Pass-through tax break passes over attorneys

The Indiana Lawyer

…Pass-through tax break passes over attorneys

January 24, 2018

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.

Murphy Murphy

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.

Feller Feller

“It stinks,” said Jay Feller, CPA and principal with Somerset CPAs and Advisors. “But nobody’s crying over us not getting it.”

Viewed differently

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.

focus-pass-through-box.gifBass 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.”

Price Price

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.”•

What the House tax bill holds for individuals…. A New “Game”

What the House tax bill holds for individuals

 

H.R. 1, known as the Tax Cuts and Jobs Act, which both houses of Congress passed on Dec. 20, contains a large number of provisions that affect individual taxpayers. However, to keep the cost of the bill within Senate budget rules, all of the changes affecting individuals expire after 2025. At that time, if no future Congress acts to extend H.R. 1’s provision, the individual tax provisions would sunset, and the tax law would revert to its current state.

Here is a look at many of the provisions in the bill affecting individuals.

Tax rates

For tax years 2018 through 2025, the following rates apply to individual taxpayers:

Single taxpayers

Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000   37%

Heads of households

Taxable income over But not over Is taxed at
$0 $13,600 10%
$13,600 $51,800 12%
$51,800 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000   37%

Married taxpayers filing joint returns and surviving spouses

Taxable income over But not over Is taxed at
$0 $19,050 10%
$19,050 $77,400 12%
$77,400 $165,000 22%
$165,000 $315,000 24%
$315,000 $400,000 32%
$400,000 $600,000 35%
$600,000   37%

Married taxpayers filing separately

Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $300,000 35%
$300,000   37%

Estates and trusts

Taxable income over But not over Is taxed at
$0 $2,550 10%
$2,550 $9,150 24%
$9,150 $12,500 35%
$12,500   37%

Special brackets will apply for certain children with unearned income.

 

The system for taxing capital gains and qualified dividends did not change under the act, except that the income levels at which the 15% and 20% rates apply were altered (and will be adjusted for inflation after 2018). For 2018, the 15% rate will start at $77,200 for married taxpayers filing jointly, $51,700 for heads of household, and $38,600 for other individuals. The 20% rate will start at $479,000 for married taxpayers filing jointly, $452,400 for heads of household, and $425,800 for other individuals.

Standard deduction: The act increased the standard deduction through 2025 for individual taxpayers to $24,000 for married taxpayers filing jointly, $18,000 for heads of household, and $12,000 for all other individuals. The additional standard deduction for elderly and blind taxpayers was not changed by the act.

Personal exemptions: The act repealed all personal exemptions through 2025. The withholding rules will be modified to reflect the fact that individuals can no longer claim personal exemptions.

Passthrough income deduction

For tax years after 2017 and before 2026, individuals will be allowed to deduct 20% of “qualified business income” from a partnership, S corporation, or sole proprietorship, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. (Special rules would apply to specified agricultural or horticultural cooperatives.)

A limitation on the deduction is phased in based on W-2 wages above a threshold amount of taxable income. The deduction is disallowed for specified service trades or businesses with income above a threshold.

For these purposes, “qualified business income” means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.

“Qualified business income” does not include an S corporation shareholder’s reasonable compensation, guaranteed payments, or — to the extent provided in regulations — payments to a partner who is acting in a capacity other than his or her capacity as a partner.

“Specified service trades or businesses” include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.

The exclusion from the definition of a qualified business for specified service trades or businesses phases out for a taxpayer with taxable income in excess of $157,500, or $315,000 in the case of a joint return.

 

For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income for that trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may get a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business’s basis in its tangible assets. However, if the taxpayer’s income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20% of the qualified business income for each respective trade or business.

Child tax credit

The act increased the amount of the child tax credit to $2,000 per qualifying child. The maximum refundable amount of the credit is $1,400. The act also created a new nonrefundable $500 credit for qualifying dependents who are not qualifying children. The threshold at which the credit begins to phase out was increased to $400,000 for married taxpayers filing a joint return and $200,000 for other taxpayers.

Other credits for individuals

The House version of the bill would have repealed several credits that are retained in the final version of the act. These include:

  • The Sec. 22 credit for the elderly and permanently disabled;
  • The Sec. 30D credit for plug-in electric drive motor vehicles; and
  • The Sec. 25 credit for interest on certain home mortgages.

The House bill’s proposed modifications to the American opportunity tax credit and lifetime learning credit also did not make it into the final act.

Education provisions

The act modifies Sec. 529 plans to allow them to distribute no more than $10,000 in expenses for tuition incurred during the tax year at an elementary or secondary school. This limitation applies on a per-student basis, rather than on a per-account basis.

The act modified the exclusion of student loan discharges from gross income by including within the exclusion certain discharges on account of death or disability.

The House bill’s provisions repealing the student loan interest deduction and the deduction for qualified tuition and related expenses were not retained in the final act.

The House bill’s proposed repeal of the exclusion for interest on Series EE savings bonds used for qualified higher education expenses and repeal of the exclusion for educational assistance programs also did not appear in the final act.

 

Itemized deductions

The act repealed the overall limitation on itemized deductions, through 2025.

Mortgage interest: The home mortgage interest deduction was modified to reduce the limit on acquisition indebtedness to $750,000 (from the prior-law limit of $1 million).

A taxpayer who entered into a binding written contract before Dec. 15, 2017, to close on the purchase of a principal residence before Jan. 1, 2018, and who purchases that residence before April 1, 2018, will be considered to have incurred acquisition indebtedness prior to Dec. 15, 2017, under this provision, meaning that he or she will be allowed the prior-law $1 million limit.

Home-equity loans: The home-equity loan interest deduction was repealed through 2025.

State and local taxes: Under the act, individuals are allowed to deduct up to $10,000 ($5,000 for married taxpayers filing separately) in state and local income or property taxes.

The conference report on the bill specifies that taxpayers cannot take a deduction in 2017 for prepaid 2018 state income taxes.

Casualty losses: Under the act, taxpayers can take a deduction for casualty losses only if the loss is attributable to a presidentially declared disaster.

Gambling losses: The act clarified that the term “losses from wagering transactions” in Sec. 165(d) includes any otherwise allowable deduction incurred in carrying on a wagering transaction. This is intended, according to the conference report, to clarify that the limitation of losses from wagering transactions applies not only to the actual costs of wagers, but also to other expenses the taxpayer incurred  in connection with his or her gambling activity.

Charitable contributions: The act increased the income-based percentage limit for charitable contributions of cash to public charities to 60%. It also denies a charitable deduction for payments made for college athletic event seating rights. Finally, it repealed the statutory provision that provides an exception to the contemporaneous written acknowledgment requirement for certain contributions that are reported on the donee organization’s return — a prior-law provision that had never been put in effect because regulations were never issued.

Miscellaneous itemized deductions: All miscellaneous itemized deductions subject to the 2% floor under current law are repealed through 2025 by the act.

Medical expenses: The act reduced the threshold for deduction of medical expenses to 7.5% of adjusted gross income for 2017 and 2018.

 

 

Other provisions for individuals

Alimony: For any divorce or separation agreement executed after Dec. 31, 2018, the act provides that alimony and separate maintenance payments are not deductible by the payer spouse. It repealed the provisions that provided that those payments were includible in income by the payee spouse.

Moving expenses: The moving expense deduction is repealed through 2025, except for members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station.

Archer MSAs: The House bill would have eliminated the deduction for contributions to Archer medical savings accounts (MSAs); the final act did not include this provision.

Educator’s classroom expenses: The final act did not change the allowance of an above-the-line $250 deduction for educators’ expenses incurred for professional development or to purchase classroom materials.

Exclusion for bicycle commuting reimbursements: The act repealed through 2025 the exclusion from gross income or wages of qualified bicycle commuting expenses.

Sale of a principal residence: The act did not change the current rules regarding exclusion of gain from the sale of a principal residence.

Moving expense reimbursements: The act repealed through 2025 the exclusion from gross income and wages for qualified moving expense reimbursements, except in the case of a member of the armed forces on active duty who moves pursuant to a military order.

IRA recharacterizations: The act excludes conversion contributions to Roth IRAs from the rule that allows IRA contributions to one type of IRA to be recharacterized as a contribution to the other type of IRA. This is designed to prevent taxpayers from using recharacterization to unwind a Roth conversion.

Estate, gift, and generation-skipping transfer taxes

The act doubles the estate and gift tax exemption for estates of decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026. The basic exclusion amount provided in Sec. 2010(c)(3) increased from $5 million to $10 million and will be indexed for inflation occurring after 2011.

 

 

Individual AMT

While the House version of the bill would have repealed the alternative minimum tax (AMT) for individuals, the final act kept the tax, but increased the exemption.

For tax years beginning after Dec. 31, 2017, and beginning before Jan. 1, 2026, the AMT exemption amount increases to $109,400 for married taxpayers filing a joint return (half this amount for married taxpayers filing a separate return) and $70,300 for all other taxpayers (other than estates and trusts). The phaseout thresholds are increased to $1 million for married taxpayers filing a joint return and $500,000 for all other taxpayers (other than estates and trusts). The exemption and threshold amounts will be indexed for inflation.

Individual mandate

The act reduces to zero the amount of the penalty under Sec. 5000A, imposed on taxpayers who do not obtain health insurance that provides at least minimum essential coverage, effective after 2018.

Alistair M. Nevius (Alistair.Nevius@aicpa-cima.com) is The Tax Adviser’s editor-in-chief, tax.