Get Your 20 Percent Deduction by Calling 1-800-888-199A.

• Author: Gassman, Alan
• Position: Tax Law

The 1,097-page Tax Cuts and Jobs Act (1) 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 owners (3) 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. [section]707(c) and are not considered to be wages for purposes of the [section]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 companies (8) 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.

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