The Tax Cuts and Jobs Act, P.L. 115-97, includes significant tax cuts for many businesses, but law firms on the whole won’t fare as well. For firms structured as corporations, there’s good news in provisions such as the decrease in the maximum corporate tax rate to 21 percent. Additionally, the corporate alternative minimum tax, or AMT, has been repealed. However, many law firms are organized as pass-through entities, and several limitations on deductions mean they won’t see as much benefit from the new tax law as some other industries.
In addition to pass-through income deduction limitations, some of the tax changes negatively affecting lawyers and law firms include restrictions on meals and entertainment deductions and limitations on interest expense deductions. Positives include expanded bonus depreciation opportunities and some of the income tax changes for individual taxpayers.
Read on to learn more about the tax changes that could affect you and your firm.
Pass-Through Income Deduction Limited for Lawyers
Many law firms are structured as pass-through entities. Pass-through entities include Subchapter S corporations, partnerships and certain limited liability companies. Owners of 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.
But this deduction is limited for lawyers and other professionals who make over $157,500 (single filer) or $315,000 (filing jointly). For individuals with more than $207,500 for individuals and $415,000 for joint filers, the qualified business income deduction starts to phase out.
Some firms might have separate divisions that perform nonlegal services that may not be subject to the professional service firm limitations on the 20 percent deduction on qualified business income for pass-through entities discussed above. In such cases, it may be possible to separate the divisions into separate taxpayers for this purpose. However, because the IRS has not yet published rules related to the qualified business income deduction, it is important to seek advice from your tax attorney and/or other advisers before implementation of any separation strategy.
Changes in Deductions for Client Entertainment and Employee Meals
In the past, business-related entertainment was 50 percent deductible as a business expense. Now, any entertainment that would distract from business discussions are no longer considered to be a business expense. Drinks and dinners may make a comeback as client entertainment; theater and sports won’t be a write-off any longer.
Many law firms provide meals in firm-sponsored cafeterias to encourage employee productivity. Prior to 2018, these could be fully deducted in some cases where these meals were provided to employees for the firm’s convenience. There were a lot of battles with the IRS as to whether these meals were truly eligible for this special treatment. Beginning this year, all meals provided to employees will be limited to 50 percent deductibility. An exception is made where the value of the meals were includible in the employees’ salaries.
When the 50 percent limitations on meals and entertainment was first enacted in the 1980s, many companies were in the habit of lumping together all their travel-related expenses in a single account, making it difficult to determine which expenses were only partially deductible. With this new change related to business entertainment and meals, firms will need to require employees and partners taking clients to events to separate the cost of admission from the cost of meals purchased at the venue.
Limitations on Interest Expense Deductions
Interest expense deductibility is limited immediately, and it will get worse. For net interest expense that exceeds 30 percent of adjusted taxable income, or 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.
Reduced Net Operating Loss Deduction
In addition to the corporate tax rate changes and AMT repeal, another change affecting firms structured as C corporations is the reduction to the net operating losses deduction. NOLs are generated when a business’ permissible tax deductions exceed its taxable income. A new change to the NOL deduction could defer some firms’ ability to benefit from NOLs and could increase their current tax liability.
The new tax law allows businesses to carry NOLs forward indefinitely. However, the law also lowers the use of NOLs to 80 percent of the business’ taxable income. Additionally, businesses are not permitted to carry back NOLs under TCJA. Before the law change, taxpayers could carry back NOLs two years or forward up to 20 years and offset 100 percent of taxable income.
A Bright Spot: Expanded Bonus Depreciation Opportunities
The new tax law changes the rules for the popular IRC Section 179 bonus depreciation, a method of accelerated depreciation that allows businesses to take an additional deduction the first year they own qualified property.
Previously, bonus depreciation was calculated at 50 percent of the basis of qualified property, and only brand-new property qualified. For property acquired after Sept. 27, 2017, and through the end of 2022, 100 percent of the basis can be depreciated. What’s more, the property now only has to be “new to the taxpayer,” therefore even if you purchase used property, it can still qualify for the deduction.
Tax Changes for Individuals
TCJA includes several provisions for individual taxpayers. Here are the top four:
- New individual income tax rates — The new tax law changes several income tax brackets and drops the maximum individual tax rate from 39.6 percent to 37 percent. Understanding your new bracket can help you plan ahead when evaluating your personal finances.
- Limited state income, sales and property tax deductions — The new tax law limits individual taxpayers to $10,000 in state income, sales or property tax deductions. Before the tax reform became law, the state and local tax deduction was unlimited.
- Doubled child tax credit — The new tax law doubles the child tax credit from $1,000 to $2,000 per child below age 17. It also allows parents to receive up to $1,400 (up from $1,100) if the credit exceeds their federal income tax liability. Additionally, the tax reform law increases the income threshold, giving parents with high incomes the opportunity to benefit from the credit.
- Increased standard deduction — TCJA raises the standard deduction to $12,000 from $6,500 for single filers, $18,000 from $9,550 for heads of households, and $24,000 from $13,000 for married taxpayers filing jointly.
Regulations related to TCJA continue to evolve, and this is not an all-inclusive list of tax provisions.