From Daily Tax Report®
December 8, 2017
Partners in small law and accounting firms may favor the Senate tax bill’s pass-through provisions over the House version’s.
Neither bill gives much, if anything, for high-income partners in services businesses. But people with more modest incomes would benefit more from the Senate bill‘s provisions, where partners in such firms who make less than a certain amount could deduct 23 percent of qualified business income—which includes profits from both business and rental income.
They would see no deduction or other gain under the House bill ( H.R. 1), but instead would continue to be taxed at the individual rates that correspond to their incomes.
“Only the Senate’s version of the pass-through rate would do law firm partners any good,” David Miller, a tax partner at Proskauer Rose LLP in New York, told Bloomberg Tax Nov. 28.
“The tax reform bills dramatically reduce the rate for corporations, and principally for political reasons, Congress felt compelled to also reduce the rate for pass-throughs because most small businesses operate in pass-through form,” Miller said.
In the House bill, the rate for some pass-throughs would decrease to 25 percent from the current top rate of 39.6 percent, although that rate would apply to only 30 percent of business income. But unlike the Senate bill, the House measure doesn’t allow service businesses like law and accounting firms to get the lower rate.
The Senate bill would provide some leniency to service trades and businesses, extending the 23 percent deduction to married individuals filing jointly who earn $500,000 or less, or who are single and make $250,000 or less. The higher deduction rate would expire, however, in 2026.
Law and accounting firm partners “have no benefits from the pass-through rate” under the House bill, Mark Nash, a tax partner with PricewaterhouseCoopers LLP in Miami, told Bloomberg Tax Nov. 28.
“On the Senate side, smaller accounting firms and law firms will benefit from the deduction, but partners at larger firms would probably not, because it would exceed that income gap,” he said.
The American Institute of CPAs declined Bloomberg Tax’s request for comment.
The exclusion of certain service businesses from the pass-through tax rate in both bills targets businesses that are primarily engaged in labor and not invested in capital, Miller said.
If labor-centered businesses received the same pass-through rate, the House and Senate plans “would effectively convert salary-type income into pass-through income,” he said.
The bills aren’t designed to benefit income attributable primarily to compensation, Nash said.
Originally, the thought process behind pass-through deductions was to ensure that no service business would be eligible for a reduced rate, J. Leigh Griffith, a partner at Waller Lansden Dortch & Davis LLP, said Dec. 4. But a complete exclusion would have been too extreme, Griffith said.
“It seemed rather harsh that automatically this group of service sector businesses would be ineligible even though these businesses are providing jobs,” said Griffith.
More than 23,000 U.S.-based law partners make more than $500,000 in annual compensation, according to ALM Intelligence’s 2017 ranking of the top revenue-grossing law firms in the country. Of 200 firms surveyed by ALM Intelligence, 148 law firms have average partner salaries greater than $500,000.
Two people with similar law or accounting jobs could find that one person receives the pass-through rate and one doesn’t, depending on the type of business their company is engaged in, Miller said.
For example, a partner at a law firm working for an industrial client wouldn’t receive the pass-through rate. However, a partner employed within the industrial company would receive the pass-through rate because the industrial company is a business that doesn’t provide labor-focused services.
With this anomaly, lawyers and accountants may be swayed to work for a client directly, instead of through a firm, even if they maintain the same salary, Miller said.
“If you are an associate at a law firm and you’re being paid $500,000 and a pass-through client offers to make you a partner, even though you do the same job for the client, you’d pay $30,000 less in taxes,” Miller said. “At the margin, that’s pretty attractive.”
Associates may also push to receive the title of partner just to receive the pass-through benefits under the $500,000 threshold. Under the Senate bill, even without paying partners any more than they earned as associates, the partners would pay less in taxes and therefore increase their salary, Miller said.
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