracking apart their business’s revenue stream from the service partnership. They could form separate firms to handle the ancillary services such as their accounting and document management software or set up a real estate investment trust. They could then charge the maximum price possible in order to lower their pass-through earnings.
The pass-through language did carve out an exception for engineers and architects in that they can take advantage of the deduction regardless of their income levels. Why these two professions were singled out is unclear, but tax attorney and former IRS employee Dave E. Price called it “bizarre.”
Price, of Price & Associates in Santa Claus, Indiana, described himself as an “old Republican” who is deeply disappointed with the new tax reform. “I generally think the whole tax bill is horrible,” he said. “I think it will cause a considerable amount of confusion.”
Within the legal profession, he said partners at large law firms and personal-injury attorneys will probably not be able to take the pass-through deduction because their income will be above the cap. Also, he believes the limited deduction could slow the pace of law firm mergers and acquisitions. Senior partners, in particular, could find themselves paying more taxes if their firms grew so they might have less incentive to combine with another law office.
Price concedes he may be exhibiting “Trumpian paranoia,” but he sees a connection between lawyers being tossed from the pass-through deduction and President Donald Trump’s disdain for the judiciary. The president has skipped having the ABA vet his judicial nominees and most recently, he called the federal court system “broken and unfair” after a judge blocked the administration’s attempt to end the Deferred Action for Childhood Arrivals.
“Do I think it’s a slap?” Price asked about the pass-through language. “Yes.”•