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November 2011 Newsletter Article

Tax Implications of Opening and Operating a New Law Firm in Florida

1) Introduction

Many of us are deciding to open our own law firms.  Whether we decide to do so as solo practitioners or in groups, we need to be aware of the tax consequences of forming and operating a law firm.  Even though the federal tax laws regarding the formation and initial operation of a law firm may appear to be mere formalities, selecting the wrong business structure under which to operate may result in unintended tax liabilities.  This article examines the federal income tax and social security and Medicare tax implications for each type of business structure under which a new Florida law firm may operate.  It assumes that all of a law firm’s income is derived from the performance of legal services.

2) Business Structures Under Which Florida Law Firms Are Operated

Pursuant to Rule 4-8.6 of the Rules of Professional Conduct, new Florida law firm may operate under the following business structures:

  1. Sole proprietorship;
  2. Professional corporation (“P.A.”);
  3. General partnership;
  4. Limited liability partnership (“L.L.P.”); or
  5. Professional limited liability company (“P.L.”).

 

3) Federal Tax Consequences of Florida Business Structures

Overview of Federal Tax Consequences of Each Type of Florida Law Firm Structure

Federal tax law will classify each Florida law firm structure as one or more of the following:
1) Sole proprietorship;
2) C Corporation;
3) S Corporation;
4) Partnership; and
5) Disregarded as an entity separate from its owner (a “Disregarded Entity”).

The following chart displays the possible classifications for federal tax purposes of each structure under which a new Florida law firm may operate:

Florida Law Firm Business Structures for Florida Law Purposes

Default Tax Consequences

Possible Elections To Be Taxed As Other Structure

 

 

Sole Proprietorship

 

 

The Sole Proprietor Attorney Is Taxed on Income Earned in His Sole Proprietor Law Practice and is liable for self-employment taxes

 

 

None

Professional Corporation

 

Taxed as a C Corporation

 

S Corporation (File Form 2553)

 

General Partnership or Limited Liability Partnership

 

Taxed as a Partnership Corporation (File Form 8832) or S Corporation

 

 

 

C Corporation (File Form 8832) or S Corporation (Corporation (File Form 2553)

 

Single-member Professional Limited Liability Company

 

Treated as a Disregarded Entity

 

 

C Corporation (File Form 8832) or S Corporation (File Form 2553)

 

 

Multi-member Professional Limited Liability Company

 

Taxed as a Partnership

 

C Corporation (File Form 8832) or S Corporation  (File Form 2553)

Analysis of Each of Federal Tax Law’s Classifications of Florida Law Firm Structures

Classification 1: Sole Proprietorship

Income Tax Consequences of Sole Proprietorship Law Firms

If the sole proprietorship has employees, it requires an Employer Identification Number (“EIN”).  In addition, the sole proprietor lawyer annually assumes all income tax liabilities from his sole proprietorship.  He does so by (1) reporting his profit or loss from his law firm on Schedule C (Profit or Loss from Business) or Schedule C-EZ (Net Profit from Business); (2) attaching the schedule to Form 1040 (U.S. Individual Income Tax Return); (3) reporting the profit or loss on Form 1040; and (4) paying any resulting tax.

Social Security and Medicare Tax Consequences of Sole Proprietorship Law Firms

In the contexts of (1) earnings to an owner in a sole proprietorship or Disregarded Entity and (2) in general, a partner in a partnership, social security and Medicare tax is referred to as “self-employment tax,” or “SECA” tax (SECA is the acronym for the “Self-Employment Contributions Act of 1954”).  The sole proprietor lawyer is liable for 100 percent of the self-employment tax on the income from his sole proprietorship.  Note, however, that a sole proprietor may deduct 50 percent of the self-employment tax liability.

Self-employment tax is composed of (1) the social security tax, which, for the 2010 and 2012 tax years, consists of 12.4 percent of the first $106,800 of the sole proprietorship’s income; and (2) the Medicare tax, which, for the 2010 and 2012 tax years, consists of 2.9 percent of all of the sole proprietorship’s income.  Note that in 2011, the social security tax rate is reduced by 2 percent, and thus the total social security tax is 10.4 percent on the first $106,800 of the law firm’s income.

Classification 2: C Corporation (for P.A.s by default, and for general partnerships, L.L.P.s, and P.L.s by election through filing Form 8832 (Entity Classification Election)

Income Tax Consequences of Law Firms Classified as C Corporations

A C Corporation requires an EIN.  In addition, if a single-member P.L. wants to elect to be taxed as a C Corporation by filing Form 8832, it must first obtain an EIN. 

Regarding income tax liability, income from a C Corporation may be taxed twice.  First, the C Corporation is taxed on profits.  Second, the C Corporation’s shareholder is taxed when he receives a dividend from the C Corporation. 

The shareholder also is taxed when he receives wages from the C Corporation, but the C Corporation receives a deduction for paying the wages.  Thus, no double taxation occurs when the C Corporation pays wages to the shareholder.

A C Corporation can receive more, and larger, deductions for expenditures on fringe benefits, which include health insurance, medical expenses, and life insurance policies, than an S Corporation.  In addition, C Corporation shareholders, more often than S Corporation shareholders, can exclude from their gross income the amount paid for fringe benefits.  

Each taxable year, a C Corporation must file Form 1120 (U.S. Corporate Income Tax Return), and individual shareholders of a C Corporation report any dividends on Form 1040 and possibly Schedule B (Interest and Ordinary Dividends).  In addition, each taxable year, to the extent the shareholder receives from the C Corporation dividends or wages, the shareholder reports the dividends or wages on Form 1040 and pays income tax on the dividends or wages.

Social Security and Medicare Tax Consequences of Law Firms Classified as C Corporations

In general, in C Corporations, wages, but not dividends, are subject to social security and Medicare taxes.  In the context of wages to shareholders in C Corporations, social security and Medicare taxes are collectively known as “FICA” taxes (FICA is the acronym for “Federal Insurance Contributions Act”).  FICA taxes for the 2010 and 2012 tax year are composed of (1) social security tax of 12.4 percent on the first $106,800 of a shareholder’s wages; and (2) the Medicare tax of 2.9 percent of a shareholder’s wages.  In 2010 and 2012, the C Corporation shareholder recipient of wages pays one half of the FICA obligation and the C Corporation pays the other half of the FICA obligation.  Note that in 2011, the social security tax rate for shareholders is reduced by 2 percent, and thus the total social security tax is 10.4 percent on the first $106,800 of a shareholders wages.

Because of the potential double income taxation if the C Corporation law firm classifies a payment as a distribution, however, more favorable tax consequences may arise if a C Corporation law firm can reasonably classify a payment to a shareholder as wages, not dividends, and then deduct the wages as business expenses. 

Classification 3: S Corporation (only by a timely and valid election through filing Form 2553 (Election by a Small Business Corporation) for P.A.s, P.L.s, general partnerships, and L.L.P.s)

How a Law Firm Becomes an S Corporation

Major Trap: A law firm that for Florida law purposes is a P.A. becomes an S Corporation only (1) if it meets statutory qualifications; and (2) if it makes a timely and valid election to become an S Corporation.  Otherwise, the P.A. will be taxed as a C Corporation, thus subjecting it to potential double taxation.

Statutory Qualifications to Become an S Corporation

An eligible Florida law firm is taxed as an S Corporation only if all of the following are met:

  1. An S Corporation election is in effect for the year;
  2. The entity is deemed to be a domestic corporation;
  3. The entity’s shareholders are allowable shareholders, which include individuals, certain trusts, and estates, but do not include partnerships, corporations or non-resident aliens;
  4. The entity has no more than 100 shareholders; and
  5. The entity has one class of stock.

 

Election to Be Treated as an S Corporation

A new law firm that for Florida law purposes is a P.A., general partnership, L.L.P., or P.L. may elect to be an S Corporation by filing Form 2553.  The law firm must file Form 2553 no more than two months and 15 days after the beginning of the tax year the election is to take effect.  If the law firm is electing to be an S Corporation during a entity’s first tax year, in order for the S Corporation election to be valid for the first tax year, Form 2553 must be filed within 2 months and 15 days of the first date that the entity has shareholders, acquires assets, or begins doing business.  If the law firm fails to file Form 2553 within 2 months and 15 days of the first date that the entity has shareholders, acquires assets, or begins doing business, the election is treated as made for the following taxable year unless the law firm is able to convince the IRS that the failure to file a timely Form 2553 was due to reasonable cause.

For an election for a future tax year, a law firm eligible to elect to be an S Corporation may file Form 2553 at any time during the tax year preceding the tax year the election is to take effect.

Income Tax Consequences of Law Firm Classified as an S Corporation

In order to file Form 2553, an EIN is required.  In addition, each year, the S Corporation files Form 1120S (U.S. Income Tax Return for an S Corporation), but the S Corporation is not liable for federal income taxes.  Instead, only the S Corporation’s shareholders are liable for federal income taxes.  The S Corporation’s shareholders report their pro-rata amounts of the S Corporation’s annual profit or loss on Schedules K-1 (Form 1120S) (Shareholder’s Share of Income, Deductions, Credits, etc.) and on Forms 1040, and pay any resulting tax.

Social Security and Medicare Tax Consequences of a Law Firm Classified as an S Corporation

The social security and Medicare tax consequences of an S Corporation are similar to those of a C Corporation.  Wages, but not dividends, to the S Corporation shareholder are subject to FICA taxes.  They are taxed at the same rate as wages to a C Corporation shareholder.  Note, however that the IRS will reclassify a dividend as wages if the S Corporation shareholder does not receive as wages reasonable compensation for services rendered to the corporation.

Classification 4: Partnership

Income Tax Consequences of a Law Firm Classified as a Partnership

A law firm that is taxed as a partnership requires an EIN.  In addition, each year, the partnership files Form 1065 (U.S. Return of Partnership Income), but is not liable for federal income taxes on income earned in by the partnership.  Instead, only the law firm’s partners are liable for federal income taxes.  They report their pro-rata amounts of the law firm’s annual profit or loss on Schedule K-1 (Form 1065) (Partner’s Share of Income, Deductions, Credits, etc.) and on Forms 1040, and pay any resulting tax.

Social Security and Medicare Tax Consequences of a Law Firm Classified as a Partnership

All income to a partner of a law firm that is taxed as a partnership is subject to self-employment taxes.  Similar to a sole proprietor, a partner is liable for 100 percent of the self-employment tax on his income from the law firm at the same rates as a sole proprietor.  In addition, the partner, like the sole proprietor, may deduct 50 percent of the self-employment tax liability.

Classification 5: Disregarded Entity (for single-member P.L.s)

A Disregarded Entity law firm is generally treated like a sole proprietorship for federal tax purposes.
           
4) Conclusion

Lawyers interested in opening and operating a new law firm should use this article as a starting point in their examination of basic federal income tax and social security and Medicare tax implications of opening and operating a new law firm in Florida.  Once they have examined all relevant federal income tax and social security and Medicare tax issues, they then must decide which entity will benefit them most.  To effectively do so, in addition to analyzing the federal tax implications of each entity, the lawyers must examine Florida law, the Rules Regulating the Florida Bar, city and county ordinances, and possibly other federal law.  When the lawyers have addressed all relevant legal issues in regards to opening and operating a new law firm, they will be more likely to choose an entity structure that provides the most benefits to them and their clients.

*Neil I. Rumbak is a tax, estate planning, and corporate attorney with Rumbak Law, P.A. (www.rumbaklaw.com), in Pompano Beach, Florida.  He would like to thank Michael Citron for his excellent research assistance.


 


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