Once you actually start a law practice you will have to decide how to operate. What type of tax classification will you choose? Will you be an LLC, a corporation, or a sole proprietorship? When choosing how to operate, people generally have two things in mind – taxes and liability. As a tax lawyer, I deal with these issues quite often. And I have a simple rule of thumb. Simpler is better.
First, let’s discuss liability. People often believe that if they form a corporation or an LLC or LLP, people will no longer be able to sue them. This is false. If only it were so easy!
Unfortunately, anyone can be sued for their own negligence, regardless of whether they were working for a corporation or entity at the time. For instance, if you form David the Lawyer, Inc., your clients can still sue you personally, even for mistakes that you made while working for the business. This is because any conceivable mistake could be attributed to you personally. So your clients could sue you for your own negligence and then seize your personal assets like any other judgment creditor. The same would be true even if your paralegal or assistant had made the mistake. Similarly, the client could sue you personally, for being negligent in hiring or supervising this person.
So what is the solution? In a word, insurance. As a solo attorney, insurance—not an LLC or corporation—is what provides you with real liability protection. This is why I encourage many small business owners to forgo forming a complicated entity and simply act a sole proprietor. It’s a much simpler way of doing business and it is much more cost-effective. Entities require administrative work, incur complicated state taxes and fees and often require you to file additional tax returns, which you may need to hire someone to prepare. While an S-corporation, LLC and sole proprietorship are all treated the same for federal income tax purposes, forming an S-corporation or LLC may require you to make additional filings with the IRS and prepare additional tax returns. There are state tax pitfalls too. Here in California, corporations and LLCs are charged $800 per year, even if they never make a dime. Pennsylvania has a complicated regime of its own, which includes a capital stock and franchise tax (among others).
Trust me, when you are just starting out, you will have enough problems to deal with. Keep your business simple. Save the time and money, form a sole proprietorship and buy some good insurance. To make things even easier, include your full name in the business. This way you don’t even have to file a fictitious business name statement with the county. For instance, I operate as the “Law Office of Douglas Greenberg.” As the Law Office of Douglas Greenberg, I never had to file a fictitious business name statement (there’s nothing fictitious about it). I just went to the bank, got a business account, got some good malpractice insurance, and went on my way.
All opinions, advice, and experiences of guest bloggers/columnists are those of the author and do not necessarily reflect the opinions, practices or experiences of Solo Practice University®.
What about self-employment taxes, which are more easily avoided by forming an S-Corp and paying yourself on a W-2?
With respect to the S-Corp, you can avoid SOME self employment taxes.
These taxes only apply up to $106,800; and you still have to pay yourself a reasonable salary, which is deducted from the $106,800. You will have to pay payroll taxes on the reasonable salary. So, if you, and hopefully the IRS, considered $55,000 year reasonable, you would save the taxes on only $51,800. ($106,800 – $55,000) That does come to several thousand dollars and is a savings.
However, you will have to pay a tax preparer or accountant to do payroll paperwork and calculations. Your tax preparation bill will also be significantly higher because you will need a professional to do your corporate taxes. You could opt to at least save by doing your personal taxes. Doing the corp taxes, even with software, is very difficult so I don’t believe it is an option.
The better idea is to find an inexpensive tax preparer rather than an accountant in order to save on payroll calculations and processing and taxes. They all run the information you provide through software anyway.
I’d say if you are solo with no paid help, the insurance without corporation option is a good idea. With an employee, you may want to consider a corporate option. Its good to start with simple, if you are making a good income, then at least you have the money to pay for the extra tax and payroll bills. And, the these bills are tax deductions too.
Ray
I’m sure that everyone is keenly aware that both States and Federal are looking for ways to get money, and are using misclasifications to obtain revenue.
Misclassification has proven to be a large money maker for them. If you are paying anyone as an independent contractor, you are begging for an audit. They come in and announce that your independent contractor is an employee, and now you owe back payroll taxes along with interest and penalties.
This is very effective where you have a big project and the alleged contractor is working solely on your project. To prevent this from occuring, be sure the independant contractor has: 1. insurance 2. business cards 3. a DBA or Corporate entity. 4. Has at least some work with someone else as a contractor.
The problem is that in many cases, they are independent contractors. But the IRS and States have increased revenue by going fishing for independent contracts that they can allege are in fact, employees. The more contractors they convert to employes, the more revenue is generated.
Ray
Great question. S corporations are often used by self-employed and small business persons. Since the distributions from an S corporation are generally exempt from FICA (social security and medicare) taxes, a common strategy is to pay yourself a low salary and take the majority of the business’s income as (payroll tax-free) distributions. This probably wouldn’t be advantageous for a solo just starting out but it might be for someone who is starting to make a comfortable living.
The main problem with this is that it is a fairly shopworn strategy. The IRS is well aware of the incentive to pay yourself an unreasonably low salary. In fact, this actually became a problem for John Edwards, the former presidential candidate. So taxpayer beware.
There is also a marketing advantage to creating an entity, if your jurisdiction permits trade names. You’ll want a corporate entity version of that trade name over a d/b/a version for sole proprietorship.
In addition, as you grow, you want a history of doing financial business as a business so you can get away from having to give personal guarantees. That’s easier done with an LLC and its EIN, versus securing an EIN as your SP, then abandoning it later (and losing that good banking and financial history).
Finally, I’ll challenge the notion that spending $800 should dissuade a lawyer or business owner from taking any particular action. If $800 is going to make or break you, your troubles are bigger than choice of entity.
Victor
I very much agree with Douglas. I have never understood why a solo attorney feels the need to spend money, time and effort on fictitious entities. Admittedly, in Texas you cannot use trade names. Even if you could it is rare that you would wish to do so. It is best to build a brand on your own name. Victor knows I like him very much, and I appreciate his opinion greatly. But, in this instance, I disagree there is any real marketing or financial advantage to a corporate entity. And, to the extent there is some, they are far outweighed by the additional cost of such an entity. Banking fees for checking accounts and the like are cheaper to maintain for a solo over a corporation. In Texas, although there is no income tax, there is a very similar franchise tax that applies to these corporate entities, but not to solos. There is also the additional cost of tax and bookkeeping compliance issues. Even if all of this amounts to a few thousand a year, it is a few thousand a solo can take home and spend on family or in paying off student loans. (Remember those). Although I agree that the cost of incorporation or setting up an entity is in and of itself a deal breaker, most people starting out only have so much money (and generally not enough) and it can be spent quickly. There are many choices that need to be made, and the money saved here is money that can be spent elsewhere, such as marketing. I know of no circumstance in which a fictitious entity is responsible for bringing a paying client through the door. But, I can think of any number of instances where $800.00 in marketing can bring in many times that amount. I also agree that if it is a matter of such an entity or malpractice insurance, the money is better spent on malpractice insurance.
What about contract liability, say for a long term lease that you have to bail on? Incorporation would protect you there, as well as for any other contracts you sign. I also dispute the notion that a negligence claim can pierce through a corporate veil if your engagement, via appropriate fee agreement, is between the PC/LLC and the client. In any event, that’s what malpractice insurance is for.
There’s also a lot more tax benefits from being an S-corp like the ability to deduct business expenses, perhaps more aggressively than if a sole proprietor.
To the query “What about contract liability, say for a long term lease…” very few commercial landlords will accept a lease in the name of a new entity without a personal guarantee from the individual owner him/herself. So in theory there may be a distinction but in practice, the liability is about the same.
A primary advantage to incorporating / forming an LLC for a law practice comes into play when the solo attorney hires staff. While the attorney cannot avoid negligence based claims with an entity, if the entity is the employer, the attorney will not face a number of employment based claims personally.
I just went solo this past Monday, and here in Texas, I formed a PLLC. It is 100% true that you as an attorney are liable for malpractice. No corporation, LLP or LLC or whatever shields you from legal malpractice. If I goof up and a client sues, I am always personally liable.
And in Texas, yes, a PLLC is subject to Texas franchise tax, while a sole proprietorship is not.
So why did I go the PLLC route?
1.) While I’m always personal liable for malpractice (Which is why you get insurance if you are concerned), I don’t want to be personally liable for other debts of the PLLC. Maybe my firm goes belly up and has vendors trying to collect. With the PLLC, they won’t touch my personal assets. WIthout it they could get a judgment against me. And since I will be paying myself most of what the PLLC makes, the PLLC won’t have much cash/assets on reserve anyways, making it fairly judgment-proof.
2.) Like the last post says, if I am in a position to grow and hire employees, I am ready to go (don’t need to wait to form an entity) and again, not worry about being personally liable for employment claims and what not.
3.) This is a very minor thing, but there is an added sense of professionalism with your own firm vs. you as a sole proprietor. It’s like how they tell solo’s don’t just use a gmail address (or if you have to, like me, buy a domain and have your e-mail forwarded to your gmail). It’s not a huge deal, but does add to the professionalism. Could matter when getting a client.
To me all of this tilts towards an entity like an LLC or S-Corp, even if in Texas you pay a miniscule franchise tax (like 1%) and you don’t even trigger that tax until you have significant revenue (right now $1.03M, but will fall back to $600k in 2014, like when I first file an annual report and see if I have franchise tax due), so if, in Texas, you are a solo and actually cutting a check to Texas for franchise tax, you are doing quite well. I would go nuts if next May 2014 (When I file my first annual report to TX for franchise tax purposes) I had to pay franchise tax, hence made $600k or more.
I disagree, every professional who is making $100k or more should definately be an S Corp. The payroll tax savings are huge. The John Edwards case was a non issue because Edwards paid himself at least $360,000 in salary every year. Way above the FICA limit but saved hundreds of thousands of $$$ because the profits were not subject to medicare taxes (2.9% at the time, now 3.8% in 2013 and beyond).
There is no way the IRS was going to argue that $360K was not enough salary because it would kill them at the C Corp level when they argue unreasonable comp issues.
If you consisently make $100k or more, S Corp is the way to go. Plus you greatly reduce your audit chances