Disclaimer. The following information is intended for general informational purposes only and does not represent tax advice to any individual or entity, either expressly or implied. Laws and regulations vary by jurisdiction and may change frequently. Compliance with such standards depends on one’s particular circumstances. Any reliance on this information is solely at the user’s own risk. Before making individual or business tax decisions, you are encouraged to seek professional tax advice.
You may also be interested in: Tax Tips for Attorneys in Family Law Practice
TAX TIPS FOR
(and small firms)
©2011 Kent Rackett
KENT RACKETT, Esq.
Tax & Business Lawyer
1350 Connecticut Avenue Suite 850
Dupont Circle, Washington, DC 20036
I. Formation. What entity best suits your practice?
A. The Sole Proprietorship. The simplest form of business entity, owned and operated by one person. Instantly receive an Employer Identification Number (EIN) online from the IRS to open a bank account. Report income and deductions from the law practice on Schedule C of your individual tax return (IRS Form 1040). Net income is taxed at your individual income tax rate and subject to an additional self-employment tax of 13.3%. In D.C., no business license is required, though if you practice under a trade name, you may want to register it.
B. The Partnership. Two or more attorneys, who share profits and losses in accordance with their partnership agreement, with unlimited joint liability for debts of the partnership. Though less expensive to form than a Corporation, there is no continuous lifespan as the loss of one partner may dissolve the partnership. Profits and losses are reported on IRS Form 1065, with net income flowing to the attorney’s individual tax return (Form1040), subject to the self-employment tax. To limit credit exposure to the partnership assets, one should form a Limited Liability Partnership (LLP) to protect the attorney’s personal assets. In D.C., the fees would consist of $165 to file the Statement of Qualification with the Department of Consumer & Regulatory Affairs and $220 for the biennial registration.
C. The S Corporation. Attorneys who form a corporate structure would not want to operate as a general C Corporation due to the unfavorable tax treatment of Personal Service Corporations that are taxed at a flat 35%. They may elect S- Corporation status, with all the benefits of a general corporation (asset protection, transfer of ownership, and a lifespan independent of its owners), combined with flow-through tax treatment to the individual owners. Income and deductions are reported on IRS Form 1120S. Profits flow through to shareholders on IRS Form K-1 to be included on the attorney’s individual tax return (Form 1040). Earnings of an S Corporation, after paying a reasonable salary to the attorney, can be passed through as distributions of profits and are not subject to self-employment tax.
Tax Tip: The most expensive to set up and operate, but well worth it as your practice grows and you’re making profits that surpass the ordinary attorneys salary, for example, when dealing with a class action or personal injury matter.
D. The Limited Liability Company (LLC). An enterprise that blends elements of the corporation and partnership, where owners, called members, function under an Operating Agreement. Members are not personally liable for debts of the entity, but are personally liable for their own negligence, wrongful acts, or misconduct. If the LLC has only one member, it may choose to be treated as a corporation, or it will be disregarded as an entity separate from its owner, thereby reporting business activity on Schedule C of Form 1040, in the manner of a sole proprietorship. If an LLC has two or more members, the IRS defaults to taxing the entity as a partnership, unless it elects be treated as a corporation. In D.C., attorneys who form an LLC must register as a Professional LLC, or PLLC. Registration fees are similar to that of an LLP.
II. Accounting and Tax Reporting
A. Cash-Basis Accounting. For simplicity, most solo practitioners account using the cash-basis method, recording income when it is received and expenses when they are paid. Because the nature of operating a law office does not generally require inventory or assets (other than a computer and bank account), a single-entry accounting system may suffice. Activity is recorded on the income statement, with little attention paid to the effect on the balance sheet. Records can be kept in a computerized spreadsheet. Information can then be given to a tax preparer to make adjustments for non-deductible items to arrive at the taxable income.
B. Bookkeeping Software. Accounting software programs, such as Quickbooks Online, are helpful in recording double-entry accounting, which tracks the impact of the balance sheet accounts. For example, if you receive a $5,000 fee for services rendered, you would book that as Revenue, which would automatically increase the assets in your Operating Account. Similarly, if you expended $1,000 in filing fees, this would decrease your assets. The balance of $4,000 in the operating account would constitute your equity in the firm. If you borrowed $500 from a bank to open the business, you would not book this as Revenue, but rather as an Asset and Liability, with no effect on equity.
ASSETS – LIABILITES = OWNERS EQUITY
Assets: Loans In, Accounts Receivable, Operating Account, IOTA Account, Computer Equipment, Auto
Liabilities: Loans Due, Account Payable
C. Constructive Receipt. For taxpayers using the cash receipts and disbursements method of accounting, an item is included in gross income when it is actually or constructively received. Income, although not actually reduced to the taxpayer’s possession, is constructively received in the taxable year during which it is credited to the taxpayer’s account, set apart for him, or otherwise made available so that he may draw upon it at any time. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
Tax Tip: The attorney may not postpone the recognition of income simply by leaving funds in a client trust account or IOLTA. Income is recognized as the work is performed and earned pursuant to the terms of the retainer, regardless of when the actual bank transfer is made.
III. Business Taxes
A. Income Tax on Profits. For the entity types discussed above, profits flow through to the attorney’s personal income tax return to be included in determining adjusted gross income on IRS Form 1040.
B. Self-Employment Tax. An additional tax on profit at the rate of 13.3% (comprised of 10.4% Social Security and 2.9% Medicare). All types of business entities in which the attorney actively participates are subject to the tax, with the exception of corporations or entities that choose to be treated as a corporation for tax purposes.
C. Estimated Tax Payments. Perhaps the biggest tax change for the solo practitioner accustomed to receiving a W-2 and having taxes withheld from the paycheck is having to remit quarterly tax payments to the IRS. Generally, the payments must be made in four equal quarterly installments (see Tax Calendar). The attorney can avoid penalties and interest for underpayment by having paid in at least 90% of the current year tax owed or 100% of the prior year tax.
Tax Tip: An attorney who receives wages in addition to self-employment income should consider increasing tax withholding on their W-2 to offset taxes due on profits from the solo practice.
D. Withholding Taxes. If you have employees, you must withhold from their pay their portion of the Social Security and Medicare taxes, in addition to the withholding for Federal and D.C. income taxes. This amount, plus the employer’s portion of the payroll taxes, must be deposited with the IRS. Depending on the dollar amount of taxes being remitted, the deposit schedule may be quarterly, monthly or more frequent.
Tax Tip: Because the penalties associated with failing to make deposits and making late deposits can be severe, I recommend the use of a professional payroll service, like the kind offered by many banks.
E. Sample Tax Calendar.
|Date||Description||IRS Form||D.C. Form|
|15-Jan||4th Installment of Estimated Tax Payments||1040-ES||D40-ES|
|30-Jan||Forms must be sent out to employees and contractors||W-2/1099|
|Federal Unemployment Tax Return||940|
|Annual Return of Withheld Tax||945||FR-900B|
|Employees 4th Quarter Payroll Tax Return due||941||FR-900Q|
|28-Feb||1099s and W-2s must be submitted to IRS and SSA||W-3/1098|
|15-Mar||Corporate Tax Returns due||1120-S||D-20|
|15-Apr||Individual Income Tax Return due||1040||D-40|
|1st Installment of Estimated Taxes due||1040-ES||D40-ES|
|Partnership Tax Return due||1065||D-65|
|30-Apr||Employeeâ€™s 1st Quarter Payroll Tax Return due||941||FR-900Q|
|15-Jun||2nd Installment of Estimated Taxes due||1040-ES||D40-ES|
|30-Jul||Employees 2nd Quarter Payroll Tax Return due||941||FR-900Q|
|15-Sep||3rd Installment of Estimated Taxes due||1040-ES||D40-ES|
|31-Oct||Employees 3rd Quarter Payroll Tax Return due||941||FR-900Q|
IV. Planning Considerations
A. The Home Office Deduction. Attorneys that maintain an office in their home may deduct a portion of their carrying costs in relation to the size of the space that is used exclusively and regularly as the primary location where business is conducted. This deduction works nicely for many start-ups that work primarily from home and maintain a virtual office.
Tax Tip: Even if you maintain a permanent office, you can still utilize the home office deduction, if you regularly meet clients at home.
B. Travel & Auto Expenses. Attorneys who use their car for travel in their practice may deduct either the actual expenses (gas, parking, repairs, and depreciation) or the standard mileage rate of 55.5 cents per mile for the business use of their personal car. The IRS requires the use of a mileage log to record business activity. An attorney whose principal place of business is their home can deduct travel to their virtual office, court and client locations.
Tax Tip: Attorneys who are considering purchasing a new car may write off up to $11,700 in accelerated depreciation in the year of purchase, provided the business use percentage is greater than 50%.
C. Meals & Entertainment (M&E). The attorney can deduct 50% of the cost of M&E with existing clients to discuss a legitimate business purpose. For potential clients, the attorney must have more than just a general expectation of a future business benefit. Similar to the mileage log requirement, a journal of the time, place, client, and business discussed should be kept. You cannot deduct the cost of your own daily meals just because you are self-employed, unless you are traveling away from home on business. However, the attorney attending a bar association meeting may deduct the cost of his own meal as entertainment.
D. Employees vs. Contractors. As the practice grows, you will likely utilize the services of a third party. Careful consideration should be given to whether this individual should be classified as an employee (in which case taxes must be withheld) or as an independent contractor. The IRS evaluates evidence of the degree of independence and control over the relationship. Generally, if you hire a paralegal, the IRS will construe this as an employment relationship, compared to the hiring of an accountant, who exercises independence in his role.
Tax Tip: Attorneys who have paid $600 or more to individuals for non-employee compensation, including other attorneys, are required to file IRS Form 1099-Misc, following the year of payment.
E. Saving for Retirement. Generally, taxpayers saving for retirement may contribute up to $5,000 ($6,000 if over age 50) to an Individual Retirement Account (IRA).
Tax Tip: Self-employed attorneys seeking a greater contribution rate (as much as 18.5% of profit) may find it beneficial to establish a Simplified Employee Pension (SEP-IRA).
F. Health Insurance. Self-employed attorneys may deduct the cost of premiums for medical, dental, and long-term care expenses for themselves, their spouses, and their dependents, so long as they are not eligible to participate in coverage in a spouse’s employer-sponsored plan.
Tax Tip: Younger, healthy attorneys who may go months or years without visiting the doctor, may find it more cost beneficial to contribute to a Health Savings Account while enrolling in a high deductible catastrophic health insurance plan.
About the Author: KENT RACKETT is an attorney admitted to practice in the District of Columbia and New York. Having successfully passed the CPA exam after college, he pursued his interest in tax by working for accounting firms before attending New York Law School. He focuses on helping individuals and small businesses save money, while protecting and enforcing their rights in the areas of tax counseling, business law, estate administration, elder law, and government benefits. Having relocated from Manhattan to D.C., he still serves as a court-appointed guardian for minors and the elderly in New York City. As a niche, he serves as an accountant and consultant to attorneys, assisting them in setting up their practices, accounting and preparing tax returns, and consulting on aspects of tax law that arise in connection with their client’s legal matters.
IRS Circular 230 Disclaimer: Any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein.