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4 Ways Law Firms Could Game the New Tax Law (But Probably Shouldn’t)

[caption id="attachment_6166" align="alignnone" width="620"] Photo: teekid/iStockphoto.com[/caption] As businesses everywhere take stock of the new U.S. tax law, both law firms and individual lawyers are asking: What's in it for us? Despite the uncertainty that remains about the law, “the gains are just too large” not to explore tax-saving tricks, said New York University tax professor Daniel Shaviro. Experts point to two potential benefits that stand out most clearly for law firms: a 20 percent deduction for pass-through entities such as partnerships, and a 21 percent tax on corporations—down sharply from the former 35 percent corporate rate. “Anyone who can afford the legal advice and has enough money at stake would be insane not to give [the potential advantages] very serious thought," Shaviro said. With the top individual income tax rate now cut from 39.6 percent to 37 percent, this is the first time the corporate rate has been significantly lower than the individual rate since President Ronald Reagan’s 1986 tax overhaul. Partners and associates both typically pay income tax at the individual rate, since most law firms are structured as pass-through entities—LLPs, LLCs, S corps or sole proprietorships—that distribute the profit to the owners. The new law’s 20 percent deduction for pass-through income reduces the top individual rate to 29.6 percent, said Michael Gillen, a CPA who heads Duane Morris’ tax accounting group. But there’s a big catch. Congress capped the income eligible for the 20 percent deduction on pass-through income from most types of professional services firms, including law firms, at $157,500 for single filers, and $315,000 for married, joint filers. That means firms with high-income partners—pretty much the entire Am Law 100—likely won’t benefit, Gillen said. “This is a costly problem and lawyers are paying careful attention to any solutions,” he said. Law Firm Inc.? The new 21 percent C-corp rate looks attractive. “It would almost be negligence not to consider,” Shaviro said. But, again, it comes with a catch: a double tax. Shareholder dividends are taxed at 20 percent, for a total tax of 36.8 percent. “The only problem is getting the money out,” Shaviro acknowledged. He and other tax experts agreed that a C-corp is likely not feasible for a big national firm. Too many operational problems arise: How does a firm handle profit distributions? And how does it deal with shareholders who come and go, in some cases frequently? What’s more, there are state law issues—and it’s not clear whether state bars allow law firms to be corporations. “This is not to say it can’t be done, but there is a lot to work out,” Shaviro said. You Inc.! Forming an individual C-corp to capture the 21 percent tax rate could work for lawyers who don’t need to live on their annual compensation, said David Miller, a tax partner at Proskauer Rose in New York. The idea is to reinvest the money to avoid getting taxed on dividends. “The corporation becomes an incorporated pocketbook,” said Alex Raskolnikov, a tax law professor at Columbia University. He suggested that lawyers could use their C-corp to buy a second home or invest in real estate and commodities. What’s more, C-corps can deduct state and local taxes, a particular attraction in high-tax parts of the northeast and the West Coast. Congress has capped those deductions at $10,000 for individual income. Still, individual C-corps must be wary of anti-abuse rules in the federal tax code. The corporation must pay its employees—in this case, the lawyer—a “reasonable salary,” Miller said, which is taxed at the individual rate. “I think it could be less than what the partner receives from the firm,” he added. “That would have to be developed.” A C-corp is also subject to a 37 percent penalty under the Personal Holding Company Rule if 60 percent of its income is passive, for instance from dividends and capital gains. “If the only thing my new corporation does is receive distributions from the law firm partnership, it won’t work,” Raskolnikov said. “But nothing is bullet-proof.” He suggested broadening the C-corp’s “principal purpose” by using it to trade in securities or real estate. “Good luck on the IRS litigating any of this,” Raskolnikov added, noting that the IRS is underfunded and understaffed. Associates as Partners? Instead of incorporating, it could make more sense for lower-income earners who want to access all of their compensation to capture the 20 percent pass-through deduction for partnerships. Miller proposed that firms organize all of their associates with salaries below the $157,500 individual and $315,000 joint-filing caps on income into a minipartnership. An associate earning the top amount would save $14,664 in taxes, he’s calculated. “For a big firm with lots of associates, that could very well be worthwhile.” But, again, complexities arise. What about health insurance, retirement and other employee benefits, including the firm’s payment of half their FICA taxes? Miller said a firm could still administer a health plan for its new associate partnership, and it could cover its FICA contribution by increasing associates’ salaries—by up to $13,000. Legal questions arise as well. If associates belong to a separate partnership that contracts with the firm, would that run afoul of federal rules barring employers from exercising control over independent contractors, for example by expecting them to be available 24/7? Who is liable if an associate makes an error on a case? Why would a firm want to deal with this extra hassle? Shaviro said the firm partnership could capture some of the tax savings by paying the associates lower salaries. “Even though there are adverse interests, any time the overall pot is larger, everyone comes out ahead,” he said. Raskolnikov disagreed, saying not enough associates would benefit to make it worth the trouble. The $157,500 individual income cap is less than a first year’s $180,000 salary at a big New York or California firm, he noted. But the median salary nationally for fourth-year associates is $155,000, according to NALP, so proponents argue that it could make sense in regional markets where associates make less money. Shell Games Raskolnikov suggested another way firms could take advantage of the 20 percent pass-through deduction: by setting up a separate partnership whose sole asset is the firm’s name. “The idea is for law firms to do the same kind of trick that Apple and Starbucks and Amazon have been doing internationally,” he said. The new partnership would own the firm’s name—Cravath, Swaine & Moore, for instance—and license it to the operating partnership for a fee, Raskolnikov said. This partnership would qualify for the 20 percent deduction because its income is not from professional services, he said. Under the new tax law, a business whose principal asset is the reputation or skill of one of its employees also does not qualify. “But Paul Cravath is long dead,” Raskolnikov said. “The value of the Cravath name is not just the reputation of current partners but the reputation or skill of generations of partners.” In 2016 Cravath grossed $738 million, with $365 million in profit distributed to its 87 equity partners. Would the IRS really think the Cravath name is worth $365 million in licensing fees? “It’s a very valuable name,” Raskolnikov said. The $750,000 Lawyer One Atlanta CPA who advises law firms, Clay David of Cain & David, warned against the urge to game the new tax regime. “People are making Herculean efforts to minimize the tax impact that they don’t really understand. That tends not to end well,” said David. He said he’s been besieged with questions from lawyer clients and acquaintances at holiday cocktail parties. Many ask if they should become a C-corp. “We recommend they stay as a flow-through,” he said. David also foresaw problems with a partnership whose only asset is a firm’s name. “What is the business purpose? If it’s only the avoidance of tax, it’s not usually looked at favorably by the IRS,” David said. “I do not advise my clients to play ‘audit roulette’ with the IRS,” he added. David suggested looking at an actual case. Take, for example, Mr. Smith, a lawyer making $750,000 who is married and filing jointly. Mr. Smith’s federal income tax for 2017 was $207,813. Itemized deductions reduced his top bracket rate of 39.6 percent to an effective rate of 32 percent: $40,000 in state income tax, $15,000 in property tax, $30,000 in mortgage interest and $15,000 in charitable contributions. That totaled $100,000 in deductions less a phase-out, for an allowable deduction of $86,914. For 2018, Mr. Smith takes the same deductions, except his state income tax and property tax deductions are capped at $10,000, for total deductions of only $55,000. Even so, his federal income tax will drop to $196,529, an $11,000 decrease. He had higher taxable income, but his rate dropped from 39.6 percent to 37 percent, for an effective rate of only 29 percent after deductions, three points lower. “By my calculations, this guy does $11,000 better by just doing nothing,” David said. The Grizzly in the Room Georgia plaintiffs lawyer Jim Butler of Butler Wooten & Peak said he’s gotten reports from the firm’s chief legal officer and its CPA on the tax bill’s possible effects, but he hasn’t looked at them yet because he’s been too busy working on cases. Butler cut off a reporter trying to explain exotic new tax dodges to him. “I abide by the tax law, whatever it is,” he said. “Tax law is administered by an outfit called the Internal Revenue Service. I have the same respect for them that I have for grizzly bears.” Another law firm head, C. Lash Harrison, the chairman of national labor and employment firm FordHarrison, was unimpressed by various tax-avoidance schemes being bandied about. “You can spend a lot of time scheming to save a dollar when you could be working to make 10,” he said.

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