Proposed Section 199A Regulations - few multinational law firm partners can benefit

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As expected, the IRS materials reiterate the exclusion of lawyers and other service providers in a specified service trade or business (“SSTB”). However, those law firm partners and sole practitioners with taxable income of less than $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers, generally may utilize this deduction. This benefit is phased out for joint filers with taxable income between $315,000 and $415,000 and all other taxpayers with taxable income between $157,500 and $207,500. Law firm partners and sole practitioners with taxable income above the $415,000 / $207,500 thresholds may not claim the deduction at all.

“Crack and Pack” Only Works In Certain Cases

The proposed regulations specifically address the various “crack and pack” strategies that have been floated around the industry over the past 8 months. In its most basic form, a taxpayer would “crack” open their business and “pack” non-SSTB services into a separate entity eligible for the 20% deduction. For example, a firm could put its building/real property or its non-legal support staff into a separate partnership, which would then rent offices back to the law firm or provide administrative support to the firm at a markup. The equity ownership of the law firm and this separate partnership would mirror each other or are nearly identical. A partner/owner might then be eligible for the Section 199A deduction on income from the non-SSTB partnership. The proposed regulations, in no uncertain terms, ensure that this benefit cannot be claimed unless most of the separated business is aimed as providing benefits to taxpayers unrelated to the SSTB.

Presumption Against “Employees” becoming Equity Partners

Some income partners at law firms whose income falls below the thresholds listed above questioned whether they could convert to be equity partners to be eligible for the Section 199A deduction and achieve a lower effective tax rate. In an effort to thwart such workarounds by service providers, Proposed Treas. Reg. Sec. 199A-5(d)(3) provides a presumption that former employees under federal tax law are presumed to remain employees where they perform basically the same services for the SSTB.

Thus, income partners that convert into equity partners of the firm may face a higher burden in overcoming this presumption that they remain de facto employees as compared to those partners that can demonstrate that the natural progression of the firm is to become an equity partner after serving as an employee / associate for several years.

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