How much will our law firm be taxed?

The amount that a firm is taxed varies by firm, but it’s likely a big expense for your firm. A wide number of factors play into what the total dollar amount is, but one factor you should pay particular attention to is your tax rate^[1].

The Tax Cuts and Jobs Act of 2017 made substantial changes in tax rates for different types of entities. Law firms that are set up as C corporations have a substantial tax cut on the net income retained in the corporation, going from a flat 35% tax rate to a flat 21%.

However, when C corporations distribute their earnings to owners as dividends, they are subject to double taxation. There has been no change in this with TCJA; dividends are taxed at 23.8% for non-corporate taxpayers^[2].

What if you’re not set up as a C corporation, though? Law firms set up as personal service corporations will experience a similar reduction in the tax rate, going from a flat 35% to a flat 21% like C corporations.

On the other hand, businesses that operate as pass-through entities, including partnerships, S corporations, and sole proprietorships, retain the top tax rate of 47%. However, they can deduct 20% of their share of business income (subject to limitations), reducing the top tax rate to a maximum of 29.6%^[3].

The pass-through structure has been a challenge for law firms to navigate, though. Not every business can claim status as a pass-through entity. Law firms, as well as other professional trades (health, law, accounting, performing arts, consulting, and financial and brokerage services) are considered “specified service businesses” and not included under the umbrella of pass-through entities. As a result, they generally don’t qualify for the special 20% deduction.

That being said, if the law partner’s taxable income, as reported on Form 1040, is below a designated threshold ($315,000 for joint filers and $157,500 for other filers), the 20% deduction can be used.

While tax rates aren’t up for negotiation, taxable income is impacted by deductions. Although the shift to the work-from-home environment may impact long-term assets, business operating expenses, business entertainment, and travel expenses. However, home office deductions, health insurance, retirement plans, and employee salaries are all still considered write-offs^[4].

References

1. Impact of the New Tax Act on Law Firms
2. Pass-Through Businesses Q&A
3. How the Tax Cut Bill Impacts Lawyers
4. Nolo’s Top Ten Deductions for Professionals