December 31, 2017

Congress Agrees on Sweeping Tax Reform Legislation

The final version of H.R. 1, tax reform legislation that is expected to be enacted before Christmas, includes ABA-supported language  granting tax relief to all “pass-through” entities, including law firms.

Although the final “pass-through” provisions do not include all of the ABA’s recommendations in this area, they represent a significant victory for the ABA and many of its law firm members.

Under the final version, individual owners of “pass-through” entities – including partnerships, Subchapter S corporations, and sole proprietorships − will be allowed to deduct 20 percent of the qualified business income they receive from the entity.

The deduction applies to all “pass-through” entities, but the benefits will be phased out for owners of law firms and other professional services businesses who earn over $315,000 (for married taxpayers filing jointly) or $157,500 (for single taxpayers).

These amounts are lower than the original $500,000/$250,00 income thresholds in the previous version of the bill passed by the Senate. However, because the final bill also lowers the top individual income tax from the current 39.6 percent to 37 percent and increases the income thresholds that a taxpayer must earn to be included in the highest income tax brackets, many high-income law firm partners and other professionals will still receive substantial tax reductions under the legislation.

During conference consideration of the tax package, the ABA had urged the conferees to include the Senate’s version of “pass-through” business tax relief in the final bill.

In a Dec. 13 letter, ABA President Hilarie Bass encouraged the conferees to apply the deduction for qualified business income contained in Section 11011 of the Senate bill to all “pass-through entities” − including law firms and all other types of professional service businesses on an equal, non-discriminatory basis.

Bass pointed out that while both the House and Senate versions of the legislation included substantial tax reductions for various “pass- through” businesses, the provisions differed significantly in several important ways.

The previous Senate-passed bill would have reduced taxes on these businesses by creating a 23 percent deduction for the qualified, non-wage portion of the “pass-through” income as determined by a complex formula. The Senate measure would have provided the deduction to all types of “pass-through” businesses, including professional service businesses, but professional services providers could only claim the full deduction if their taxable income did not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals.

The House-passed bill would have taxed many “pass-through” businesses at a maximum rate of 25 percent on qualified business income, but would have treated other income as compensation subject to the taxpayer’s ordinary individual income tax rates. A reduced “pass-through” rate of 9 percent would have been phased in over five years for small “pass-through” entities based on certain income thresholds. These lower “pass-through” rates, however, would not generally have applied to law firms and many other types of professional service businesses.

The ABA supported the Senate approach as far preferable to the House approach, which Bass said unfairly excluded professional services businesses from the lower tax rates applicable to other non-service “pass-through” entities.

“Law firms, accounting firms, and many other types of professional service providers create a large number of good paying jobs,” Bass explained. Professional service providers also help stimulate job creation in the local community and throughout the nation by purchasing goods and services from numerous other businesses, she added.

“Because professional services businesses provide just as many benefits to our economy and society-at-large as other ‘pass-through’ businesses,” Bass concluded, “the conferees should adopt the Senate’s language – and thus create a more level playing field – by applying the same basic tax rates, deductions and other tax benefits to all types of ‘pass-through’ business entities.”

In addition to the “pass-through” provisions, the tax reform package also benefits lawyers and law firms in several other specific ways.

For example, the final bill does not include the harmful ABA-opposed mandatory accrual accounting proposals that would have required many law firms to switch from cash to accrual accounting and therefore pay taxes on their work in progress, accounts receivable, and other “phantom income” long before it is received from clients. The final legislation does not include a controversial provision opposed by the ABA that would have barred contingency fee lawyers from deducting lawsuit-related expenses before the cases are resolved.

In addition, conferees preserved the ABA-supported deduction for student loan interest payments in the final bill, which will benefit many younger lawyers still struggling to pay off college or law school debts.