“In previous years, companies were allowed to deduct 50% of expenses incurred while entertaining clients or prospective clients”
On Dec. 22, 2017, President Donald Trump signed H.R. 1 into law, making the Tax Cuts and Jobs Act (TCJA) the most significant update to the U.S. tax code since 1986. Questions regarding the new law’s impact on business and individual taxes were hotly debated. The foremost question being, will the new tax law actually reduce taxes? For most corporations and many individuals, the answer is yes. However, for specific professional service businesses, such as law firms, the answer is less certain.
The highlight of the TCJA is the reduction in both individual and corporate tax rates. Tax rates dropped for most individuals, regardless of their profession. The highest individual rate decreased from 39.6% to 37%, with the lowest rate of 10% affecting a larger income base than under the previous law. Additionally, the corporate tax rate was dramatically changed from the former graduated tax rates of 15% to 35% to a flat rate of 21%. Personal service corporations, including law firms, may have the most to gain as they are now taxed as any other corporation, with tax rates dropping 14% from a flat 35% to 21%.
The TCJA also gives a tax break to owners of pass-through entities by introducing Qualified Business Income (QBI) and an associated deduction. Qualified business income is essentially the ordinary, domestic, non-investment income earned by a sole-proprietorship, S corporation, or partnership. The new QBI deduction allows the owners of flow-through entities to deduct up to 20% of their allocable share of the business’s QBI on their individual tax returns, resulting in considerable tax savings.
Unfortunately, the QBI deduction is limited for owners of certain service businesses. Partners and owners of law firms qualify for the full 20% deduction only if their individual taxable income in 2018 is below $315,000 for married filing jointly (MFJ) or $157,500 for all other taxpayers. The deduction phases out for those whose individual taxable income is between $315,000 and $415,000 (MFJ) or between $157,500 and $207,500 for all others. As a result, no QBI deduction is allowed for individuals with taxable income of more than $415,000 (MFJ) or $207,500 for all other taxpayers. In all likelihood, high income partners and owners will not benefit from the new QBI deduction.
Some have suggested that law firms currently organized as pass-through entities convert to corporations in order to take advantage of the attractive 21% tax rate. Because the corporate rate reduction is a permanent change and the QBI deduction expires on December 31, 2025, organizing as a corporation seems even more appealing. However, since a corporation’s earnings are taxed twice—once at the corporate level and again at the individual level—the tax savings may be diminished. Nonetheless, provided state law allows a law firm to organize as a corporation, the idea is worthy of consideration.
Another significant change that will impact attorneys and law firms is the complete elimination of the entertainment expense deduction. In previous years, companies were allowed to deduct 50% of expenses incurred while entertaining clients or prospective clients (e.g. theater tickets, golf outings) as long as the expenses were directly associated with the active conduct of the trade or business. Under the TCJA, however, these expenses are no longer deductible.
There is still debate regarding the deductibility of business meals that do not have an entertainment component. Previously, the costs of business meals with clients and prospective clients were 50% deductible. Although the American Institute of Certified Public Accountants (AICPA) takes the position that business meals with clients and prospective clients “where the taxpayer has a reasonable expectation of deriving income or other specific trade or business benefit” are still deductible at 50%, the TCJA is not entirely clear on this point. Clarification is still needed from the IRS before proper treatment of business meals can be determined.
Many have questioned whether expenses previously considered entertainment expenses can be reclassified as marketing or advertising expenses. A preliminary look at the TCJA indicates that these expenses cannot be reclassified. The Internal Revenue Code, as amended by the TCJA, indicates that any activity involving “entertainment, amusement, or recreation,” regardless of its purpose, is no longer deductible.
At first glance, the TCJA appears to be beneficial for most American taxpayers, resulting in tax savings at both the corporate and individual level. However, certain taxpayers will see little to no change to their overall tax bill. While tax professionals are scrambling to understand and correctly apply the new law, until such time as IRS guidance and Treasury Regulations are published, questions will remain over the practical application of some provisions of the TCJA.
Until such guidance is available, and even afterwards, the advice of a qualified tax professional is needed to develop successful tax strategies under the new tax law.