Impact of Recent Federal and State Tax Legislation on Professional Service Firms and Their Owners
By: Julian Fortuna
On December 22, 2017 President Trump signed into law the Tax Reform Reconciliation Act, also known as the Tax Cuts and Jobs Act (“the Act”). The Act is a major overhaul of the tax system and contains numerous revisions of tax laws applicable to both business and individual taxpayers, including professional service firms and their owners. Some states, including Georgia, have already enacted corresponding legislation.
Potential Tax Benefits – Parts of the Act that may provide tax benefits to professional service firms and their owners are:
- Capital Expenditures - Immediate write-off of qualifying expenditures for equipment, building and leasehold improvements, and certain other expenditures for property placed in service before January 1, 2023;
- Family and Medical Leave - New tax credits of 12.5 to 25 percent of wages paid to employees on employer-paid family and medical leave if the wages are at least 50 percent of normally paid wages to those employees effective only for tax years beginning in 2018 and 2019;
- Corporate Tax Rate – Reduction in the corporate tax rate from 35 percent to 21 percent;
- Individual Tax Rates – Temporary reduction in individual tax rates and brackets with a new top rate of 37 percent effective for tax years beginning before 2026; and
- Pass-thru Deduction - New deduction for 20 percent of qualified business income, not including wages or guaranteed payments, from a pass-thru entity for individual taxpayers with taxable income below the threshold amount of $157,500 ($315,000 for married filing jointly). The good news for owners of architectural and engineering firms is that the taxable income ceilings do not apply to them.
Potential Tax Burdens – Other parts of the Act applicable to professional service firms that may increase taxes are:
- Client Entertainment and Membership Dues - Disallowance of deductions for client entertainment, amusement or recreation and membership dues for clubs organized for business, pleasure, recreation or other social purposes;
- Employee Meals and Transportation - Reduction in the deduction for meals provided to employees on the premises of the employer from 100 to 50 percent and disallowance of deduction for transportation fringe benefits provided to employees;
- Net Operating Losses - Repeal of net operating loss (NOL) carrybacks and limitation of NOL deduction to 80 percent of taxable income with carryforward of disallowed amount;
- Business Interest Expense - Limitation on deduction of net business interest to 30 percent of the business’s adjusted taxable income with carryforward of disallowed amount (disallowance not applicable to businesses with less than $25 million in annual gross receipts); and
- Individual Income and Property Taxes – Limitation on itemized deductions for income and property taxes to $10,000 ($5,000 for married filing separately).
Responding to the Act - What, if anything, should professional service firms do in response to these changes?
Professional service firms should consider the following actions:
- Capital Expenditures - Reevaluate mid and long-term plans for expansion or relocation to maximize benefit from expensing before January 1, 2023;
- Entertainment, Meals, and Transportation - Begin tracking expenditures for non-deductible entertainment expenses and employee meals and transportation fringe benefit expenses, and evaluate the need for expenditure and/or reimbursement policy changes;
- Family and Medical Leave - Consider adopting or changing an existing employer-paid family and medical leave plan to qualify for the new credits; and
- Interest Expense - If the firm projects $25 million or more in gross receipts, calculate the net business interest expense to see if the 30 percent limit will apply and, if so, consider refinancing or changes to partner compensation in order to avoid to limit.
Professional service firms and their owners should also begin planning structural changes pending the issuance of definitive guidance from the IRS or technical corrections from Congress on those provisions in the Act which are ambiguous, require further explanation, and/or do not appear to accurately reflect Congressional intent. Structural changes that might be worthy of consideration are the following:
- Pass-thru Entities. Professional service firms operating as pass-thru entities (partnerships, LLCs, or S corporations) should consider restructuring, if necessary and feasible, to take advantage of the 20 percent deduction for qualified business income by, for example, (i) moving into a separate entity any business activities not constituting the provision of professional services, and/or (ii) changing partner compensation from guaranteed payments or wages to distributive shares. Owners who qualify for the 20 percent pass-thru deduction would enjoy a top tax rate of 19.26 percent (80 percent of 24 percent) on their allocable shares of qualified business income if their taxable income is below the threshold amount. Owners operating as partnerships or LLCs who do not qualify for the pass-thru deduction should explore the feasibility and tax benefits of holding their interests thru a C Corporation to capture the 21 percent tax rate on income that doesn’t need to be paid out to them as compensation or dividends and to avoid the $10,000 limit on individual itemized deductions for income and property taxes.
- C Corporations. Professional service firms operating as C Corporations with cash flow in excess of both their near-term capital needs and the cash flow needs of their shareholders should consider reasonably limiting the payment of compensation and dividends in order to accumulate funds for investment and future capital needs. Larger firms with capital needs should avoid debt which might either become subject to the limitations on interest deductions or create net operating losses or, if eligible, consider making an S election where a significant number of the shareholders could benefit from such losses. A firm operating as a C Corporation projecting positive taxable income should also explore an S election if the pass-thru deduction would be available to a significant number of shareholders thereby reducing their tax rates on qualified business income distributed to them from 39.8 percent (21 percent corporate rate plus 18.8 percent individual rate on dividends) to 19.26 percent.
Corresponding State Tax Legislation - In considering policy or structural changes, professional service firms and their owners should also review recent changes to state tax laws in those states where they practice. For example, tax law changes were passed by the Georgia General Assembly and signed into law in by Governor Deal on March 2, 2018.
The new Georgia tax rules that may impact laws firms include:
- Reduction of both the top individual and corporate income tax rates to 5.75 percent, effective January 1, 2019;
- Adoption of the federal changes to interest and net operating loss limitations; and
- Adoption of some but not all of the federal changes to expensing and depreciation of amounts expended for property used in a trade or business.
Conclusion – All professional service firms should be reviewing the recent federal and state tax legislation to determine the impacts on the firm, its owners and employees, and, possibly, its clients.
Disclaimer – The information in this law alert is for informational purposes only and does not constitute legal advice. No attorney-client relationship has been or will be formed by any communication(s) to, from or with the law alert or author. The opinions expressed are those of the author, and decisions relating to the content belong to the author.