Parsley Sage Rosemary & Ginsburg llp
“always a reasonable result for a reasonable fee, always”
December 11, 2012
Cliff Notes – 2012 Year-end Tax Planning for the Firm
I recently conducted a brief, informal and very unscientific survey of tax accountant friends who advise high income individuals, including a number of partners (shareholders) in law firms. Their advice: law firms should accelerate revenue and defer expenses this year in anticipation of higher tax rates in 2013.
1. Why Accelerate Income and/or Defer Expenses?In most years, taxpayers prefer to defer revenue and accelerate expenses in order to minimize taxable income. This year is different. Absent agreement in Washington to the contrary, the highest marginal tax bracket automatically increases to 39.6% from the current 35% on January 1, 2013. In addition, a new 0.9% Medicare contribution tax on earned income takes effect for 2013 for married taxpayers with modified adjusted gross income over $250,000 and over $200,000 for taxpayers filing single. Taken together, the tax rate applicable to most law firm partners will increase by 5.5% on their law firm income earned next year.[i]
With these likely 2013 rates, partners will owe 5.5% more in federal income tax on every dollar earned next year at the highest marginal rate as compared to the 2012 rates. Accordingly, the partners will save $5,500 on every $100,000 of taxable income which can be “shifted” into 2012 from 2013.
Generally speaking, the idea of deferring income/accelerating expenses is a good idea when tax rates remain the same or are likely to decline year-to-year. Conversely, if rates are likely to increase in the succeeding year (i.e., the likely 2012/2013 scenario), the opposite is true. However, there are some caveats:
A. Law firm compensation percentages are not static. Partner A may be entitled to 30% of the profits for 2012. Shifting $100,000 of income from 2013 to 2012 to take advantage of lower rates could result in a $5,000 windfall if Partner A’s profit percentage in 2013 falls from 30% to 25%.
B. For every action there is an opposite and equal income or not-income reaction for someone else. Assume you pay your tax accountant every December for the advice and service provided during the year – including the suggestion this year to defer expenses in 2013 to maximize taxable 2012 taxable income. If you decide to defer the accountant’s payment to January 2013, your law firm wins, and your CPA loses. Because of your decision to defer the regular December payment to January, you have shifted taxable income from the lower rates of 2012 to the higher 2013 rates for your CPA. Talk about being hoisted on your own petard!
C. It is often difficult to “go back” in time. Should your firm decide to defer associate and staff bonuses from December 2012 to January 2013, later reverting to a December bonus payday becomes problematic. Switching back will mean 2 bonus payments in a single calendar year – one in January for the prior work year and a second in December for the concurrent work year. Such moves should not be taken lightly since they impact issues raised in both A and B above.
D. Not all partners are created equal from a tax perspective. Whatever your firm decides to do – take your CPA’s advice and accelerate income/defer expenses for 2012 or simply maintain business as usual – discuss it with all the partners. Don’t assume every partner has the same individual tax goals and will benefit from the same strategies. Moreover, a dramatic income shift may subject certain partners to penalties and interest for underpayment of quarterly federal and state income tax estimates for 2012.
2. Deferring 2012 Expenses to 2013The following is a partial list of things to consider if your firm wants to defer 2012 expenses into 2013:
A. Vendor Payments. Most law firms pay their vendors on a 30-day (possibly longer) payment schedule. In prior years, your firm likely accelerated items scheduled for payment in early January in order to take the tax deduction in the current year. If your firm decides to maximize 2012 taxable income, you will want to defer as many expense payments as possible.
B. Year-end Bonuses. If your firm typically pays bonuses to associates, staff and non-equity partners in December, you may want to consider postponing those payments to January 2013. Be mindful, however, that the deferral of bonus payments may subject the receipients to higher tax liabilities at 2013 rates.
C. Delay 4th Quarter Nonresident State Composite Filing. If your firm processes 4th quarter composite filings in December (so partners can deduct the state income tax payments on their personal returns), deferring those filings and payments to January will shift the personal deduction from 2012 to 2013.
D. Depreciation Elections. Consider electing out of 50% bonus depreciation for qualifying assets placed in service in 2012 tax year.
E. Qualified Retirement Plan Contributions. Generally, contributions to a qualified retirement plan for 2012 are deductible in 2012 if contributed in 2013 before the extended due date of the law firm’s tax return for 2012. Firms wishing to maximize partner income for 2012 may want to consider taking a 2013 tax deduction for the 2012 plan year contributions, rather than electing to take the deduction for tax year 2012.
3. Accelerating Income into 2012Law firms seeking to accelerate revenue can consider the following:
A. Accelerate billable hours and progress bill clients for December time and soft costs and collect before December 31, 2012.
B. Collect non-refundable retainer payments in December for work to be performed next year.
C. Collect on outstanding accounts receivable, giving discounts were appropriate in order to save on the tax differential.
D. Advise partners that they may want to consider converting their 401(k) account balances to Roth 401(k) balances before year-end – and pay the taxes this year at current rates as opposed to the then-prevailing rate applicable to future withdrawals. (One nice feature of the Roth IRA conversion is it comes with a “reversal feature.” If a taxpayer converts a regular IRA to a Roth IRA before year-end and it turns out to be a bad idea, the conversion carries with it a “re-characterization” feature. Up until the due date of your tax return in 2013, you can reverse a Roth conversion.)
ConclusionRegardless of whether the President and Congress reach a compromise on “the fiscal cliff,” it is a safe bet that tax rates – for married taxpayers who earn over $250,000 ($200,000 if single) are going to be higher in 2013. As a result, law firm managers should work with their outside accountants to make a plan and then involve the partners (and other stakeholders) in the 2012 year-end tax planning effort. Doing nothing is a perfectly viable option – but only after all other alternatives are thoroughly explored and discussed. Effectively, it may come down to something this simple – as to each thing which can be accelerated or deferred – should the partners pay the tax now or later?
OBLIGATORY DISCLAIMER: This presentation was prepared for general guidance and discussion purposes and does not constitute professional advice. Readers should not act upon the information contained herein without obtaining specific professional advice. No representation or warranty (express or implied) is made as to completeness or accuracy of the matters discussed herein.
[i] For purposes of this memo, I’m assuming all partners are in the highest marginal tax rate – currently 35%.