From law firms advising on cases setting historic precedents to architects and engineers designing our towns and cities, professional service firms play an extremely important role in the business world.
Despite the many different industries a professional service firm may operate in, there are several common tax issues that the leaders and shareholders of these firms must be aware of. By taking a proactive approach to navigating these issues, firms can build an efficient tax strategy. Done right, this enables partners to preserve and grow significant wealth while remaining in compliance with all state and federal regulations.
Recent years have seen significant changes to the ways that professional services firms, and their owners, are taxed. First came the Tax Cuts and Jobs Act (TCJA), a sweeping tax reform law passed in December 2017 that had major ramifications for all kinds of businesses.
Many states have adjusted their own tax laws in response. State nexus standards continue to evolve.
Additionally, the sustained popularity of remote work has changed the way many professional service firms operate, with employees now increasingly spread across multiple tax jurisdictions.
These factors, and others we’ll discuss here, create an extremely complex web of tax considerations that professional service firms must navigate. Success demands an understanding of the issues, a proactive approach, and the guidance of sophisticated tax advisors that understand the unique challenges professional service firms face.
As tax regulations continue to evolve across the nation, professional services firms must stay abreast of the issues that stand to affect them the most. By optimizing their tax strategy to account for these considerations, partners in successful firms stand to realize significant tax savings.
Below, we explore five of the most important tax issues that professional service firms should bear in mind.
The choice of entity structure for a professional service firm is an important decision that has many tax implications. Several factors drive this choice, including the number of owners involved in the firm, the desired level of flexibility in adding and removing new owners, and the owners’ long-term exit strategy. Taking a considered approach to making this decision when establishing a professional services firm can save partners major headaches later on.
For professional service firms with only one owner, an S-Corporation or a single-member LLC is typically the favored method. For firms with several owners, a partnership is generally the best fit. Partnerships offer a variety of substructures, provide partners with legal protections, and offer increased flexibility in areas such as allocating income and adding new partners.
While this may sound relatively straightforward, the choice of entity structure can often be complicated by state-level regulations. Some states place restrictions on the individuals that are eligible to be partners in a professional service firm. In California, for example, all owners of a law firm partnership must have passed the bar. If your firm has external investors, you may need to consider alternative entity structures.
Dive Deeper: The Importance of Entity Choice
For many businesses, including real estate firms or manufacturing businesses, determining state nexus is relatively straightforward. For professional services firms, it’s often more nebulous: there are no manufacturing facilities or rental properties that offer a black-and-white demarcation of your business’s presence in a state.
Complicating matters further are the differing standards in place from state to state. During the pandemic, many states introduced temporary relief that meant businesses could largely ignore the tax implications of their employees being based in a different state. These measures have now expired, but many employees have remained in states where their employer is not based, continuing to work remotely. The result is that many professional services firms may be failing to account for tax exposure in multiple states.
Alongside nexus, there’s also the question of apportioning income between states. The state a business is headquartered in is not the sole determinant of where it is liable for income tax: other considerations include the location the work is being performed and the state the benefit is being received in. Again, standards differ from state to state, underscoring the importance of working with tax advisors that have experience navigating regulations in every state.
While the TCJA introduced many favorable tax provisions for corporations and individuals alike, it also introduced a $10,000 limit to the State and Local Tax (SALT) Deduction that adversely impacted many taxpayers who itemize their deductions on their personal return, particularly those in higher cost-of-living states.
In response, states including California and New York introduced a pass-through entity tax. Previously, taxes on income from a pass-through entity (such as a partnership or an S corporation), were paid at an individual level. However, with the lowered SALT cap in place, taxpayers received significantly less benefit for this at a federal level. Now, certain states allow pass-through entities to elect to pay and deduct state income taxes at the entity level rather than the individual level.
This tax, which has been approved by the IRS, offers the owners of professional services firms significant tax benefits. However, there are nuances to keep in mind. In California, for example, every owner who is a resident of California will have every dollar of their earned income taxed by the state, not just income apportioned to California. If professional service firms opt into California’s pass-through entity tax without appropriate consideration, they may end up paying more tax than they would have otherwise.
There are various opportunities for professional service firms and their owners to leverage tax credits and deductions at both an entity and an individual level.
At the entity level, some states offer retraining credits for certain initiatives. R&D credits represent another opportunity, both at a federal and state level, although this is a complex field where Congress is currently trying to introduce new laws.
At the individual level, the main opportunity for professional service firm owners to be aware of is the 20% pass-through tax deduction. This allows business owners to deduct 20% of their Qualified Business Income (QBI) up to a certain threshold.
Two main tax considerations exist for retirement planning for professional services firms: traditional retirement plans, and what happens when a partner retires or leaves the firm.
Professional service firms may adopt traditional solutions such as 401(k) plans, but certain defined benefit plans allow contributions well over the limits that apply to 401(k) contributions. These plans require businesses to treat all employees equally and come with additional compliance requirements but allow partners to defer significant portions of their current income into retirement accounts.
When partners retire or leave the professional service business, the business must have a plan in place that outlines the terms of this process. This can have major tax implications, particularly when a partner is bought out or receives retirement payments.
Tax planning is a complex field, particularly for growing professional service firms with a regional or national presence. Successfully navigating these complexities to build an efficient tax strategy demands a proactive approach led by experienced tax professionals.
At Smith + Howard, our tax team works closely with professional service firms including architectural firms, law firms, insurance firms, and more to craft efficient tax strategies that maximize partner returns. We bring significant experience and have a wealth of internal tools that enable us to analyze complicated tax issues and design tailored solutions for the needs of our clients.
Our approach is a consultative one that continues on a proactive, year-round approach: not just during tax filing season. Our advisors can work with the Smith + Howard Wealth Management team to help professional service firm owners be better equipped to build a sustainable financial plan that moves them toward their financial goals.
To learn more about how Smith + Howard can support your professional service firm’s tax planning needs, contact an advisor.
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