This blog post was originally published on February 19, 2018. It was updated on November 13, 2018.
As we noted earlier this year, the Tax Cuts and Jobs Act, although generally “business friendly,” doesn’t treat law firms very kindly. For some firms, there’s good news in provisions such as the decrease in the maximum corporate tax rate to 21%. The corporate Alternative Minimum Tax (AMT) has been repealed. But many law firms are organized as pass-through entities, and they won’t fare as well.
Just because the impacts may be negative doesn’t mean you can ignore year-end planning.
The best planning strategy may be to maximize your profits.
For our law firm clients, focusing on efficiencies and internal processes typically lives on the important but not urgent list. We understand – generating revenue through client billing is always the top priority. In most small to mid-sized firms, the administrative or operations team is directed by lawyers whose time is money.
But a law firm is a business. Assessing your performance at year-end and setting up the right processes and reporting as you begin the new year can help you turn data into actionable insights that can improve your performance for the coming year.
As 2018 draws to a close, consider these questions:
- What are the key performance indicators in our business? Utilization, realization, and average hourly rates come to mind easily. Can you compare them across offices, practice areas, and down to the individual level? And what about more subtle factors like practice mix?
- Throughout the year, did management have access to the trends in these KPIs, so course corrections could be made, or improvement plans implemented?
- Does your internal accounting staff have the skills, tools and time to provide the data you need to run your business on a real-time, active basis? Or are they spending all their time on the urgent tasks like booking revenue and paying bills?
Before 2018 ends, talk to your advisors about options to improve your business performance using your data in a more active, powerful way.
You’ve probably read about how the creation of a new tax regime for Qualified Business Income (QBI) doesn’t benefit lawyers. You still need to plan.
Pass-through entities include subchapter S corporations, partnerships and some limited liability companies, but the benefits of the new QBI deduction are severely limited for “specified service trades and businesses” (SSTB), including lawyers. Owners of some pass-through entities will receive a 20% deduction on qualified business income, effectively reducing their maximum effective tax rate from 39.6% in 2017 to 29.6% in 2018. However, this deduction is limited for lawyers who make over $157,500 (single filer) or $315,000 filing jointly. For those with more than $207,500 for individuals and $415,000 for joint filers, the deduction starts to phase out.
Some have suggested a strategy of breaking out non-legal services into separate entities. But, as I wrote in Law360 in August, the proposed regulations severely limit the ability of law firms to segregate their non-legal services like title companies, qualified intermediaries and stenography services in order to maintain the tax benefit. Rental income from ownership of real estate is generally not considered to be SSTB, unless the primary tenant is the law firm.
Be sure to consult a tax advisor and review all the implications before taking any action. Tax planning for year-end 2018 should include discussion of salaries, timing and distribution of income.
What expenses are deductible, and how in the world can you track down to this level?
In the past, business-related entertainment was 50% deductible as a business expense. Now, any entertainment that would distract from business discussions means it’s no longer a business expense. Drinks and dinners may make a comeback as client entertainment but must be tracked separately when in conjunction with non-deductible expenses like theater and sports.
As you get set for 2019, ask your advisors about automated solutions that make expense management and other bookkeeping tasks manageable.
Law firms whose capital strategy relies on borrowing should consider other options.
Interest expense deductibility is limited immediately, and it will get worse. For net interest expense that exceeds 30% of adjusted taxable income (ATI), deductibility has been limited. Through 2021, ATI is computed without accounting for depreciation, amortization or depletion, but beginning in 2022 those items are included. This could decrease your ATI, and thus limit your interest expense deductibility further.
Start thinking about your strategy now – 2021 will be here before you know it.
Regulations related to the Tax Cuts and Jobs Act continue to evolve. Get in touch with your tax advisor to put plans in place before year-end for these and other provisions that could affect you or your law firm.