Get Your 20 Percent Deduction by Calling 1-800-888-199A
The 1,097-page Tax Cuts and Jobs Act1 was enacted on December 22, 2017. The IRS may issue guidance on some key aspects of the act this summer, but it will take many years to sort out a number of the issues discussed in this article.
The purpose of this article is to enable readers with little or no tax background (our non-“code head” colleagues and friends) to understand the income tax planning that may take place for Florida lawyers and law firms in 2018. The new laws will benefit thousands of Florida lawyers who may need some degree of restructuring as soon as possible during 2018 to maximize tax benefits. Readers who want to understand how the tax law works in this area, or who need a refresher should also benefit from reading this article and its sometimes repetitive examples.2
This article is tailored to fit the Bar Journal’s size restrictions. A longer red-lined version with useful charts, additional examples, and with many more footnotes is available by contacting the authors.
Important Definitions and Terminology
The authors recommend skimming the first two sentences of each definition, and returning as needed.
1) W-2 Wages: Compensation paid to employees of a flow-through entity, including S corporation owners3 and nonowner employees of all flow-through entities, that must be reported to the IRS within 60 days of payment to qualify as W-2 wages for the wage and qualified property test as described below. Wages, themselves, will never qualify for the 20 percent deduction. High-earner taxpayers cannot qualify for the 20 percent deduction if the entity that provides the flow-through income does not have sufficient W-2 wages or “qualified property” as described below. Wages do not include amounts paid to independent contractors. It is noteworthy that the IRS may re-characterize wages as being dividends from a company to its shareholders or dividends as being wages.
2) Guaranteed Payments: Payments made by the partnership to a partner that would otherwise be considered as “wages” are called “guaranteed payments” under I.R.C. §707(c) and are not considered to be wages for purposes of the §199A wage measurement rules. This can cause confusion, and loss of the 20 percent deduction.4
3) Qualified Property: Physical depreciable assets, including real estate, furniture, and equipment of a flow-through entity or an individual taxpayer that has not yet exceeded the longer of its depreciable life or 10 years. For example, nonresidential real property placed in service after 1986 has a depreciable life of 39 years, while equipment normally will have a five- or seven-year life depending upon its nature. As a result, nonresidential real property may be used for the wage and qualified property test for 39 years, and equipment for 10 years.
4) Effectively Connected Income: Income that is derived from assets used in or held for use in the U.S., and the activities of the U.S. business were a material factor in the realization of such income. The 20 percent deduction does not apply for non-U.S. trade and business income with the exception of Puerto Rico.5
5) Taxable Income: An individual’s or married couple’s taxable income consists of all income, minus deductions for permitted business expenses and certain above-the-line deductions, minus the greater of 1) a standard deduction of $12,000 for a single taxpayer or $24,000 for a married couple filing jointly; or 2) the amount of the taxpayer’s itemized deductions.6
For the Purposes of this Article…
We refer to the trade or business entity as being the “flow-through entity.” This includes only entities treated for income-tax purposes, such as S corporations, partnerships, and individually owned trades and businesses. C corporations and other taxable entities do not qualify.
We refer to the person, married couple, trust, or estate that owns the flow-through entity interest, actually pays taxes, and can qualify for the 199A deduction as the “taxpayer.”
C Corporation Discussion
The act provides that all C corporations are taxed at a flat 21 percent of taxable income. In addition, Florida imposes a 5.5 percent income tax on C corporation income; however, the Florida income tax is deductible by the C corporation against the federal income tax, bringing the effective combined state and federal tax rate to 25.345 percent. C corporation shareholders also pay income tax on dividends and liquidation proceeds, bringing the highest combined C corporation state, federal, and Medicare tax rate to 43.11 percent. Therefore, many C corporations will convert to S corporation status for the new 199A deduction. Although the “unrecognized built-in gain rules” and a “sting tax” can apply to S corporations that converted from C corporations, these can often be avoided with proper planning.7
1202 Companies
1202 companies8 are one variety of a C corporation that will not subject its shareholders to tax on the sale of stock if certain requirements are met, which include not being in one of the “specified service trades or businesses” listed below, or in the business of engineering, architecture, oil and gas, hotels, motels, or restaurants.9 Although 1202 companies will not qualify under 199A, lawyers may set up management or intellectual property and marketing 1202 companies to provide services to reduce law firm net income, or separate S corporations that will qualify under 199A.
199A Discussion
199A provides a 20 percent deduction for flow-through taxable income that meets certain requirements. If a person or a trust that is taxed as a separate entity receives direct income from the ownership of a trade or business that is a flow-through entity, as described above, the “qualified business income” received may qualify for this deduction. Below are some additional definitions that apply, and further examples to show how they work.
Example 1: If a single person’s K-1 taxable income from an S corporation law firm is $100,000, and his total taxable income from all sources is less than $157,500, then a $20,000 (20 percent x $100,000) deduction can be claimed on the owner’s personal tax return.
• Qualified Business Income (QBI) — Income received from flow-through entities. The amount is based upon the K-1 reported income that flows through from the S corporation or partnership entity to the taxpayer, or the tax reported income on the Schedule C or Schedule E, and not the amounts of dividends or distributions.
Example 2: John Lawyer owns 100 percent of a law firm that earns $80,000 a year. He also has a rental business that makes $20,000 a year and earns a salary of $50,000 a year from a part-time job. His QBI is $100,000 ($80,000 + $20,000). John’s 199A deduction would be $20,000.
• Specified Service, Trades, or Businesses — Categories of businesses or activities that will not qualify for the 199A deduction if the taxpayer reporting the flow-through income has taxable income exceeding the $207,500/$415,000 thresholds. These service entities are defined by reference to I.R.C. §1202(e)(3)(A) and include any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business that the principal asset of such entity is the reputation or skill of one or more of its employees.10
Example 3: In the example above, John earns $500,000 from the law practice S corporation. The deduction will not apply for the law income because of the limitation; however, the deduction may still apply for the rental income depending upon whether the wage and qualified property test described below is satisfied.
Law firms often provide many non-law services, such as trusteeship, serving as personal representative, title-agent work, expert-witness work, and management and clerical services. Law firms may separate out the net income associated with nonlaw activities, so that high earners can take the 199A deduction on such nonlaw categories of income, assuming that the wage and qualified property test can be met.
As of early 2018, it is unknown whether each separate “line of business” will need to be in separate entities, or whether the deduction can be taken based upon a grouping of trades and businesses operated under one entity. For example, is a law firm taxed as an S corporation that owns its own building and provides legal, title insurance, and trustee services considered to be one law services business or four distinct businesses, with three of them qualifying for the deduction? The AICPA has sent a letter to the IRS requesting the ability to have reasonable allocations and groupings without forming separate entities,11 but IRS personnel have indicated they do not expect to permit this without separate operation of separate entities.
Section 199A separates taxpayers based on their income into three basic groups: 1) taxpayers earning less than $157,500 for single filers or $315,000 for married taxpayers filing jointly (modest earners), who will always be able to take the 20 percent deduction, regardless of being a specified service; 2) taxpayers earning between $157,500-$207,500 for single filers or between $315,000-$415,000 for married taxpayers filing jointly (middle-of-the-road earners); and 3) taxpayers earning over $207,500 for single filers or $415,000 for married taxpayers filing jointly (high earners). Married individuals can file separate tax returns to each use the $157,000 to $207,500 thresholds if this saves taxes, or if the spouses keep separate finances. For trusts, the threshold is $157,500 to $207,500, which makes these entities more popular than they were before, for this and several other reasons.12
Further, the §199A deduction is limited to 20 percent of the taxpayer’s taxable income. This prevents taxpayers who have large losses that reduce their otherwise applicable taxable income from taking advantage of §199A. For this article, we assume the taxpayer’s flow-through income is equal to or less than their taxable income.
Example 4:Jane Lawyer and her schoolteacher spouse have combined marital taxable income of $365,000, which includes $200,000 of K-1 income received from a legal practice taxed as an S corporation. The $200,000 of income will be eligible for the deduction; however, since the couple’s taxable income exceeds $315,000, the deduction will be subject to the ratable phase-out. Therefore, Jane and her spouse will receive a deduction of $20,000 ($200,000 x 0.20 x 0.50).13
Example 5: Joe Lawyer and his spouse have a law practice in an S corporation, a rental business, own a widget factory in a partnership, and earn over $415,000 a year. They would not be eligible for 199A on the law firm income or guaranteed payments from the partnership. They may qualify for the 20 percent deduction on the rental income and widget factory income, if these entities paid sufficient wages or owned sufficient qualified property. If the couple transfer their ownership of the rental property and the widget factory to their four children and each child earns less than $157,000, then each child will be able to deduct 20 percent of their share of K-1 income, for a net tax rate not exceeding 29.6 percent, even if the kiddie tax were to apply.14
What is the W-2 limit? For high earners, the taxpayer’s deduction is limited depending on what we are referring to as the wage and qualified property test. This test will also be phased-in for middle-of-the-road earners. Admittedly, this is the most complex part of 199A.
To calculate this limitation, start with taking the greater of the following: 50 percent of the taxpayer’s proportion of W-2 wages paid to all employees, including the owners if such owner may receive W-2 wages; or the sum of 25 percent of taxpayer’s proportion of W-2 wages paid to all employees plus 2.5 percent of the taxpayer’s proportion of the original cost (unadjusted basis immediately after the acquisition) of all qualified property used in trade or business.
If the greater of these two values is less than the taxpayer’s tentative deduction (20 percent of QBI), then the 199A deduction will be limited. The taxpayer only gets to count his or her proportion of the W-2 wages and qualified property — meaning that with a 50 percent ownership interest in the company, the taxpayer may only use 50 percent of the W-2 wages paid by the flow-through entity.
A majority of entities owned by high income taxpayers will meet this test by assuring that W-2 wages equal 50 percent of the otherwise applicable taxable income coming from the flow-through entity, while most real estate companies will meet the test by multiplying the value of the qualified property by 2.5 percent (this includes depreciable buildings but not land).
Example 6: Joe and his spouse, who together earn over $415,000 per year, keep the widget and rental entities, which each give them K-1 income of $100,000. They cannot deduct $20,000 of the widget factory income unless it pays at least $40,000 of W-2 wages to employees, and cannot deduct $20,000 of rental income unless it has $800,000 or more in qualified property.
The high earner’s scenario is easier than that of the middle-of-the-road earner. A high earner is never allowed to take the deduction on the flow-through income from a specified service trade or business. Therefore, law firm/legal services income for a high earner never qualifies for 199A. High earners with unspecified service trades or businesses have complex calculations to do, as further discussed in the endnotes.15
Middle-of-the-road earners, and trusts with income between $157,500 and $207,500, who are owners of specified service flow-through entities will be subject to a phase-out of the deduction as income exceeds the $157,500/$315,000 amount, and the ratable phase-in of the Wage and Qualified Property Test as income exceeds $157,500/$315,000.16
Explanation: There are two possibilities for the phase-in of the wage and qualified property test, either 1) 20 percent of the QBI is lesser than the limitation amount, in which case the phase-in does not apply; or 2) 20 percent of QBI is greater than the limitation amount, in which case the phase-in will apply. The limitation amount is defined as the greater of 50 percent of W-2 wages or 2.5 percent of depreciable assets, plus 25 percent of wages.
Example 7:John Lawyer is married and his total income for the year is $365,000, $200,000 of which is flow-through income from his law firm. John’s tentative deduction (20 percent of QBI) would be $40,000 ($200,000 x 0.20). If John’s law firm pays $100,000 in wages, then John would satisfy the wage and qualified property test because 50 percent of wages ($50,000) is greater than $40,000, and no phase-in applies. John is subject to the ratable phase-out for the specified service entity. His deduction will be reduced ratably by the amount that his taxable income exceeds $315,000. His deduction is reduced by 50 percent, for a total of $20,000 ($40,000 x 0.50).
Example 8:If John’s law firm, from above, only paid $60,000 in wages, 50 percent of the W-2 wages ($60,000 x 0.50 = $30,000) is less than 20 percent of his QBI ($40,000). John’s deduction will be limited by the phase-in of the wage and qualified property test. To calculate this, we take the proportion that John’s taxable income exceeds the threshold amount (($365,000 – $315,000) / $100,000 = 50 percent) and apply the result to the difference between John’s tentative 199A deduction and the limitation amount (($40,000 – $30,000) x 0.50 = $5,000). As a result, John’s deduction is reduced to $35,000. John’s deduction will be further reduced since he is also subject to the ratable phase-out on income from a specified service business. John’s 199A deduction (after the phase-in) will be reduced by 50 percent, for a total deduction of $17,500 (35,000 x 50 percent).
High-earning lawyers may qualify to take the deduction for flow-through income that is separate and apart from law firm income to the extent that the wage and qualified property test are met.
Example 9: If John Lawyer’s law firm S corporation K-1 income is $1 million, his title insurance company’s income is $200,000, and is not considered as income earned in the legal profession, and his rental net income is $100,000 a year, then he can qualify for a tax deduction based on 20 percent of the $200,000 of the title company as long as it pays W-2 wages of at least $80,000 per year, and he can qualify for a 20 percent deduction on the real estate company income as long as it has qualified propertywith an original cost basis of at least $800,000 ($20,000 / 2.5 percent).
Other Rules/Traps for the Unwary
There are also some additional rules that can significantly impact tax planning:
1) Under the “guaranteed payment” rules, partnerships cannot pay W-2 wages to a partner. If an individual or married couple is a direct partner in a law firm or other entity taxed as a partnership, they may want to transfer their ownership interest so that they are not personally partners, and then receive wages as appropriate to meet the wage test if it applies.
2) It does not appear to be possible for a Schedule C or Schedule E individually owned business to pay a wage to the owner/taxpayer, although it appears possible that one spouse can own a proprietorship or disregarded LLC reported on a joint tax return, while paying the other spouse W-2 wages. As a result, a high earner individual taxpayer owning a Schedule C business that does not pay sufficient wages to those other than the owner/taxpayer may consider transferring the business to an S corporation so the owner can receive wages.
3) “Trade or business” means a United States trade or business. Any part of a trade or business that occurs or is located outside of the U.S., including territories with the exception of Puerto Rico, cannot be counted as trade or business income for 199A. Businesses that outsource billing, IT, customer service, and other items may want to separate these to avoid confusion.
4) To assure that real estate rental activities can be considered a “trade or business,” it may be necessary for the landlord to provide significant services for the tenant, such as maintenance, management of landscaping, and other functions. The statute does not define “trade or business,” but the definition of “trade or business” generally has been interpreted to mean an activity engaged in with continuity and regularity and the primary purpose of which must be for income or profit.17 The AICPA submission to the IRS requests that all rental activities should qualify, but it is unknown whether the IRS will agree.
5) Many law firms will increase the rent paid in order to reduce the income of the law firm and increase the income of the rental entity, which may qualify for the 199A deduction, but this may cause imposition of higher sales tax if rent is actually paid to the rental entity.18
6) Rental payments, management fees, or other income paid to related entities must be considered reasonable and commensurate with other arm’s-length arrangements, or income may be reallocated to the business under I.R.C. §482.
7) Unfortunately, all legal practice entities must be owned by lawyers, or professional entities that are owned by lawyers. In Florida, these entities must be the individual lawyer, a general partnership of lawyers (which is never recommended), and professional corporations. Almost all other professions (other than optometrists and dentists) can operate under entities that can be owned by spouses, children, and trusts for spouses and children that would be able to receive up to $157,500 each of income that could qualify for the §199A deduction. This eliminates an important planning opportunity for lawyers.
The Florida Board of Dentistry, the Florida Board of Medicine, and other boards throughout the country have approved having the “goodwill” of a dental or medical practice owned by a nonphysician or dentist under a “management company,” which may receive a significant portion of the revenues or otherwise applicable net income as management fees to reflect the value for the use of intellectual property, practice assets, and management and oversight services. It should, therefore, be possible for a lawyer to have his or her legal practice contract with a legal practice management company owned by family members and/or a trust or trusts to allow profits attributable to management services, marketing, and branding ingenuity to be taxed to lower-bracket taxpayers who may qualify for the §199A deduction so long as the arrangement is at arm’s-length and complies with applicable Florida Bar rules.
Example 10: A married doctor who receives $100,000 of salary and $200,000 of medical practice S corporation income, with a spouse who earns no income, will qualify for the 20 percent deduction, but a married medical doctor who earns $100,000 salary and $315,000 of medical S corporation income will not qualify for the full deduction unless he or she transfers at least 31.75 percent ownership in the medical practice entity to one or more children or trusts for children. This would bring the doctor’s taxable income down to approximately $315,000 ($100,000 salary + 68.25 percent of $315,000), and may allow the K-1 income from the entity (approximately $100,000) to flow to the irrevocable trust and/or children, ideally in lower tax brackets. Legal practices will need to pay legitimate management, advertising, clerical, and other fees for a commensurate result.
Conclusion
In conclusion, lawyers with taxable income below the $157,500 (if single), or $315,000 (if married filing jointly) threshold, will be eligible for a 20 percent deduction on nonwage law firm income that meets the requirements set forth in this article. High earners may be well advised to segregate income from law firm management, intellectual property, nonlegal services, and real estate into separate entities, or at least separate cost-accounting components, since high earner lawyers who have ownership in nonspecified service trades or businesses may qualify for the 20 percent deduction if wage and qualified property requirements are met. Lawyers may also consider using C corporations, which are in a 21 percent federal income tax bracket and 5.5 percent state bracket, for a combined bracket, after deduction, of 25.345 percent. The law in this area will develop rapidly, and planning structures may save significant monies for well-advised practitioners.
1 The act is officially titled, “An Act to provide for reconciliation pursuant to Titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
2 Thanks to Professor Jerry Hesch for pointing out that repetition and examples, preferably without citing very many Tax Code sections, are often the primary stepping stones to understanding tax law.
3 Wages paid to a partner are considered guaranteed payments and are not W-2 wages. Owners of sole proprietorships, Schedule C, and E entities may also not pay themselves W-2 wages.
4 Payments from a partnership do not have to be “guaranteed” from a state contract law standpoint in order to be characterized as a guaranteed payment. This causes a lot of confusion, even for experienced tax lawyers.
5 I.R.C. §199A(f)(1)(C).
6 Itemized deductions consist of permitted mortgage interest deductions (on up on $750,000 of interest or up to $1 million of debt incurred prior to Dec. 15, 2017), up to $10,000 of state and local taxes (including real estate taxes), charitable donations, and medical expenses exceeding 7.5 percent of gross income See IRS Form 1040, Schedule A.
7 See BNA Portfolio 731-3rd: S corporations: corporate tax issues, detailed analysis, I, C, 7 and detailed analysis, I, B, 5; Traum, Taking the “Sting” Out of S Corporations’ Earnings and Profit.
8 Named after I.R.C. §1202. For more on 1202, see Gassman & Ketron: 1202 Things to Consider When Setting Up a Related Business Servicing Company LISI Business Entities Newsletter #152 (July 13, 2016).
9 See I.R.C. §1202(e)(3) for a list of all businesses that will not qualify under §1202.
10 I.R.C. §1202(e)(3)(A) also includes engineers and architects; however, there is a specific exclusion for engineers and architects under §199A. It is unclear whether engineers or architects could be brought back under the reputation and/or skill clause.
11 Letter from Annette Nellen, Tax Executive Committee Chair, AICPA, to Victoria Judson, associate chief counsel, I.R.S., and Janine Cook, deputy associate chief counsel, I.R.S. (Feb. 21, 2018) (on file with AICPA).
12 A trust may own real estate and deduct up to $10,000 of taxes per year and may avoid state income tax that its grantor and beneficiaries would otherwise be subject to. See Blattmachr & Shenkman, Wrap Up Lecture: Planning after the Tax Cuts and Jobs Act of 2017 52nd Heckerling Institute on Estate Planning.
13 50 percent is derived from dividing the amount by which the couple’s taxable income exceeds $315,000 and dividing the result by $100,000 (the length of the phase-out) ($365,000 – $315,000 / $100,000).
14 The kiddie tax applies to unearned income received by individuals under the age of 18 or under the age of 24 if a full-time student and taxes such income at the compressed rate brackets applicable to trusts and estates.
15 For those curious to know, for nonspecified service earners, if the taxpayer’s taxable income is over $207,000/$415,000 (individual/married), the taxpayer’s deduction will be the lesser of 20 percent of the taxpayer’s QBI and the greater of 1) the wage test (50 percent of W-2 wages); and 2) qualified property test (25 percent of wages plus 2.5 percent of the taxpayer’s basis in depreciable assets).
16 The amount of phasing in or out is calculated by finding where the taxpayer’s income is proportionally between the low- and high-earning limits (simply: married joint filers – (taxable income – $315,000) / $100,000; single filers – (taxable income – $157,500) / $50,000).
17 Commissioner v. Groetzinger, 480 U.S. 23 (1987). Justice Blackmun noted the term trade or business is not defined in the I.R.C. “We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”
18 Florida imposes a 5.8 percent sales tax on rent, and many counties charge a local surtax on rent ranging between 0.5 percent and 1 percent, which is deductible for federal income tax purposes. As a result, the payment of extra rent will cost the taxpayer a minimum of 3.654 percent ((1-37 percent) x 0.058 = 3.654 percent).
ALAN GASSMAN,J.D., LL.M., is a partner in the law firm of Gassman, Crotty & Denicolo, P.A., in Clearwater. He has authored several books and many articles on estate and estate tax planning, trust planning, creditor protection planning, and associated topics.
BRANDON KETRON,CPA, J.D., LL.M., is an associate at Gassman, Crotty & Denicolo, P.A., and practices estate planning, tax, and business law. He is a licensed CPA and received his J.D. from Stetson, and his LL.M. in taxation from the University of Florida.
The authors thank Florida Bar Journal Tax Section Editor Michael D. Miller and Law Clerk Scotty Schenck for their extensive work on this article.
This column is submitted on behalf of the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.
