Here at Skorheim & Associates we serve numerous lawyers and law firms, and so we have been monitoring the current Tax Reform proposals for changes that will affect the legal community.
While lawyers and law firms will of course be impacted by the general tax law changes included in the competing House and Senate tax plans, such as the revisions in tax rates and itemized deductions, there are two provisions of Tax Reform specifically aimed at the legal profession. The first denies the proposed tax benefits for pass-through entities to some lawyers and law firms. The second now resolves a conflict among the courts and the IRS about the deductibility of costs advanced by lawyers in contingency cases.
Pass-Through Entities: Under both the House and Senate tax plans, owners of pass-through entities such as sole-proprietorships, partnerships and S-Corporations are granted tax relief in the form of a preferential 25% tax rate (House bill) or a 23% tax deduction (Senate bill) on some or all their business income derived from those pass-through entities (See our December 4, 2017 Blog on Pass-Through Entities).
Congress will be reconciling the differences between the two tax versions, but both plans include a prohibition on the use of these pass-through tax benefits for a small group of professional service businesses, including any trade or business involving the performance of services in the field of law (note that these pass-through entity rules do not apply to law firms operated as regular C corporations). Both tax plans include a phase-in of this prohibition for law businesses, which will allow tax relief for some lawyers and law firms under these pass-through entity provisions.
Under the House bill, lawyers with annual taxable incomes of less than $150,000 (for a joint return) would be allowed a tax reduction equal to 3% (when fully phased-in) of up to $75,000 of their law firm’s net active business income. This provision allows a maximum tax reduction of $2,250 ($75,000 times 3%). The 3% rate applies for tax years after 2021. A 1% rate applies for tax years 2018 and 2019 and a 2% rate applies for tax years 2020 and 2021.
The Senate bill provides pass-through tax benefits to lawyers with less than $500,000 in taxable income (for a joint return) and phases-out those benefits between $500,000 and $600,000 of taxable income.
Costs Advanced by Lawyers in Contingency Cases: Under current law and authorities, a conflict has arisen about the deductibility of costs advanced by lawyers under contingency fee agreements. The IRS has consistently taken the position that such costs are reimbursable and therefore are not deductible when paid by the lawyer, but also, do not constitute taxable income when the lawyer receives payment, typically upon disposition of the case. Some courts have held that in so-called “gross fee arrangements,” where the attorney agrees to pay the costs and will accept a gross fee upon disposition, with no cost reimbursement, the attorney may deduct the costs as paid.
The House version of Tax Reform resolves this conflict by disallowing the deduction of all such costs until the disposition of the case (when the contingency is resolved). This could be a big problem for firms that have traditionally deducted these costs as paid or incurred. The bigger problem looming is that this provision, as written, appears overly-broad. It applies to any expense relating to a contingency fee case and could be interpreted to include general case expenses such as payroll for attorneys and staff working on the contingency cases. Let’s hope that this House version fails in the Congressional reconciliation effort.
The Tax Reform provisions applicable to lawyers and law firms are complicated and potentially worrisome. Please talk to your tax adviser earlier rather than later to determine how the pending legislation may affect you.