This past Friday, President Trump signed into law the most expansive changes to our federal tax laws in over 30 years. The centerpieces of this new legislation are aimed at making American business & industry more competitive in the global marketplace. The key pro-business provision that applies to individuals is the so-called pass-through business income deduction which provides individual taxpayers with a deduction of up to 20% of the taxpayer’s income from pass-through business entities including sole proprietorships, partnerships, limited liability companies, S-corporations, estates and trusts, Real Estate Investment Trusts (REITs) and farming cooperatives. This new deduction is available for calendar years 2018 through 2025.
Unfortunately, Congress limited this pass-through business deduction for certain specified service businesses including lawyers & law firms. In the case of lawyers, only single taxpayers with $157,500 to $207,500 of taxable income ($315,000 to $415,000 on a joint tax return) are allowed to use this new deduction. For taxable incomes between these two income ranges, the deduction is phased-out ratably. Thus, a single lawyer with taxable income in excess of $207,500 is denied the deduction (in excess of $415,000 on a joint return). Lawyers with $157,500 or less of taxable income get the full deduction ($315,000 or less for a joint return). Lawyers with taxable incomes within these ranges will get a partial deduction.
But like most things in our tax laws, it isn’t that easy; further complications exist. This deduction is calculated for qualifying lawyers as 20% of the lesser of the qualifying law practice income (after deductible expenses) or the taxpayer’s total taxable income (less capital gains). Let’s look at some examples to help flesh out these rules.
A single lawyer is a partner in a law partnership and has $189,500 of law partnership income allocated to him. He also has $32,000 of itemized deductions for medical expenses, state & local taxes, and charitable contributions. His taxable income is $157,500 ($189,500 less $32,000). Since his taxable income is $157,500 or less, he qualifies for the full pass-through business income deduction. This deduction is calculated as 20% of the lesser of his law partnership income of $189,500 or his taxable income (less capital gains) of $157,500. Thus, his allowable deduction is $31,500 (20% of his taxable income of $157,500). Now his taxable income will be only $126,000 ($157,500 less $31,500). Under the new tax rates, this lawyer would save $7,560 in taxes for this pass-through business income deduction.
Assume the same facts as Example One but the lawyer has no itemized deductions and instead takes the $12, 000 standard deduction under the new law. Now his taxable income is $177,500 ($189,500 less $12,000). Since his taxable income is more than $157,500 but less than $207,500 (the phase-out range), he will qualify for only a portion of the pass-through business income deduction. To determine the deductible portion, take 100% and reduce it by the portion of his taxable income over $157,500, compared to $50,000 (the difference between $157,500 and $207,500, the phase-out range). His taxable income exceeds $157,500 by $20,000, which in turn is 40% of the $50,000 phase-out range ($20,000 divided by $50,000). 100% less 40% equals a 60% allowable deduction. Recall that the deduction is 20% of the lesser of the law partnership income of $189,500 or his taxable income of $177,500. The deduction then is $21,300 (20% of taxable income of $177,500 times the deductible portion of 60%). His new taxable income is now $156,200 (taxable income of $177,500 less the allowable portion of the pass-through business income deduction of $21,300). At the new tax rates, his tax savings for this new $21,300 deduction is $6,712.
These examples would apply similarly for a joint tax return except the phase-out range is $100,000 ($315,000 to $415,000). If we doubled the amount of the income and deductions in the two examples above for a married couple filing jointly, the tax savings generated by this new deduction would double as well.
But there are other considerations that apply. If the lawyer’s taxable income falls between the two phase-out ranges, then another limitation applies to the deduction. In such case, the new deduction cannot exceed the greater of 50% of the taxpayer’s share of wages paid by the law firm, or 25% of such wages plus 2.5% of the taxpayer’s share of the costs of qualified depreciable property of the law firm. If the wage and depreciable property limits are less than 20% of the lawyer’s business income, then the difference will reduce the available deduction ratably for taxable income between $157,500 and $207,500 for a single lawyer (between $315,000 and $415,000 for a joint return).
In addition, the lawyer’s wages, reasonable compensation, guaranteed payments and investment income of the pass-through business do not qualify as part of the business income base used for calculating the 20% deduction.
As you can see, the application of the rules for qualification and calculation of the new pass-through business income deduction are complicated, but the available deduction and resulting tax savings can be substantial. As a result, early planning for lawyers is key to maximizing the benefits of the new deduction. Choice of form of entity, properly managing the amount and character of firm income, along with the structure of wages, guaranteed payments and qualified depreciable property can all enhance the opportunities for lawyers to benefit from this new business deduction.