Do Lawyers Benefit from the Qualified Business Income Deduction?

The Tax Cuts and Jobs Act’s flagship provision was to reduce the corporate tax rate from a max of 37% down to a low, flat rate of 21%. Overnight, U.S. C corporations became more competitive in the global marketplace, and here at home they had grand plans for the tax savings they were bound to accumulate. Their good fortune made pass-through entity owners question whether their entity selections were still viable. Fortunately, the tax law also provided a break for these concerned business owners: the potential to take a 20% deduction off of their bottom line. This deduction, called the Qualified Business Income Deduction, can greatly reduce the tax bills of some flow-through entity owners, but others may not be as lucky. Lawyers in particular may find themselves at a disadvantage.

Deduction Basics

The Qualified Business Income Deduction, also referred to as the §199a deduction, is available only to owners of pass-through entities like partnerships, S corporations, trusts, and estates. Even though it is called a “business deduction,” it will be taken by the business owner on their individual income tax return. Unfortunately, it is subject to a multitude of limitations, the details of which have only recently been finalized. First, the deduction cannot exceed an individual taxpayer’s taxable income for the year reduced by net capital gains. And second, it is limited for taxpayers whose taxable incomes are too high. The limitation is as follows:

The taxpayer’s deduction will be limited to the greater of (1) 50% of their portion of the business’s W-2 wages, and (2) the sum of their portion of 25% of wages plus 2.5% of adjusted basis of all qualified business property.

Married and non-married taxpayers whose taxable incomes are no more than $315,000 and $157,500, respectively, will not be subject to this high-earner limitation. Married and non-married taxpayers whose taxable incomes are above $415,000 and $207,500, respectively, must apply the limitation in full. And individuals with taxable incomes between those two thresholds must phase in the limitation gradually, fully applying it when their taxable incomes reach the upper limit.

Sadly for lawyers and other service-based professionals, there is yet another limitation. Taxpayers working in certain specified service trades or businesses, including law, health, accounting, consulting, athletics, performing arts, actuarial science, financial services, and investment management, will lose their deductions all together when their taxable incomes exceed the upper thresholds ($415,000 or $207,500). When their taxable incomes are between the lower and upper thresholds, they will partially reduce their deduction, and it will be fully gone when they reach that upper limit.

Lawyer Considerations

Law firms may find it difficult to plan how this deduction will impact each owner. Because the deduction is at the individual level, there will be disparity among the partners in how effective the deduction is at reducing their tax bill. Take, for instance, a two-person law firm, with one partner who is married, and one who is single. If the firm’s $500,000 earnings are split evenly between the two, the married partner will be eligible for the full deduction; their $250,000 of earnings will be below the $315,000 limitation threshold. The single partner will report the same $250,000 but will be ineligible for the deduction since their earnings exceed the non-married upper limitation threshold of $207,500.

With the help of a trusted professional, lawyers may be able to plan around these disparities. Increasing retirement plan contributions rather than salaries can effectively convert an individual’s income into a tax-deferred personal asset, reducing the likelihood that the taxpayer’s income will exceed the limitation thresholds for that year. Optional deductions like bonus depreciation or Section 179 depreciation give you the freedom to find the perfect deduction balance to benefit all of your business partners. We suggest taking a long-term outlook when calculating the effects of the qualified business income deduction. At the moment, the deduction is scheduled to sunset at the end of 2025, so plan take advantage of it while you can – if you can.

Contact Us

The 199a deduction can be quite limited, but when it works, it can pack a real punch. The tax savings from a 20% business deduction will be quite noticeable. Even receiving a partial deduction will be worth your while. If you have any questions about the Qualified Business Income Deduction and would like to talk to a professional about your partnership or S corporation’s tax plans for the year, contact us as soon as possible. We would love to help you figure out how to take advantage of §199a. We look forward to speaking with you soon.