The best way to pay yourself as a lawyer is a matter of debate. However, determining the method that will work best for you is one of the most important things you will decide when establishing a law firm. Because your options are largely determined by how you structure your law firm as a business, it’s important to explore your self-paying options as early as possible.
Listed below are the three most common methods of self-pay for lawyers, along with the pros and cons of each method.
1. Draw Payment
Some law firms self-pay using draw payments. This means you’re choosing to pay yourself a portion of your firm’s profits. Sole proprietors and single-member LLCs can use this method. In this scenario, how much you pay yourself and how often is up to you. Draw payments are common across various small businesses because they’re flexible. The owner’s draw can be determined by how well the business is doing.
But draw payments have downsides, too – mostly around taxes. If the amount you pay yourself from your business is inconsistent, you’re more likely to draw scrutiny from the IRS. Even if your firm didn’t do anything unethical or illegal, audits can take up a lot of time and energy. Draw payments also mean that your taxes aren’t being withheld, so you will need to dedicate time and money to keeping up with quarterly payments and footing a large tax bill in April.
2. Distributive Share
In a multi-member LLC, lawyers who practice self-pay can take a distributive share instead of a draw. Distributive shares are the allocation of income from a business to a partner as determined by a partnership agreement. Distributive shares operate similarly to draw payments, but must be recorded on a Schedule K-1. Unlike draws, which are accounting transactions, distributive shares show up on tax returns. The individual partners must pay self-employment tax (Social Security and Medicare) based on their distributive share of the partnership, as shown on Schedule K-1.
3. Earned Salary
If you’re considering transforming your law firm into an S-corp, then the ways in which you can pay yourself will also be affected. S-corporation owners who work in the business they own can take a salary. Taking a salary from your law firm can make your personal and business finances more predictable and less labor-intensive: if you operate on a salary basis, you have more consistent numbers with which to plan your budget.
Determining the right salary for you can mean more work up-front. Tax laws and ethics rules mandate that you pay yourself “reasonable compensation” as a self-paying lawyer. Therefore, you should pay yourself a market-rate salary while also leaving your firm with enough money to meet other financial obligations.
To decide on an appropriate salary, you’ll want to track metrics to determine what your firm’s finances look like monthly and annually. Unlike lawyers who take a distributive share, law firms that are S-corporations must distinguish owners and partners from shareholders. Shareholders do not pay self-employment tax, because they are not considered owners. Although a salary gives you less overall flexibility than the draw approach, you can still adjust your salary from one year to the next.
Ultimately, you’ll want to use your law firm’s current corporate structure and financial situation to predict the pros and cons of implementing different self-paying methods for lawyers.
Looking at similar firms in your practice area can also help you make an informed decision. Whichever method you choose, you can pay yourself reliably and legally by identifying your firm’s legal framework and leveraging your practice management software.
