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Business Formation and Tax Considerations for Solos and Small Firms

Cameron Hillyer Davidson


  • Consider the pros and cons of the various legal entity options, including LLCs, PLLCs, LLPs, C corporations, and S corporations.
  • In a C corporation, a sole practitioner will want to reduce the corporation’s realized income by taking out as much compensation as is reasonable.
  • S corporations have added limitations that apply to the shareholders.
  • LLPs and PLLCs limit liability as to the other partner/member’s wrongful acts, as well as personal liability for the debts of the business.
Business Formation and Tax Considerations for Solos and Small Firms
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Aside from the familiar choice between a corporation, general partnership, or limited liability company (LLC), legal practitioners are afforded the option of particular professional entities formed under state law and registered with their local bar association. It may even be a requirement to form a professional entity if the company is to provide legal services. State professional codes will control which options a lawyer may have to choose from, so a starting point should be with your state bar. The decision to form a separate legal entity rather than practice as a sole proprietor should be predicated first on liability protection. In many states, attorneys cannot limit their liability for their own wrongful acts. If the practitioner is hiring employees, a professional corporation or professional limited liability company (PLLC) should insulate the practitioner from liability for the company’s debts and wrongful acts of employees. Only a practitioner bringing on a partner may form a limited liability partnership (LLP), and doing so will add a layer of liability protection from the wrongful acts of other legal partners.

Not all states permit LLCs to render legal services; California is among them (Cal. Corp. Code § 17701.04(b)). Where allowed, a PLLC offers an attractive pass-through vehicle without requiring two or more partners. Sole practitioners in states disallowing LLCs from providing legal services will have the professional corporation as their chief option. Professional corporations are governed by the same rules as apply to corporations generally with added requirements imposed by state bar registration. C corporations provide time-tested protection against personal liability for the wrongful acts of employees, but the corporate entity pays tax at its own rate before paying dividends to the shareholder. As discussed below, it is probably advisable in almost every case for a sole practitioner to elect for the firm to be taxed as an S corporation for this reason.

C Corporations

If taxed as a C corporation, a sole practitioner will want to reduce the professional corporation’s realized income by first taking out as much compensation as is reasonable. The compensation is an expense that will reduce the extent to which the sole practitioner is taxed twice on that single source of income (I.R.C. §§ 61(c)(1), 162(a)(1)). The key factor here is that such compensation is limited to the extent that it is reasonable. If it is determined to exceed a reasonable amount of compensation, the difference will be taxed as a dividend, leaving the attorney again to be taxed twice on that income (Treas. Reg. § 1.162-7).

There might still be ways a sole practitioner could zero out the income of their C corporation law firm. Whether by leasing property or contracting for services with the C corporation, a lawyer with a professional corporation taxed as a C corporation will engage in a strategy that focuses on limiting the C corporation’s realization of income. In the end, there will be a limit to how much a sole practitioner can mitigate the income realized at the corporate level, particularly as the receipts of the firm outstrip their own reasonable compensation. A lawyer might decide later to elect for S corporation status for this reason, but for reasons discussed below, the practitioner should consider making this election in the first tax year to avoid the added accounting headaches of a later conversion. It is also worth noting that a corporation of either C or S status should not be used to hold appreciated property if possible. A corporation will be forced to recognize a gain on appreciated property distributed to shareholders equal to the difference between the corporation’s adjusted basis in the asset and the current fair market value (I.R.C. § 311(b)(1)). Worse still, the corporation cannot recognize losses on that same distribution of property unless the distribution is made in complete liquidation (Id.). If the practitioner owns any capital assets to be used in connection with the business, particularly real property, the practitioner should consider holding said property through another vehicle such as an LLC and lease the property back to the corporation as needed.

Payroll Tax Considerations

A final advantage of a corporation, with or without the S election, is deducting the employer’s share of payroll tax. As discussed above, a C corporation shareholder will be incentivized to take as much as is reasonable out as compensation, meaning a greater deduction for Federal Insurance Contributions Act (FICA) taxes. As discussed below, the inverse might be true of corporations with an active S election. In either case, the amount of a shareholder employee’s renumeration that must be treated as wages subject to FICA is determined from examining the particular facts and circumstances and is subject to IRS reclassification (Joly v. Commissioner, T.C. Memo. 1998-361, aff’d by unpub. op., 211 F.3d 1269 (6th Cir. 2000)). It would be best for all practitioners to err on the side of caution when setting their wages, and the IRS provides the following factors to consider: (1) training and experience; (2) duties and responsibilities; (3) time and effort devoted to the business; (4) dividend history; (5) payments to non-shareholder employees; (6) timing and manner of paying bonuses to key people; (7) what comparable businesses pay for similar services; (8) compensation agreements; and (9) the use of a formula to determine compensation. Suffice to say, lawyers should set their compensation in accordance with the local norm for their area of practice and not get too creative with setting their wages if they want to avoid reclassification. Whatever amount is ultimately subject to employment taxes, the rate will be preferable to the Self-Employed Contributions Act (SECA) rates paid by sole proprietors.

S Corporations

S corporations are in most respects like C corporations, except that there are added limitations that apply to the shareholders. There may not be more than 100 shareholders, and there may be only one class of stock. In every instance, the sole practitioner would have little trouble qualifying personally as a shareholder of an S corporation. It is worth noting, however, that this will prevent other legal entities such as C corporations from participating in ownership. The advantage is that the income of the S corporation is only taxed on the shareholder’s return. This gives the attorney-shareholder many of the advantages of a C corporation without having to find a means to zero out the C corporation’s income through a combination of compensation and other expenses.

S corporations generally owe no tax on cash distributions to shareholders (I.R.C. § 1368(b)(1)); however, distributions of appreciated property will generate taxable gains on distributions to the shareholders (I.R.C. § 311(b)). For this reason, if the practitioner should own real property related to the business, it would be better not to have the professional corporation own this asset outright. One strategy might be to have a separate LLC hold such appreciated assets and lease them back to the professional corporation. As a pass-through, a corporation under an S election would also permit sole practitioners to mitigate payroll tax by setting their compensation to a lower reasonable figure and taking more of the corporation’s income out as a distribution if they so choose.

While there is certainly a preference for a sole practitioner to form a professional corporation and make an S election where local law does not permit PLLCs, the timing of the S election is another consideration. Practitioners may well infer that their own individual rates are higher than the applicable corporate rates and therefore seek to defer the S election until a later point when they can no longer find the means to zero out the professional corporation’s income, thereby taking greatest advantage of both. While this is at first promising, lawyers should be wary of the built-in gains of C corporations for ten years after making their first S election (I.R.C. § 1374). Gain on built-in assets can include both accounts receivable and corporate goodwill if the practice is sold within those first ten years after having made the S election (I.R.C. § 1374(d)(7)(A)).

Considerations in Making a Later S Election

C corporations that later make an S election do not get the full benefit of pass-through taxation in assets acquired by the corporation before the effective date of the S election and will need to carry forward built-in gains on these assets and realize the gain thereon when they are sold if they are sold in the first ten years after making the S election (I.R.C. § 1374). The upshot is that the S election cannot be used to avoid the double tax on assets the firm holds. This includes the accounts receivable of a cash method law practice. The shareholders would be well advised to purchase the accounts receivable, agreeing to pay the amounts received back to the corporation, and having the firm elect out of the installment method of reporting under I.R.C. § 453(d). This accelerates the income into the final year the corporation is taxed as a C corporation and avoids later paying the double tax on the amounts realized in a later year (Treas. Reg. § 1.1374-4(h)). If the practice is sold in the next ten years following the S election, the goodwill of the firm may also be subject to this carried over double tax from the final C corporation year (Id. § 1.1374-3(c)). This is all to say that the business owner would do well to make an initial S election when forming the professional corporation. The accounting challenges can be overcome with added preparation and the double tax mitigated by not having the C corporation hold such appreciated assets in the first place where possible.

QBID Considerations

A practitioner attentive to the recent changes in the law precipitated by the Tax Cuts and Jobs Act of 2017 may be familiar with the qualified business income deduction (QBID) (I.R.C. § 199A). The QBID was intended to give taxpayers operating a pass-through business such as an LLC or S corporation a special pass-through tax rate akin to the recently reduced C corporation rates. And as any practitioner may already be aware, there are limitations to the application of this special deduction. Chiefly, a specified service trade or business (SSTB), including legal services, is subject to an additional phaseout of the deduction (I.R.C. § 199A(d)(2)). The SSTB limitations don’t apply for taxpayers with taxable income at or below the threshold amount. Limitations are phased in between two inflation-adjusted thresholds, at present completely eliminating the deduction for joint filers by $415,000. This deduction isn’t available to the shareholders in a C corporation, so while it may at first seem to incentivize using a pass-through for your law practice, the income limitation means this will not be a deciding factor in initial entity selection.

Limited Liability Partnerships and Professional Limited Liability Companies

If sole practitioners decide to partner with another attorney in forming a new law firm, they will have the added option of forming either an LLP or PLLC. Functionally, the two are similar in that they will each limit liability as to the other partner/member’s wrongful acts, as well as personal liability for the debts of the business. For federal income tax purposes, an LLP is a general partnership (Treas. Reg. § 301.7701-2(a)). In states permitting the formation of PLLCs, this may prove the clear choice for practitioners as a single-member LLC in addition to practitioners partnering with another attorney. PLLCs, just as LLCs, have the option of selecting corporate tax treatment for their income or taxing the entity as a partnership. With respect to LLCs taxed as partnerships, there are additional pitfalls to be familiar with, and these concerns will extend to LLPs as well. Unlike the concern with corporations holding appreciated assets, distributions of appreciated property should rarely trigger tax on the gain, assuming the adjusted basis of such partner’s interest in the partnership is not exceeded by the built-in gains for the asset (I.R.C. § 731).

The key difference is in the liability for the wrongful acts of general partners. The LLP will insulate practitioners from their partner’s wrongful acts where a general partnership would not. This is also the aim of PLLCs. Partnerships offer some advantages in terms of their flexible management that can come with some accounting headaches if the partners are not mindful. In a professional setting, this may be less of a concern as the partners are less likely to engage in contributions of appreciated assets, but it could mean added complexity to liquidating distributions when a partner finally retires from the firm.

There is a long history of litigation considering whether a partner can also be an employee of the partnership. The partnership passes its income through to the partners in accordance with the operating agreement, which is reported annually to the IRS on a K-1 statement. The partnership itself pays no tax and files only an informational Form 1065. However, the IRS takes the view that this fixed, periodic payment to the partner is not compensation as an employee but a guaranteed payment in exchange for services rendered.

Options for Solos

As any firm continues to grow, it may become necessary to revisit its structure, but by front-loading some of the planning, sole practitioners can achieve the liability protection they would want from forming any legal entity paired with some tangible tax benefits. Where LLCs are not permitted to provide legal services, a professional corporation filing an S election will suit many practitioners who wish to remain solo. An additional partner will open up the opportunity to form an LLP in those jurisdictions not permitting a PLLC. Finally, a PLLC should be considered wherever that option is available. The advantages and disadvantages of each should be considered, and a tax professional should be consulted to tailor the analysis to the practitioner’s unique situation.