Many successful solos operate their law practices as corporations, LLCs, or other business entities. A separate business entity can reduce taxes and protect you from certain business liabilities. In one famous example, former vice-presidential candidate John Edwards made $25.5 million from 1995 to 1998 as a personal injury lawyer in North Carolina. According to Professor Walter Schwidetzky, writing for the Taxprof blog, Edwards saved about $600,000 in taxes by operating as an S-corporation as opposed to a Schedule C sole proprietorship. I assume some of the tax savings were used to pay for his expensive haircuts.
But there are also many solo practices operating under a limited liability entity with no income or profit. Regardless, owners have to pay the state’s annual entity fee and separate entity income tax returns on top of their personal income tax returns.
So when does it make sense for solos to set up a separate business entity? By far, the most common choices are a limited liability company (LLC) or a corporation with S-corporation tax treatment. At times, I will use California law to illustrate the costs and nuances involved.
Non-Tax Issues to Consider
First off, as a solo lawyer, be aware that setting up a corporation does not give you malpractice protection—even if the malpractice is committed by your employees. Also, employee injuries must typically be covered by worker’s compensation insurance.
Second, check to see if the business name you want is available for use. If you have a common name (for example, Sam Glover), you will not be allowed to use it as your business name if someone else is using it first.
Third, check to see if your state prohibits professionals from creating certain types of business entities. In California, lawyers are not allowed to use LLCs to set up a law practice.
Finally, if you plan to buy or refinance a house in the near future, check with your lender to see if setting up a separate entity will have an adverse effect on your loan application process.
Tax Treatment of Business Entities
A solo practitioner with no separate business entity has to pay self-employment taxes—on top of income tax—on the business’s net profit. Self-employment taxes are the equivalent of payroll taxes for business owners to fund Social Security and Medicare. For 2015, the first $118,500 of profit is subject to a 15.3% Social Security and Medicare tax. Any profits higher than that are subject to a 2.9% Medicare tax with a 0.9% increase for profits exceeding $200,000 for single people and $250,000 for married people filing jointly.
Generally, LLCs are given the same tax treatment as sole proprietorships. This means the LLC’s income and expenses are reported on the Schedule C of the federal income tax return. This makes tax return preparation simpler and less expensive, but the entire income is subject to self-employment taxes. LLCs can elect to be taxed as an S-corporation by filing a Form 8832.
Corporations have to file separate tax returns where it reports its income, expenses and its net profit. There are two types of corporations for tax purposes: the C-corporation and the S-corporation.
C-corporations are discouraged for most lawyers; the IRS considers them to be a “personal service corporation” and taxes corporate profits at a flat 35% rate. Also, C-corporations are infamous for its double taxation rules: one tax at the corporate level and the other at the personal level as dividend income.
In many states, this can mean a tax disaster. For example, California imposes its own flat tax of 8.84% on corporate profits which means that fifty percent of your profit will be used to pay federal and state income taxes.
To avoid double taxation, owners of C-corporations pay out its entire corporate profit to its owners as a salary. But this salary is subject to payroll taxes which can defeat the purpose of setting up a corporation for tax reduction purposes in the first place.
An S-corporation is the preferred business entity because its profit is not subject to double taxation. It is also not subject to the 35% personal service corporation tax rate mentioned above. Instead, the S-corporation’s profits pass through to the owner’s personal income tax return.
An S-corporation pays its solo practitioner owner in two ways. The first is by an owner’s draw from the profit, also known as a distribution. The distribution is only taxed once at the individual income tax rates and is not subject to the self-employment tax.
The second way an owner is paid is by salary. The IRS requires S-Corporations to pay its owners a reasonable salary in the same way they would pay an employee. Like a typical employee, he or she is paid on a regular basis and it is subject to self-employment tax. One half of the tax is paid by the corporation and the other is paid by the employee through withholdings. The corporation deducts the salary and payroll taxes as a business expense on its income tax returns while the salary is reported as W-2 income on the owner-employee’s personal tax returns.
So in essence, S Corporations reduce taxes by minimizing (but not eliminating) self-employment taxes. While Schedule C sole proprietors have to pay self-employment tax on its net profit, S-corporations can manipulate how much self-employment tax is paid by adjusting the employee salary.
Owners of S Corporations would be tempted to avoid payroll taxes by paying themselves a minimum wage salary and distributing the rest. But the IRS requires S Corporations to pay its owners a reasonable salary. What a reasonable salary is depends on the facts and circumstances. Solo practitioners would have to estimate how much other attorneys in the area with similar specialties and credentials are paid.
But it is not always advantageous for S Corporations to pay its owners a low salary, even if it can pass IRS scrutiny. If the owner plans to participate in a SEP-IRA or a self-employed 401(k) retirement plan, the corporation can contribute a percentage of the employee salary (but not distributions) to the plan and deduct it as a business expense. So a larger salary allows a larger tax-deductible contribution which may provide bigger tax savings in the long run.
Finally, another benefit of an S-corporation is that according to statistics, the IRS is less likely to audit an S-corporation tax return as long as it complies with the reasonable salary rule described above.
Performing a Cost-Benefit Analysis
Setting up a business entity can reduce taxes, which is ultimately about saving money. But if the cost of keeping the entity is higher than the tax savings, then you are doing it wrong. Here are a few routine costs that arise while maintaining a separate business entity. While they are relatively small individually, they add up.
- Fees. Most states require you to pay an annual fee to keep the entity in good standing. For example, in California, corporations have to pay a 1.5% tax on its profits. But even if the corporation is not profitable for the year, it is required to pay a minimum $800 franchise fee. Some cities may charge higher annual business license fees for corporations.
- Other taxes. Since corporations require owners to be employees, they must also pay state taxes for employers. For example, in California, employers must pay quarterly unemployment insurance taxes, employee training taxes, and state disability insurance taxes.
- Tax return preparation. Business entities generally have to file separate tax returns. In most cases, this is not too problematic. But if the corporation’s income and assets exceed $250,000 for the year, you are required to complete a very complicated, intrusive, and time-consuming Schedule L (balance sheet) and Schedule M-1 (reconciliation statement). On top of all this, you will also have to file quarterly employment tax returns, make monthly tax deposits, and submit annual Form W-2s and 1099s. All of this additional work will require a professional tax preparer and payroll servicer.
For these reasons, I generally do not advise solo practitioners in California to incorporate for tax purposes unless their net income is consistently above $54,000 per year. This is because at that amount, the corporate income tax exceeds the $800 minimum franchise fee.
What’s Right for Your Practice?
While your decision to set up a professional entity will depend on many factors although, for solo practitioner lawyers, taxes play a significant role. It is best to meet with a tax professional who can compare the tax consequences while taking into account your current income and future income projections.