Tax Tips for Law Firms

Law firms face many of the same tax issues and enjoy similar tax benefits as other businesses.  However, attorneys often overlook the tax issues and benefits for their firms while focusing on their client’s affairs.  Neglecting tax implications can cost the firm money in the form of lost benefits as well as greater accounting fees.  While your firm continues to finalize its taxes, consider the following eight tips to ensure accuracy and compliance.

1.  Have you structured your business properly?  Your choice of business entity may be the biggest factor that affects your tax bill.  Law firms can be sole proprietorships, partnerships or LLC, or corporations.  Two areas greatly affected by the choice of entity are self-employment tax and taxation of distributions.

• All the net income of a sole proprietorship is subject to self-employment tax.
• The net income passed through to the partners and members of partnerships and LLCs also are subject to self-employment tax.  All income is subject to income tax so cash removed from the business is spared from another layer of tax.
• The only income subject to payroll taxes in a C-corporation are the wages reported on your W-2. One-half of the payroll tax is paid by and deducted by the corporation.  However, distributions of profits as dividends to the shareholders will be subject to additional taxation.  This is the double taxation problem of a C-corporation.  Keep in mind also that dividends are taxed at a lower rate than wages.
• The shareholders of an S-corporation will incur payroll taxes only to the extent of wages paid to them (same as in a C-corporation).  The shareholders also pay income taxes on their share of the net income of the corporation, so subsequent distributions are generally nontaxable.  Legislation has recently been introduced in Congress to make the entire net income from an S-corporation service business subject to employment taxes as is the case in a partnership.

2.  Is your owner agreement viable? Many attorneys write excellent agreements for their clients but fall short in drafting their own firm agreements.

• Terminology is very important in drafting owner buy-out provisions.  Imprecise terminology for buy-outs can create ordinary income to the exiting owner rather than a capital gain.
• Allocation of current income can be complicated in a professional firm.  The allocations may look great on paper but are impractical in application. Have your accountant run the allocations using different assumptions before you actually have to compute allocations at the year-end.
• My suggestion: if you do not routinely write professional firm agreements, have an outside counsel write or review the agreement.

3.  Will you get tripped up on your compensation?  S-corporations are the second most common entity type (sole proprietorships are number one) and the IRS is taking a close look at them.  Even if Congress does not act on the legislation mentioned above, the IRS is looking diligently at compensation of S-corporation shareholders as part of an enhanced audit program of S-corporations.  Compensation first has to be reasonable to be deductible.  “Reasonable” generally means not excessive but commensurate with the employee’s duties.  However, you also cannot pay an unreasonably low salary to S-corporation shareholders and then make large distributions of cash that is not subject to payroll taxes. The IRS would likely argue that these types of distributions are actually disguised wages.

4.  Are your expenses appropriate?  The IRS is looking more closely than ever at expenses, particularly in S-corporations.  Mixing personal and business expenses is a bad idea.  Personal shareholder expenses like individual tax preparation, personal insurance, or personal vehicle and travel costs should not be claimed as business expenses.  The IRS is also closely reviewing unsubstantiated expenses.  You should be familiar with the level of documentation required for different types of expenses.

5.  Are you using the right basis of accounting?   The basis of accounting also affects your tax bill because it determines when you recognize income and expenses.  If you’re on the cash basis, you recognize income when you actually receive it.  If you’re on the accrual basis, you must recognize the income when you do the work and bill for it.

The right choice of accounting method depends on your particular practice.  There are also specific rules that prevent law firms from deducting expenditures on open cases for which they will be paid later.

6.  Do you have a retirement plan?  An appropriate retirement plan is a great way to defer tax on income.  The company (or owners if the firm is taxed as a partnership) receives a current deduction and the owner will likely be in a lower tax bracket when they actually receive the income.  Consider your goals when setting up a plan.

The Wall Street Journal1 recently pointed out that “making contributions to a retirement plan may help to save more taxes than merely the savings resulting from the contributions. The deduction for employer contributions reduces income, which may help owners to avoid higher tax brackets as well as the additional Medicare taxes scheduled to take effect in 2013.”

Many companies use 401(k) plans because they are relatively easy and inexpensive to administer.  Other qualified plans may benefit older or higher paid individuals.  There are also simplified plans for smaller employers.  The array of options requires careful planning with a qualified retirement plan expert.

1.  Did you buy equipment or improve your property?  The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 increased bonus depreciation for qualifying assets to 100%.  This bonus depreciation applies to assets placed in service in 2010 and 2011.  This includes qualified leasehold improvement property, which could apply to a law practice.

2.  Are you prepared for upcoming regulations?  You need to be prepared for two new reporting rules.

• You will need to comply with reporting requirements for the new healthcare act.  You are required to report, on each employee’s W2, the health care premiums you paid on the employee’s behalf for the 2011 tax year.  This is for data gathering purposes – these benefits are still not taxed.
• Starting in 2012 you will need to issue Forms 1099 to all vendors who provide either services or goods, including payments to corporations.  You should obtain Forms W9 now to gather the vendors’ information.  These expanded reporting requirements were enacted in 2010 in two pieces of legislation. These particular reporting requirements are the subject of current Congressional debate and may be repealed or amended.

These are just a few of the tax opportunities and risks specific to the legal profession.  Make sure you’re taking good care of your own practice, as you would for your clients.

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