Choosing the Best Tax Structure for a Law Firm
Attorneys have a unique set of considerations when choosing their tax structure due to their high incomes and professional regulations. State law limits the types of business entities you can select from, but you still have a number of federal tax options you can use to lower your taxes.
Check with Your State and Bar Association
State law and bar rules specify which types of business entities attorneys can use. Most notably, attorneys generally cannot form a business corporation.
Personal service corporation.
Professional limited liability company (PLLC).
Professional limited liability partnership (PLLP).
Federal Tax Rates
For sole proprietorships and partnerships, each attorney will pay their personal income tax rate on their share of the profits.
A personal service corporation may be taxed as a C-corporation or S-corporation at the firm's option. Firms taxed as C-corporations pay a flat 21% corporate income tax rate. Member attorneys also pay their personal tax rates on their wages and dividends. If the firm elects S-corporation status, there is no corporate tax. Each attorney pays their personal tax rate on their salary plus their share of the profits.
A PLLC can elect to be taxed as a C-corporation or S-corporation similarly to a professional service corporation.
State Tax Rates
Washington does not have a personal or corporate income tax, meaning that attorneys working only in Washington need only consider federal taxes. Other states may have a corporate income tax but no personal income tax, or they may charge corporations higher tax rates.
If you have clients in other states, you should review if you're liable for taxes in those states and how those states' tax rates affect your overall taxes for a given business entity type.
C-Corporation Election and Double Taxation
While the 21% tax rate of electing to be taxed as a C-corporation appears tempting, remember double taxation. You will first pay the corporate income tax and then pay your personal income tax rate on your salary and dividends.
You also can't avoid personal taxes by not paying yourself and leaving money in the corporation. Any accumulated earnings beyond the reasonable cash needs of the firm are subject to an additional 20% accumulated earnings tax.
C-corporation tax status will make the most sense when you are in growth mode and need to reinvest a large portion of your profits into the firm.
Is the S-Corporation Election Worth It?
The main advantage of an S-corporation is reducing the amount of income that you pay 15.3% in self-employment taxes on. When using a sole proprietorship or partnership, you pay self-employment taxes on every dollar of income. When using an S-corporation, you pay the same employment taxes on the income you count as wages but not on the income you count as dividends.
The catch is that you can't just choose to make your income dividends. You must calculate and take reasonable compensation in wages. For a solo attorney doing all of the work on your own, reasonable compensation will be almost all of your income. If you're a partner with several associates under you, you have a stronger argument to call more of your income (from their work) dividends.
However, the second catch is that you only pay the 12.4% Social Security tax that S-corporation status helps you avoid on your first $132,900 (in 2019). If your reasonable compensation is above that number, the S-corporation doesn't help reduce your Social Security taxes.
Qualified Business Income Deduction
The new (starting in 2018) qualified business income deduction also adds a wrinkle in planning. This deduction is a deduction on your personal tax return equal to 20% of your share of your firm's profits subject to certain limits.
Must Be a Pass-Through Entity
You must use a pass-through business entity. This includes sole proprietorships, partnerships, S-corporations, or other entities that are taxed as a partnership or S-corporation.
Personal service corporations taxed as C-corporations are not eligible.
Attorneys are a specified service business and lose the deduction if their personal income exceeds $207,500 as a single filer or $415,000 as a joint filer. For incomes above either $157,500 (single) or $315,000 (joint), the deduction is reduced.
Wages Don't Qualify
Wages received from an S-corporation are not qualified business income. If you use an S-corporation, only the dividend portion is eligible for this deduction. The salary portion is not. This further reduces the benefit of an S-corporation to attorneys.
Retirement Contributions Reduce Your QBI Deduction
Any retirement contributions you make as an employer reduce your business profits and therefore your qualified business income. In many situations, this won't matter since these contributions are a 100% deduction on their own. However, there are two planning moves to consider.
If you aren't maxing out your employer plus employee retirement contributions, contribute as an employee first. Your employee contributions don't reduce your qualified business income.
If you need to get under the income limits to receive the deduction, maxing out your retirement contributions as an employer may be able to get you there.
Talk to Your Accountant
Even though you likely have a thorough understanding of the legal ramifications of different entity types and the basics of taxation, there are a lot of moving parts that determine exactly how much you will pay in taxes. Ask your accountant to help you run the numbers for your specific situation.