Finances for a Solo Attorney: Paying Taxes and Managing Income (Part 3 of 4)

In many ways, the toughest transition for solo attorneys is learning how to run a small business. First you need to set up bank accounts. Next, you need to figure out how to manage cash flow and lines of credit.

The next step is what I consider a good problem: what to do when you make money. Make sure you withhold for taxes and stuff some cash under a mattress for the inevitable bad month.

Yes, you have to pay taxes—start saving yesterday

In case you didn’t already know this, I’ve got some bad news: small business owners have to withhold and pay their own taxes. Solo attorneys are considered self-employed, which means you need to pay estimated taxes throughout the year, or take a penalty and write a big check at the end of the year (disclaimer: I am not an accountant or a tax attorney).

I know lots of solo attorneys and exactly 0.0% of them use a payroll service to pay themselves, which means they are responsible for withholding and paying their own taxes. Some of them, however are better at it than others. For many attorneys, settling a big case means it’s time to go buy a new car, a new computer, or a new suit. In other words: spend everything, assume you can withhold enough for taxes later. Last time I checked, some of those attorneys made installment payments to the IRS. I’d suggest avoiding that scenario.

Here’s an easy way to avoid that issue: open a distinct and separate bank account that only contains money saved for taxes. When the firm receives income, set aside 30%-33% for taxes. In all likelihood, that is an excessive amount. When you do your taxes (or hopefully an accountant/tax attorney does), you can pay yourself a nice bonus because you have an excess.The alternative is to guess low, and end up having to cough some extra cash to pay your taxes. I’d rather err on the side of caution, but depending on your financial situation, that may not be possible (see the previous installment on cash flow).

The reason to keep the money in a separate account is to ensure it doesn’t get spent and it is easier to track. If you simply put everything into your business checking, how do you know how much money is set aside for taxes? You probably don’t. Many banks charge a small fee for savings accounts, but you can usually get that waived by depositing a certain amount each month. Which means if you are withholding 30-33%, you should get any fee waived.

After another five years in practice, maybe I’ll figure out a better way. For now, however, stashing away the money in a separate account has been brilliant.

Open another account for a excess income

Cash flow for a solo attorney is like a roller coaster, but less predictable, and not as safe. Depending on your practice area, you might go months without a significant amount of income. One month you can make $15,000, but the next two might result in $2,500. I’m not pulling those numbers out of thin air—that is based on some real-life experience.

During a “bonzo” month, I don’t buy a new car, a new computer, or a new suit. I pay myself the same salary that I make when the income for the month is $50. The only reason I can do that is because I stick all the excess into my fourth account, my excess account. I call it the “rainy day” account. Or, practically speaking the “I can pay myself out of this account when I have a month that sucks” account.

You will have bad months. If you want to still pay yourself, then create an excess account. Even if you just need to float some cash to pay part of your salary, an excess account is perfect for that. I guarantee that psychologically speaking, having an account with a few extra months worth of salary is worth ten times the actual money in there. Even if you can’t afford to put much in an excess account, make contributions when you can.

Until you get used to the ups and downs of cash flow, just knowing you have a safety net is useful, even if you never touch it. Unfortunately, chances are you will probably need to use it at least once, or twice, but hopefully not to the point of draining it.

Maintaining financial sanity

Some attorneys spend inordinate amounts of time doing their works and paralyzed by the constant fear of not making money. The fear never goes away, but it does get better.

Next up: forecasting income, analyzing your balance sheet, and maintaining financial sanity.

(photo: http://www.flickr.com/photos/68751915@N05/6355816649)

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  • http://lawyerist.com/author/samglover/ Sam Glover

    This is fantastic, Randall!

    I’m going to open another savings account when I go to the bank today!

  • Trent

    If you are set up as a corporation you do not pay self employment taxes.

    • http://lawyerist.com/author/samglover/ Sam Glover

      No, but you still have to pay quarterly estimates.

      • http://consumerlawyer.mn/cgi-sys/suspendedpage.cgi Randall Ryder

        I am not a tax attorney or an accountant, but I believe sole proprietors of a LLC have to pay self-employment tax. http://www.irs.gov/taxtopics/tc554.html

        • http://lawyerist.com/author/samglover/ Sam Glover

          Yes, but LLCs and corporations have different tax rules.

          • http://consumerlawyer.mn/cgi-sys/suspendedpage.cgi Randall Ryder

            Reason #4,245 why I hire someone to prepare my taxes.

  • Jen Becker

    Someone was just laughing at me yesterday for my 4 accounts! Glad to see this – and see that there are others out there doing the same :)

    • http://consumerlawyer.mn/cgi-sys/suspendedpage.cgi Randall Ryder

      I hope you laughed at them back!

  • http://blog.simplejustice.us shg

    It’s not so much that there is a need for gimmicks like this to handle what should be obvious to any self-employed person, that taxes must be paid. What disturbs me is that you’re saying this to lawyers. If they don’t grasp this need without reading this post, what are they telling clients?

    Seriously, has law school (and whatever other generational issues exist) changed this much that new lawyers are either unaware, or can’t manage on their own (resist the temptation to squander their income?) to save enough money to pay their taxes without someone holding their hand? And we want to entrust clients to these lawyers? If so, things are even worse than I thought.

    • http://www.meganhuntlaw.com Megan C. Hunt

      Interestingly enough, Randall’s advice re: saving for taxes is the exact same thing my accountant told me at the beginning of 2011. (And it worked as he described — I ended up with a substantial surplus in that savings account.)

      I went to law school right out of college. Being a solo lawyer is the only “grown-up” job I’ve ever had. I knew I had to pay taxes, but I really had no clue about what the mechanism should be for doing so. I didn’t know if I would need to pay quarterly taxes immediately (I didn’t in the first year) or if I would need to pay payroll taxes when paying myself (I didn’t) — hence hiring an accountant in the first place.

      I disagree that if new lawyers aren’t saving for taxes they must be “squandering” their money. Sometimes, especially in the very beginning, there just isn’t enough money to go around.

      Quite frankly, this is the kind of advice new lawyers need the most: bad financial practices/decisions are often what cause lawyers to be desperate enough to “borrow” from their trust accounts.

  • http://constructionlawva.com Christopher G. Hill

    As one who uses a payroll service through my accountant’s office, I want you to know that you now know one who uses a payroll service. I am all for making sure I’m doing it right with a pro (my accountant). This was one of the first things I thought of when opening 2 years ago.

    • http://consumerlawyer.mn/cgi-sys/suspendedpage.cgi Randall Ryder

      Sweet! I’m curious about the logistics, do you pay them a big chunk, and they take out taxes and their fees, and pay you?

  • http://www.swoodlaw.com Stephen

    Great article! I found it extremely helpful.

  • Daniel Z

    This is great reading. As one who is just starting the process to go solo, I find the articles fascinating. I plan on taking your advice regarding finances. I am terrified, but I am confident with regular oversight and a thrifty attitude I should be okay. I hope.