Philadelphia law firms are holding urgent meetings this week to decide whether to remain partnerships for tax purposes or to change into different corporate entities, attorneys and legal executives said Wednesday.
Why? The new Tax Cuts and Jobs Act. Pass-through companies — which include both mom-and-pop businesses and large partnerships such as law and accounting firms and hedge funds — may find tax filing more complicated starting next year.
Many law firms are set up as partnerships today and are taxed as pass-throughs, so attorneys pay taxes as individuals. Under the new law, partnerships may not be so attractive tax-wise.
At Stradley Ronon LLP, “we’re having a management committee meeting [Thursday] to discuss it,” said chairman William “Bill” Sasso.
“The tax partners are coming to the meeting,” he said. “It’s complicated, to say the least. The way [the tax-reform law] was rushed through, there’s a lot of uncertainty and unanswered questions.”
The new law changes the way pass-throughs — companies that pass profits directly to their owners as personal income — are treated.
In 2018, many will be able to cut 20 percent off their taxable earnings. Someone earning $50,000, for example, may have to pay taxes on only $40,000.
Owners of pass-through businesses such as sole proprietorships, LLCs and S corporations are entitled to a 20 percent deduction for business-related income, applied to tax years beginning after Dec. 31, 2017, and expiring for tax years beginning after Dec. 31, 2025. But personal-service businesses — such as law firms, accounting firms, investment-advisory businesses, consulting firms, or medical-service businesses — do not qualify for the deduction.
That 20 percent deduction for pass-through income is limited to the first $315,000 in income for couples filing jointly and $157,500 for single filers. Still, it may incentivize some law firms to reclassify their tax status.
And under the new law, firms also may lose their charitable deductions, as well as business-expense deductions such as event sponsorships and meals.
“We have to take a careful look at everything,” said Stradley Ronon’s Sasso.
Taking advantage of the lower pass-through tax rate “is definitely going to be helpful to smaller law firms — to reorganize and get the pass-through that way,” said lawyer Robert H. Louis, of Saul Ewing in Center City.
“Another idea floating around is spinning off associate attorneys in law firms into a separate entity,” Louis said. “Those associates could become partners in their own partnership. They would get the benefit of the pass-through because they are at lower income levels. Bottom line: It’s going to be helpful for smaller firms, and lawyers in big law firms with lower incomes, to reorganize” away from the partnership and into a pass-through entity.
Much of America makes money through pass-through income, according to the Harvard Business Review. Those who don’t may start gaming the tax code so they can. “For example, if I’m a partner in a law firm, and there’s income in the law firm, and it goes straight to me, and I get taxed as an individual at my labor marginal rates of 39.6 percent, let’s say, today, if I was in the top bracket,” noted Mihir Desai, a professor of finance at Harvard Business School.
Under the new law, Desia told Harvard Business Review, “that income that gets passed through to you as a partner in a partnership, we’re going to actually let you deduct 20 percent of it, which is basically like saying, we’re going to cut tax rates on those kinds of incomes by one-fifth. That’s a pretty big deal. And that is going to make people want to become pass-through entities, and it’s going to make some people want to become corporations.”
The tax games begin as the corporate rate also drops: The current graduated corporate rate structure, with its top rate of 35 percent. is replaced with a flat 21 percent rate beginning Jan. 1, 2018.
For sole-practitioner lawyers, the new tax law definitely helps.
“The deduction phases out after about $150,000 of income, so for solo practitioners that don’t make a lot of money, it’s great,” said Jeremy Wechsler, a lawyer in Willow Grove with his own practice.
“Larger law practices currently organized as an LLC will be thinking about converting their practices to C corps, since they’re going to get the 21 percent corporate tax rate,” Wechsler said.
For owners of legal-related businesses such as Rob Mattern, “personally, the law got rid of the home equity line deduction, which was a loss for me. I use that to supplement my business credit line,” said the founder and president of Mattern & Associates, a Chadds-Ford-based legal support services consulting business that helps law firms outsource back- and middle-office operations.
“And the small businesses still take a hit on health care. My premiums went up 120 percent this year” for his employees’ benefits, Mattern added. “That problem wasn’t solved.”
As a solo practitioner, Wechsler said, he operates as a single member LLC/pass-through entity, and “I won’t be reorganizing at this point because I can likely take advantage of some of the pass-through deductions at this time. However, I will keep an eye on what Congress does to fix parts of the new tax law that are temporary.
“They’re going to have to get back to work on this at some point. Otherwise, they’ll let middle-class tax cuts expire while corporate rates perhaps stay at 21 percent,” Wechsler said. “I’ll probably take a fresh look at my structure again in 2019 or 2020.”