The Tax Checklist
Entity tax structure.
The options for law firms include C corporation tax status (historically taxed at a professional service corporation rate), S corporation tax status, partnership and disregarded entity. If the legal form of the entity is a corporation, then the options are C corporation or S corporation. If the legal form of the entity is a limited liability company (with some variations based on state law), the entity may generally elect any of the various tax statuses. A partnership can only use partnership status (with limited exceptions that are beyond the scope of this article). A sole proprietorship will be reported on Schedule C of the owner’s personal income tax return (same as disregarded entity tax status for a limited liability company).
Part of the annual tax review for any law firm is to consider whether entity tax status should be changed for the upcoming tax year (or even retroactively if that is possible).
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the landscape of tax status for law firms significantly, including changing the tax rate for all entities with C corporation tax status to 21 percent. That tax rate applies to professional corporations whereas prior to the TCJA, professional corporations were taxed at 35 percent. Most law firms distribute the bulk of income to lawyers in the form of compensation and/or dividends and distributions. For law firms paying out most of their income to their service providers, the benefits of C corporation tax status will not be significant as income paid as wages will be taxed at the ordinary income tax rates of the lawyers. For law firms that retain income as capital or for purposes of making investments in infrastructure (such as technology infrastructure), C corporation tax status should be considered.
The TCJA provided a deduction (referred to as the 199A deduction) for businesses that are not C corporations. Such a deduction was intended to make the ultimate effective tax rate of C corporations and pass through entities substantially similar; however, “specified service entities” are not eligible to take the deduction. Lawyers are generally specified service professionals and not eligible for the deduction except to the extent that the individual lawyers of a firm have income less than $157,500 for a single taxpayer or less than $315,000 for a married taxpayer.
Some law firms have sources of income that are not service related. The regulations under 199A generally result in all income of a law firm being treated as specified service income. Separate flow through entities will typically be aggregated with the law firm, and all income will be treated as specified service income. A separate entity with C corporation status should be considered for distinct sources of income.
Review income before year-end.
After the tax year of a law firm ends, it is too late to manage income. Review income and expenses prior to year-end. Manage the income. 2020 may be a tough year for some law firms impacted by COVID-19. For firms that are negatively impacted (or simply having an off year in 2020 for whatever reason), look for opportunities to accelerate income and defer expenses. For firms that have had a great year, look for opportunities to defer income and accelerate deductions.
Review benefit plans.
If your law firm does not have a 401(k) plan, consider whether a plan should be adopted. In addition to creating opportunities to defer income, a tax credit currently exists for three years to allow firms to recover some of the costs of setup and administration. When the law firm has a good year, discretionary employer contributions can be made to a retirement plan. Such contributions are tax deferred to lawyers and employees on behalf of whom such contributions are made. If the law firm has had a challenging year financially, discretionary employer contributions are not required.
The CARES Act included provisions allowing employers to amend retirement plans to provide employees more access to retirement funds. For example, the CARES Act provided an increase in amounts that participants can borrow from retirement plans. The CARES Act also provided for penalty-free, “coronavirus- related” early distributions. Such distributions can be repaid over three years and avoid taxation on the distributions as well as penalties. Employers can amend plans any time prior to Jan. 1, 2022, to allow law firm employees to take advantage of the CARES Act provisions.
Always review the structure of health insurance and other benefit plans from the perspective of tax efficiency. There are numerous opportunities that allow law firms to provide benefits such as health insurance for employees at a low cost to the employer and at the same time provide a cost-effective benefit for employees. A law firm could choose to contribute only a small portion of the employee premium but still give the employee a benefit by (1) offering the plan; and (2) allowing the employee to pay the premium on an entirely pretax basis.
To use or not to use bonus depreciation.
Most business owners assume they should “take advantage” of the maximum amounts of Section 179 deductions and bonus depreciation. That isn’t always true. A flow-through entity that takes the maximum possible deduction in one year may have little or no income in that year and then significant income the following year. A five-year income analysis should be considered before making a decision about how to use Section 179 and bonus deprecation.
Qualified improvement property deduction.
When the TCJA was passed, one of the intentions of the act was to expand the availability of bonus depreciation. As a result of a drafting issue in the TCJA, tenant improvements have not been eligible for bonus depreciation. The CARES Act corrected this technical error. A 15-year recovery period applies to tenant improvements, which makes such property eligible for bonus depreciation. The CARES Act allows the correction to be applied retroactively to any property that was placed in service in 2018 or thereafter. A law firm that was affected by the drafting error in the TCJA can amend prior year returns to take advantage of any increased depreciation.
Review interest expense and plan ahead.
The TCJA imposed limitations on the deductibility of interest expenses. Business interest expense deductions were limited by the TCJA to 30 percent of a corporation’s taxable income. Many law firms pay out most income in the form of compensation and may not have significant taxable income. The CARES Act modified the limitation on deductibility of business interest. For 2019 and 2020, law firms can deduct business interest up to 50 percent of taxable income. Another provision in the CARES Act allows use of 2019 taxable income for purposes of calculating the deduction in 2020. If 2020 is a lower income year with higher interest costs, such provision may be helpful in maximizing deductions in 2020.
Maximize expense reimbursements.
Many expenses of lawyers can be deducted at the business level and reimbursed to lawyers on a tax-free basis. As a generality, to minimize taxable income of the law firm owner, focus on reimbursing expenses that are deductible—consider equipment used at home that is primarily for business use, home office expense, travel, auto mileage (there are various ways to deduct auto expense; the best approach always requires that you do that math on the various alternatives), and marketing expenses. Structure your compensation plan to allow expense reimbursements that maximize this strategy. IRS Revenue ruling 2012-25 prevents you from reducing a paycheck by the amount you reimburse yourself. For example, assume a lawyer is paid $10,000 per month. If such lawyer’s check is reduced by $5,000 and such $5,000 is paid as a reimbursement, the IRS will treat the reimbursement as taxable compensation subject to Social Security taxes, employment taxes and federal income taxes. Instead, establish an expense reimbursement plan that doesn’t run afoul of such rule and allows reimbursement of expenses.
Review applicable state income taxes.
If you operate in more than one state, you are likely subject to allocating income among states. Many states offer a variety of tax credits.
Deductions related to remote workers.
The TCJA limited miscellaneous itemized deductions. This had a negative tax impact on employees who telecommute. In 2020, due to coronavirus, many employees who previously did not telecommute have been forced to do so. For many law firms, telecommuting of some employees will continue beyond 2020. In some cases, there are no cost savings to employers related to employees working at home. In other cases, there might be. Law firms should evaluate how all employees will work on a go-forward basis and consider restructuring compensation and reimbursements in a way that considers the deductibility of such expenses at the law firm and individual level. Some employees can receive more net cash by being reimbursed for expenses that they can no longer deduct. The expenses that telecommuters used to be able to deduct included professional fees, dues, education, tools and supplies, home office, business travel and meals. To the extent an employer pays some of these expenses, the employer is eligible for a deduction.
State and local income tax deduction at entity level.
The TCJA limited the deduction of state and local income taxes to $10,000. Many states have sought to develop “SALT workarounds” to allow taxpayers the benefit of paying state and local taxes. Several states (including Wisconsin, Connecticut, Oklahoma, Louisiana and Rhode Island) have passed laws allowing pass-through entities to elect to pay state income taxes at the entity level. Although the IRS has indicated that many of the SALT workarounds will not work, as of the date of writing this article, the entity level deduction has not been eliminated as a strategy.
Tax Considerations Resulting From Coronavirus Legislation
Employee retention credit for employers subject to closure due to COVID-19.
The CARES Act includes a refundable payroll tax credit for law firms that were subject to closure or significant loss of business due to COVID-19. Such credit is capped at $10,000 of compensation to each eligible employee. The credit is available with respect to wages paid or incurred from March 13, 2020, to Dec. 31, 2020. This credit is only available to law firms that did not receive a small business loan under the CARES Act.
Paycheck Protection Program loans.
Many law firms received a loan under the Paycheck Protection Program (PPP). Many such loans will have been forgiven all or in part. To the extent a loan under the PPP has been or will be forgiven, no income is recognized relative to the forgiveness. (This is different from the usual rule that results in taxable income on loan forgiveness.) Note that some law firms may have also received a grant under the Small Business Administration Hardship Distribution Loan program. To the extent such a grant was received, it will have been rolled into any PPP loan and any forgiveness will be calculated on an overall basis. While the PPP loan forgiveness is not taxable by statute, the IRS indicated that deductions for expenditures from forgiven PPP amounts would not be deductible. At the time this issue went to press, a bill was pending that would override the IRS position.
Net operating losses.
Prior to the TCJA, net operating loss (NOL) carrybacks were available to corporations. That is, a corporation that had an operation loss could carry back such loss and apply it to reduce income in the prior two years. The TCJA eliminated such carrybacks and required that losses could only be carried forward.
The CARES Act allows corporations to carry back NOLs arising in 2018, 2019 or 2020 to be carried back as much as five years. Law firms that have C corporation tax status and unused losses arising in 2018, 2019 or 2020 may be able to amend prior year returns.