Regardless of whether you are just starting your own law practice or you have a well-established law firm, entity structure is something to consider. After all, your entity choice affects when you pay tax, what tax you pay, how the tax is paid, your liability in running the firm and much more. Here are a few options available to law firms. For a detailed analysis specific to your needs, you should contact your trusted advisor.
Single Member LLC (SMLLC) Taxed as a Sole
This entity is available if there is only one owner. Earnings will be reported on the 1040 (personal tax return) and are subject to self-employment tax (Social Security and Medicare). By creating an LLC, you are creating a separate legal entity from the owner. The owner will not be liable for debts of the business in excess of the owner's investment or for contracts of the LLC. However, the owner will be liable for malpractice claims which apply to all entity choices. Malpractice insurance should be held for this reason.
LLC Filing as a Partnership
This option is similar to the SMLLC, but allows for additional partners. A separate partnership return will have to be filed and all income and deductions will pass-through to the partners. The exact allocation of items of income and deductions will be allocated based on the agreements between the owners.
An S-corporation is a type of pass-through entity with its own rules. The key differences are the rules of who can form an S-corporation and that shareholders are paid reasonable wages. The rules to qualify as an S-corporation are complex, but the IRS provides a breakdown of the requirements. By paying shareholders a fair wage, you get to separate income subject to Social Security and Medicare. For example, for a lawyer that is a partner in a partnership, all income will be subject to Social Security and Medicare. But for an S-Corporation shareholder, only the wages will be subject. There is a discussion of changing tax law that could negate this benefit which is discussed later in this blog.
For an S election to be valid, each owner must receive the same pro-rata income and distributions per share. This does not mean that each shareholder-owner must receive the same W-2 wages in exchange for services.
A C-corporation is the only entity listed here that does not pass-through all income to the owner each year. The C-corporation earnings are taxed at the corporate level and are only taxed to the owner when dividends are issued. These two layers of tax usually result in a higher overall effective tax rate on income. However, just like the S-corporation, reasonable compensation will be paid to shareholders working at the corporation as wages. These wages will be subject to only one level of tax.
SPECIFIC RULES FOR PROFESSIONALS FORMING BUSINESSES
Certain states have rules that may require a specific formation type for certain industries. It is important to check with the state of filing for its laws.
Professional Limited Liability Company (PLLC)
Professional Limited Liability Company (PLLC) is a type of LLC which applies to only certain professions. Different states have different rules about professions that may – or must – use PLLC rather than a typical LLC. PLLC provides special rules to separate malpractice from personal liability. As noted above, business entities do not shield you from malpractice liability which is why malpractice insurance should always be maintained.
There are several other rules and regulations regarding PLLCs which differ between states. Often members, managers and the PLLC will have to hold a license specific to the field of service. Make sure that you work with an attorney who is knowledgeable about your state laws to ensure that you are in compliance with licensing rules in order to achieve the most effective liability shield available.
Professional Corporation (PC)
Professional Corporation (PC) is a corporation with a principal activity of performing personal services that are substantially performed by employee-owners. Similar to the PLLC, different states have different rules about what professions may – or must – use a PC, as well as what licensing is required for the PC and its members.
PCs will be categorized as C-corporations but, if qualified, an election can be made for S-corporation status. You will want to review your state rules regarding this election and also make sure that the PC qualifies based on the federal S-corporation rules.
CURRENT PROPOSED CHANGES
Proposed federal legislation would subject all pass-through business income of an individual with more than $400,000 of adjusted gross income (AGI) for the taxable year ($500,000 for married filing joint) to the 3.8% Medicare tax, either through the net investment income tax or the self-employment tax. The definition of net investment income would be amended to include pass-through income and gain that was not already subject to self-employment taxes for individuals above the AGI thresholds. This amendment, if passed, would apply to taxable years beginning after December 31, 2021.
This change would affect S-corporations. By paying wages and being active in their businesses, they can often avoid this tax on some of their earnings.
Choosing an entity for your law practice can be difficult as there are so many things that must be factored into it. Consulting with your trusted advisor before selecting an entity can help you choose what is right for you.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.