Pass-Through Deduction Passing Over Many Lawyers

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IRS Cracks Down on ‘Crack and Pack’ Business Segregation Tax Strategy

The IRS’ proposed regulations on the 20% pass-through deduction are somewhat of a mixed bag of provisions, with some that were expected and others that came as a bit of an unwelcome surprise for lawyers and other professionals.

One of the surprises relates to what has quickly come to be known as the “crack and pack” strategy. When the Tax Cuts and Jobs Act (TCJA) was first passed, there was a lot speculation that law firms may be able to segregate or spin off certain parts of the business for tax purposes. However, the IRS put that speculation to rest on August 8, when the agency issued proposed regulations under new Internal Revenue Code Section 199A regarding the implementation of the 20% tax deduction for qualified business income. What was at first a grey area, now appears to be more black and white – and not good news for lawyers.

Under TCJA, sole proprietors and some pass-through entities will receive a 20 percent deduction on “qualified business income,” effectively reducing their maximum effective tax rate from 39.6 percent in 2017 to 29.6 percent in 2018. Pass-through entities include Subchapter S corporations, partnerships and certain limited liability companies. Many law firms are structured in this manner.

Phase-out of 20% pass-through deduction

The 20% qualified business income deduction begins to be phased out for lawyers and certain other professionals (accountants, medical professionals, consultants, athletes, etc.) who make over $157,500 (single filer) or $315,000 (filing jointly). For individuals with more than $207,500 in income for single filers and $415,000 for joint filers, the qualified business income deduction is entirely phased out.  For purposes of these proposed regulations under Section 199A, these professions are known as “specified service trades and businesses”(SSTB).

The proposed regulations severely limit the ability of law firms and other SSTB professionals to segregate SSTB and non-SSTB services and still obtain benefits from the qualified business income classification. Examples of such non-SSTB services would be title companies, qualified intermediaries and stenography services. Rental income from ownership of real estate is generally not considered to be SSTB. 

Proposed regulations in action

Let’s look at a couple of examples of these anti-“crack and pack” regulations in action.

For example, a law firm creates a separate company with 100% common ownership that owns real estate and leases it to the firm. This law firm also employs non-attorneys to perform administrative services for the law firm through a company, which is also 100% commonly owned.

Assume that all of the rent collected by the real estate division and all of the fees collected by the administrative division are paid by the law firm. 

The proposed regulations provide that if an otherwise non-SSTB division provides more than 80% of its services to the law firm and is 50% or more owned by the same owners as the law firm to which it provides those services, then the taxable income from those divisions will not be segregated from the SSTB income earned by the law firm.

In the example above, all of the income earned by the law firm, the real estate division and the administrative services division would be treated as SSTB. The partners of the law firm will be subject to the income limitations on SSTB service income.

Possible exceptions

Now let’s assume the same facts as the first example, except that 40% of the rent collected by the real estate division comes from unrelated tenants. 

If an otherwise non-SSTB division provides less than 80% of its services to the law firm and is 50% or more owned by the same owners as the law firm to which it provides those services, the percentage of the net income of the division representing the rent from the law firm over the total rent collected will be included as part the law firm’s income for the SSTB limitations.

In this second example, all of the taxable income from the administrative division will be treated as SSTB.  However, only 60% of the net taxable income from the real estate division will be treated as SSTB.  The other 40% of the net rental income may be treated as non-SSTB to the owners of the law firm.

As in the example above, in some cases it may be possible for a separate division of a law firm or a commonly controlled pass-through entity that provides non-legal services to avoid classification as an SSTB. The portion of divisional net taxable income not treated as SSTB is limited to the percentage of revenue from unrelated parties as a portion of total revenue. This percentage must be greater than 20%, otherwise the entire divisional taxable income is SSTB.

In conclusion, because lawyers are treated as specified service trades or businesses under Section 199A, many owners of law firms may not be able to qualify for the 20% pass-through income deduction. Limitations on the way their income is classified under the tax law will in many cases result in the phase-out or elimination of the 20% deduction against qualified business income. And while there may be some exceptions, “crack and pack” business segregation strategies generally will not be effective for most law firms.    


Evan S. Morgan, CPA, is a director of tax services in the Miami office of Kaufman Rossin, one of the top accounting firms in the U.S. He can be reached at

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