More About Tax Reform Pass-Throughs
What is a pass-through entity?
Pass-throughs are legal entities where income “passes through” to investors or owners, who then must report the income or loss on their own individual income tax returns. Common types of pass throughs include partnerships, Subchapter S corporations, limited liability companies, and sole proprietorships. A pass through is the preferred type of business entity for most small and new businesses, and the vast majority of law firms are organized as pass-throughs. Currently, pass-through entities generate more than 50% of business income reported to the Internal Revenue Service.
How are law firms treated unfairly in proposed tax reform legislation?
On November 16, 2017, the House passed its comprehensive tax reform bill, H.R. 1, titled the “Tax Cuts and Jobs Act,” which includes significant tax reductions for various pass-through businesses.
Under the House bill, many pass-through businesses would be taxed at a maximum rate of 25 percent on qualified business income, but any portion of the taxpayer’s net business income not deemed to be qualified business income would be treated as compensation subject to the taxpayer’s ordinary individual income tax rates. In addition, a reduced 9 percent pass-through rate would be phased in over five years for small pass-through entities based on certain income thresholds. However, the pass-through rate reduction in the House bill would generally not apply to law firms and many other types of professional services businesses, including those engaged in the fields of health, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services.
On December 2, 2017, the Senate passed its own version of the Tax Cuts and Jobs Act. The Senate bill would reduce taxes on pass-through businesses by creating a 23 percent deduction for the non-wage portion of the pass-through income, effectively resulting in a top rate of 29.6 percent in the absence of other limitations. Unlike the House bill, the Senate measure would provide the deduction to all types of pass-through businesses, including professional service businesses, but professional service providers could only claim the deduction if their taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals.
On December 13, 2017, ABA President Hilarie Bass sent a letter to the House-Senate conferees urging them to adopt the Senate’s version of the pass-through tax relief. The ABA’s letter also urged the conferees to apply the tax relief to all pass-through entities—including law firms and all other types of professional service businesses—on an equal and non-discriminatory basis.