Law firms, like every other business, have to navigate complex tax liabilities. What many law firms may not realize, however, is that the business entity you choose to establish your firm under has enormous implications for your taxes – and by extension, your profitability and success.
If you are considering changing the corporate structure of your law firm, you’re probably asking yourself: Which structure is right when I start my law firm? If I start with one structure and find it isn’t a good fit, can I change it? Should I change it? What tax advantages can I gain from such a change?
Why become an S-Corp as opposed to some other tax entity?
Most attorneys choose to establish their firm as a Limited Liability Corporation (LLC) or a Limited Liability Partnership (LLP). Doing so limits personal liability and avoids the double taxation that occurs under C-Corporations, where both corporate income and payroll are taxed concurrently. Still, income from LLCs and LLPs are subject to the 15.3% self employment tax – that is, the individual income taxes for Social Security (6.2%) and Medicare (1.45%), as well as the other half of any employees’ payroll taxes (7.65%).
The best way for your law firm to save money on these taxes may be to take the S-Corp election, and thereby reclassify some of this income for tax purposes. If your law firm is incorporated as an LLC, you firm will remain an LLC; taking steps to apply for S-Corp status simply means you will be treated as an S-Corp when you file your taxes. This will allow you to pay yourself a reasonable salary and to deduct the employer paid payroll taxes (7.65%) on that salary as a business expense. This can add up to thousands in savings per year!
Now, you may be asking yourself: Can my law firm even take the S-Corp election? Here are a few rules your law firm must abide by if and when you are filing as an S-Corp:
- You must be a domestic corporation with NO foreign shareholders.
- You must have no more than 100 shareholders.
- Your shareholders must be only individuals, estates, exempt organizations, or certain trusts. (Spouses and any respective estates count as only ONE shareholder.)
- You must file the S-Corp 2553 Form.
- You must be willing to have a 52- to 53-week tax year that ends on December 31st.
- You must pay any owners fair salaries.
If your law firm – like many other small businesses – has cash flow issues, electing for S-Corp filing status means you can make distributions to shareholders monthly, quarterly, or annually, allowing for some much-needed flexibility. Moreover, because each distribution is based on your law firm’s performance and profits, you can better gauge your firm’s financial standing, and take any necessary steps to enhance performance and efficiency. Even better, these distributions are not subject to the 15.3% self employment tax, which saves you money!
With all this information in mind, you may be thinking: Why don’t more law firms choose to classify as an S-Corp?
It’s important to note that becoming an S-Corporation is not for every firm. However, if your law firm is an established business that is sustaining profits and expanding in terms of shareholders or employees, this election may save you money.
Unfortunately, even the most successful small law firms often lack experienced financial advisors that are familiar with the S-Corp tax status. Also, S-Corp formation can be difficult to navigate, and most small law firms don’t have the time or resources to handle the payroll requirements and S-Corp paperwork that are necessary to administer this change in tax status.
With the help of experienced bookkeepers and tax professionals, your law firm can take the S-Corp election with little to no hassle! Regardless of your law firm’s current tax structure, choosing to undergo the S-Corp election may be the best option to lower your firm’s tax liability and save you money!
