Gavin Howe
The 20% pass-through tax deduction, established by the 2017 Tax Cuts and Jobs Act (TCJA), allows owners of pass-through businesses to deduct 20% of their qualified business income (QBI) from their taxable income. This deduction is applicable to various business structures, including sole proprietorships, partnerships, and S corporations. However, it is important to note that the deduction is not available to all businesses and has certain limitations, especially for specified service trades or businesses (SSTB), which include law firms. Law firms and other SSTB professionals face challenges in segregating SSTB and non-SSTB services to maximize the benefits of the qualified business income classification. The income threshold for single filers is $157,500, and for joint filers, it is $315,000, above which the deduction begins to phase out for lawyers and certain other professionals.
| Characteristics | Values |
|---|---|
| Year of implementation | 2017 |
| Type of businesses | Sole proprietorships, partnerships, limited liability companies, S corporations |
| Type of income | Qualified business income (QBI) |
| Deduction percentage | 20% |
| Maximum income for single filers | $157,500 |
| Maximum income for married filers | $315,000 |
| Income threshold for single filers | $207,500 |
| Income threshold for married filers | $415,000 |
| Type of businesses excluded | Specified service trade or business (SSTB) |
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What You'll Learn
Law firms as pass-through entities
Law firms are often structured as pass-through entities, also known as flow-through entities, due to traditional prohibitions against practising law in corporate form. Pass-through entities are businesses that are taxed at individual income tax rates. The income of a pass-through entity is reported on the owner's individual income tax return and taxed at the individual income tax rate. This means that the business itself pays no corporate tax.
Pass-through entities are beneficial to law firm owners as they are not subject to federal income tax and can avoid double taxation. In the case of a net operating loss, the personal tax liability for the owner is reduced, and they can claim an NOL deduction on their personal taxes.
The 2017 Tax Cuts and Jobs Act (TCJA) established a 20% pass-through tax deduction for business owners, which includes law firms. This deduction is capped at 20% of a business owner's total taxable income, allowing them to deduct up to 20% of their qualified business income. However, this deduction is not available to high-income owners of "specified service businesses", which includes law firms.
Despite the benefits, there are considerations to be made before a law firm makes a pass-through entity tax election. For example, the state tax deductions that owners of pass-through entities can claim on their Federal income tax return are limited by the TCJA's $10,000 SALT cap. Additionally, the deduction is heavily tilted towards the wealthy and big businesses, with 61% of its benefits going to the top 1% of households in 2024.
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Qualified business income
The Qualified Business Income (QBI) deduction is a tax deduction that allows eligible self-employed and small-business owners to deduct up to 20% of their QBI on their taxes. QBI is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.
The QBI deduction is available to taxpayers regardless of whether they itemize deductions on Schedule A or take the standard deduction. However, it is not an "above the line" deduction that reduces the adjusted gross income (AGI). Instead, it only reduces income taxes and not Social Security or Medicare taxes.
To determine the pass-through deduction, taxpayers must first calculate their total taxable income for the year, excluding the pass-through deduction. This is the total taxable income from all sources, including business, investment, and job income, minus deductions such as the standard deduction. The pass-through deduction can never exceed 20% of the taxable income.
The QBI deduction was established by the Tax Cuts and Jobs Act (TCJA), which took effect in 2018. The Act introduced a 20% deduction for certain income that owners of pass-through businesses report on their individual tax returns. These pass-through entities include S corporations, partnerships, and certain limited liability companies, which is how many law firms are structured.
However, it's important to note that the QBI deduction begins to be phased out for lawyers and certain other professionals, such as accountants, medical professionals, and consultants, who make over a certain income threshold. For 2024, the phase-out begins at $191,950 for single filers and $383,900 for joint filers. The deduction is entirely phased out for individuals with more than $241,950 in income for single filers and $483,900 for joint filers.
Furthermore, under Section 199A of the Internal Revenue Code, lawyers are treated as "specified service trades or businesses" (SSTB), which means that many owners of law firms may not qualify for the 20% pass-through income deduction due to limitations on how their income is classified under tax law.
In summary, while the QBI deduction is available to eligible self-employed and small-business owners, including those in the legal profession, the specifics of an individual's or business's income and tax situation will determine their qualification for and application of the deduction.
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Income thresholds for pass-through deductions
The pass-through deduction is capped at 20% of a business owner's total taxable income. This deduction allows business owners to deduct up to 20% of their qualified business income (QBI) from each pass-through business. QBI is defined as the net profit that the business receives during the year. This involves calculating the total income of the business and subtracting regular deductions.
For 2024, if your taxable income is at or below the $191,950/$383,900 threshold, you can take the full 20% deduction. If your taxable income is within these thresholds, you are effectively taxed on only 80% of your business income.
If your 2024 taxable income exceeds $191,950 if single, or $383,900 if married, calculating your deduction is much more complicated and depends on your total income, the type of work you do, and whether you have employees or business property.
If your 2024 taxable income exceeds $241,950 (single) or $483,900 (married filing jointly), your maximum possible pass-through deduction is 20% of your QBI, just like at the lower income levels. However, when your income is this high, a W-2 wage/business property limitation takes full effect. Your deduction is limited to the greater of: 50% of your pro-rata share of W-2 employee wages paid by the business, or 25% of W-2 wages plus 2.5% of the acquisition cost of depreciable property used in the business.
If you are a business owner who provides services, you won't qualify for the pass-through deduction if your income exceeds certain thresholds. For example, if your business is a specified service business, and your 2024 taxable income exceeds $191,950 (single) or $383,900 (married), your pass-through deduction is gradually phased out up to $241,950/$483,900 of QBI. At the top of the income range, you get no deduction at all. This phase-out was intended to prevent highly compensated employees who provide personal services—such as lawyers—from having their employers reclassify them as independent contractors so they could benefit from the pass-through deduction.
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Phase-out of pass-through deductions for high-income earners
The 20% pass-through tax deduction was introduced by the 2017 Tax Cuts and Jobs Act (TCJA). It allows owners of pass-through businesses to deduct 20% of their qualified business income (QBI) from their taxable income. QBI is defined as the net profit that the business receives during the year.
However, the pass-through deduction is not meant for all businesses. It excludes certain high-income owners of "specified service businesses", including law, health, and financial services. This is to prevent highly compensated employees, such as lawyers, from being reclassified as independent contractors by their employers to benefit from the pass-through deduction.
The pass-through deduction is also heavily skewed in favor of high-income earners. Wealthy households benefit the most because they receive the majority of pass-through income, have a much larger share of their income from pass-throughs, and receive the largest tax break per dollar of income deducted. A 2019 study found that about three-quarters of high earners' pass-through income is a form of labor income, which should be taxed at ordinary income tax rates.
Due to the skewed benefits of the pass-through deduction, there have been calls for its repeal or phase-out for high-income earners. President Biden's proposal to phase out the deduction for households with incomes over $400,000 is estimated to raise $143 billion over ten years, primarily from the top 1% of households.
As of 2021, if you have $329,800 or less in taxable income, or $164,900 or less if you are single, you will receive a deduction of 20% of your QBI. Above these income thresholds, the deduction is reduced by 1% for every $1,000 ($500 if single) that your income exceeds the threshold, until you reach $429,800 ($214,900 if single), where you can no longer claim the deduction.
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Crack and pack business segregation strategies
The 20% pass-through tax deduction, established by the Tax Cuts and Jobs Act (TCJA) in 2018, allows owners of pass-through businesses, such as sole proprietorships, partnerships, and S corporations, to reduce their taxable income. This deduction is applicable to income taxes, excluding Social Security and Medicare taxes. However, the benefit is phased out for certain high-income professionals, including lawyers, with the threshold set at $157,500 for single filers and $315,000 for joint filers. Above these income levels, the deduction is entirely phased out.
The "crack and pack" business segregation strategy came into focus following the introduction of the TCJA. It refers to the idea of segregating or spinning off certain parts of a business, particularly law firms, for tax purposes. The strategy involves either "cracking" or "packing" key constituencies to dilute their influence. In the context of political gerrymandering, "cracking" refers to dividing a group of voters among multiple districts to reduce their influence, while "packing" involves concentrating them into a single district.
The "crack and pack" strategy in the context of law firms and the 20% pass-through deduction relates to the challenge of segregating "specified service trades and businesses" (SSTB) from non-SSTB services within a law firm. SSTB includes professions such as law, health, and financial services. By segregating SSTB and non-SSTB services, law firms aimed to maximize their tax benefits.
However, the IRS issued proposed regulations under Section 199A that limited the ability of law firms to successfully employ the "crack and pack" strategy. These regulations clarified that the 20% deduction applies to qualified business income, and law firms, as SSTB, face restrictions in qualifying for this deduction. While there may be exceptions, the "crack and pack" strategy generally proves ineffective for most law firms due to the limitations imposed by the IRS regulations.
In conclusion, the 20% pass-through tax deduction introduced by the TCJA has had an impact on business segregation strategies, particularly for law firms. The "crack and pack" approach, which involves segregating SSTB and non-SSTB services, has been restricted by IRS regulations. While some law firms may explore alternative structures or separate divisions to navigate these limitations, the overall effectiveness of such strategies is limited due to the specific guidelines established by the IRS.
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Frequently asked questions
Pass-through businesses are those that are structured as sole proprietorships, partnerships, limited liability companies, and S corporations.
The 20% pass-through deduction is a tax deduction for owners of pass-through businesses. It allows them to deduct 20% of their "qualified business income" (QBI) from their taxable income.
It depends. Law firms are generally considered "specified service businesses" (SSTB) and are subject to income limitations. If a law firm owner's taxable income is below a certain threshold ($315,000 for joint filers and $157,500 for other filers), they can take the 20% deduction. Above these thresholds, the deduction is phased out, and at higher income levels, it is not available at all.
Law firms are considered SSTBs because they provide professional services in the field of law. SSTBs include businesses in fields such as health, law, accounting, consulting, and financial services.
To calculate your pass-through deduction, you must first determine your total taxable income for the year, excluding the pass-through deduction. This is your income from all sources minus deductions and losses connected with your business. If your income is below the thresholds mentioned earlier, you can take the 20% deduction. However, the deduction cannot exceed 20% of your taxable income.
