Attorneys: Get up to speed on Tax Cuts and Jobs Act

California attorneys will receive benefits and burdens once the Tax Cuts and Jobs Act is signed into law. Both the House and Senate voted to pass the tax overhaul legislation this week, and President Donald Trump is expected to sign the bill as early as Friday.

"Federal-state nonconformity" is a phrase used by tax practitioners to describe the challenges faced by taxpayers when the federal rules are not consistent with the state rules where a taxpayer lives, works or allocates income. It remains to be seen how California will address the issues the act raises. There are significant differences between current California tax rules and the federal rules. For example, the federal rules allow generous expensing of assets acquired in a trade or business up to $500,000. California limits it to $25,000.

Here, we have tried to provide an early and high-level overview of federal income tax issues with which California attorneys should be familiar as we all watch the implementation of the act.

Tax Entities Used for the Practice of Law

Attorneys engage in the practice of law as individuals, partnerships, S corporations and C corporations.

The act may trigger rethinking the best entity for the practice of law so that California attorneys can take advantage of new benefits and avoid new burdens effective Jan. 1, 2018.

Pass-through entity deduction. Starting in the 2018 tax year, the Act allows a new deduction of 20 percent for taxpayers who have domestic "qualified business income" from a partnership, S corporation, or sole proprietorship, limited to 50 percent of the W-2 wages paid by the business.

The 20 percent deduction for the nonwage portion of pass-through income is allowed for attorneys whose taxable income is less than the threshold amount of $315,000 for married individuals filing jointly or $157,500 for individuals without regard to a W-2 wage limitation. At that point, limitations on the deduction would begin to phase in and would be fully phased in for taxpayers with $50,000 of taxable income more than the threshold amount ($100,000 in the case of a joint return). The 20 percent reduction is not allowed as an above the line deduction in computing adjusted gross income but is used as a deduction reducing taxable income. This deduction is available to both nonitemizers and itemizers.

Corporate Taxation

The corporate alternative minimum tax is repealed. The act allows the prior year minimum tax credit to offset the taxpayer's regular tax liability for any tax year.

The corporate tax rate is 21 percent. Professional service corporations may provide a new opportunity to attorneys. Historically the 35 percent federal income tax rate made professional service corporations unattractive to some attorneys. In firms that did not pay out all profits each year or that did not take case costs as expenses in the current tax year, the 35 percent tax rate was a hefty price to pay for retaining capital necessary to operations. The new 21 percent rate presents an opportunity to some firms by reducing the cost of retaining capital.

Retaining the Boccardo Advantage

The 9th U.S. Circuit Court of Appeals ruled in Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995), that plaintiffs' lawyers are entitled to deduct their case costs in contingency fee matters as a business expense in the year in which they are incurred, without waiting for the resolution of the case for which they incurred the costs. Attorneys in the 9th Circuit who wish to expense case costs in the current tax year have been able to rely on the Boccardo rule to substantial advantage. If your firm is not already doing this, a word of caution: there are important tax and engagement letter steps to take before making this change. For example, your fee agreements with plaintiffs or class representatives must comply with the principles in the Boccardo decision.

The House bill would have eliminated this rule in the 9th Circuit. The act that the president will sign does not contain this provision. The backstory is an interesting one, but beyond the scope of this article.

Individuals

Most provisions begin in the 2018 tax year and end in the 2025 tax year.

The highest federal individual income tax bracket has been 39.6 percent and has been reduced to 37 percent. There are seven tax brackets. So much for simplification.

The individual alternative minimum tax exemption remains but the exemption has been increased to $109,400 for married tax payers filing jointly or for surviving spouses; $70,300 for single taxpayers; and $54,700 for married taxpayers fling separately.

The act retains the deduction for mortgage interest for up to $750,000 of acquisition indebtedness incurred after Dec. 15, 2017. The $1 million limitation remains for pre-Dec. 15 debt. The mortgage interest deduction for interest on home equity financing is eliminated.

You should allocate some of that holiday celebration and gift cash flow to paying your 2017 (or earlier) state income and other taxes in 2017. If your ability to deduct state income and other taxes will not be limited by the alternative minimum tax you should make these state and local tax payments in 2017. In and after 2018, if your state and local income, property and other tax exceeds $10,000 a year, you will not be able to deduct more than $10,000. Individuals will only be allowed to deduct these state and local taxes related to a trade or business. If you are thinking of paying your state or local income taxes for the tax year 2018 early, don't. You cannot receive a 2017 tax benefit by pre-paying your 2018 state income tax.

The reduction in the threshold for deduction of medical expenses has been reduced to 7.5 percent of adjusted gross income, retroactively for the 2017 tax year and prospectively for the 2018 tax year. Thereafter it increases. You may not have thought that your medical expenses for 2017 would reach the former threshold of 10 percent of adjusted gross income. It may be wise to reevaluate your medical expenses and pay them in 2017 to reach the 7.5 percent threshold, thus allowing you to deduct them.

The act eliminates all miscellaneous itemized deductions that are subject to the 2 percent floor under present law. It suspends the overall limitation on itemized deductions.

The act increases the AGI limitation on charitable cash contributions from 50 to 60 percent, effective for contributions made starting in the 2018 tax years.

The act eliminates the current above-the-line deduction for alimony. For alimony agreements entered into or modified after 2018, alimony payments are not deductible by the payer and are not income to the recipient. This is one of the few provisions that becomes effective after 2018.

Saving the Weirdest Carve-Out for Last

Perhaps a legislator with a passion for collegiate sports insisted on this timing delay. The deduction for university athletic seating rights are gone, essentially. The act repeals the current 80 percent deduction for contributions made for university athletic seating rights, effective for contributions made in the 2018 tax year. But the odd thing is that this section of the act uses the language "contributions made," so if you can pre-pay contributions that entitle you to special seating at your favorite college or university sporting event in 2017 and want the deduction, then make the contribution before Dec. 31.