Should you incorporate your firm as an S corporation?
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The business entity you select for your firm has enormous implications for your annual tax liability. In addition, determining whether to make additional tax elections with the IRS can be one of the more confusing aspects when establishing a law firm. Which structure is right when you start your firm? Should you start with one structure and modify it down the line? What tax advantages could you gain from a change?
Most firms opt for a structure that limits personal liability and avoids double taxation in the form of a pass-through entity such as a limited liability corporation (LLC) or limited liability partnership (LLP).
These structures vary from state to state, but they all eliminate the double taxation inherent in C corporations, where corporate income is taxed once and payroll is taxed again. But by using an LLC or LLP instead of a C corporation, the tax consequences are still substantial; the income from the business flows through to your personal return and is subject to income tax at your individual tax rate, Social Security (6.2%) and Medicare (1.45%).
And the business is liable for the other half of the employee’s payroll taxes (another 6.2% + 1.45%). That 15.3% in addition to federal and state income tax is sometimes referred to as the small business tax.
The best way to save money on taxes is to reclassify some of that income, and that process is made much easier if an LLC or LLP elects to be treated as an S corporation for tax purposes. There are a few important considerations. First, taking the S corp election does not change the structure of your company; it changes the way you file the taxes.
Instead of filing Schedule C on your personal return (single-member LLC) or Form 1065 (LLPs and multimember LLCs), you will file a separate S corporation return (Form 1120-S). So if you are incorporated as an LLC, you will stay an LLC, but you will be treated as an S corporation when you file your taxes.
Who can take the S corp election?
There are a few rules about who can take the S corp election, including:
- You must be a domestic corporation and file Form 2553.
- You must have no more than 100 shareholders. Spouses and their estates can count as only one. (Please note that many states have rules limiting ownership of law firms while some have relaxed this rule. These rules may limit who can own shares of the newly formed S corporation.)
- Your shareholders must be only individuals, estates, exempt organizations or certain trusts.
- You may not have non-resident alien shareholders.
- You can only have one class of stock if you have issued stock.
- You must be willing to have a 52- to 53-week tax year that ends on December 31.
Most law firms can meet these requirements to qualify for the S corp election, but maintaining that status to minimize taxes requires an additional step: paying owners a fair salary. The S corp election still treats your company as a pass-through, meaning income flows to your personal returns and is not subject to payroll taxes. But the IRS requires that shareholders of S corporations who also perform services for those businesses receive a salary. That salary is subject to payroll taxes, and S corporation shareholders who failed to pay their share of payroll taxes have had their S corporation status revoked, leading to additional taxes and penalties. To avoid that unfortunate situation, there are two ways to compensate shareholders:
• Pay yourself a reasonable salary. This is the amount you would pay another person to do your job or the job of each shareholder (owner). This is taxed at the same rate as an LLC. Please note that each shareholder can earn a different salary based on tenure, experience, etc. However, each shareholder must meet the minimum threshold.
• Pay earnings on top of your reasonable salary as a distribution. The money distributed to shareholders in this fashion is not subject to the 15.3% payroll tax, which lowers tax liability and saves money.
What does the IRS consider a “reasonable” salary? That depends on comparable salaries in your area. Websites like salary.com and glassdoor.com are great places to start comparing. In some instances, a large contingency award may make a temporary adjustment of your “reasonable salary” necessary. Be sure to consult your tax professional if you work on contingency.
The bottom line
Is all of this extra work worth it? Take a look at the scenario below. It is a general table for a single owner who is not married, but it could easily translate to multiple owners and would apply for those filing as married with some bracket adjustments. Salary and income tax vary by state. Click here for state-specific tables. Adjusted gross income paid as salary, distributions, and state income tax vary by state because a reasonable salary differs based on where you live. Click here to find that information.
Sample Law Firm, LLC Filing as LLC
| Adjusted Gross Income | Federal Tax (24%) |
State Income Tax (if applicable) |
Payroll Tax (15.3%) |
Total Tax Liability |
| $125,000 | $30,000 | Click here to see state-by-state tables | $19,125 | $49,125 |
Sample Law Firm, LLC Filing with S Corp Election
| Adjusted Gross Income Paid as Salary |
Federal Tax (24%) |
State Income Tax (if applicable) |
Payroll Tax (15.3%) |
Total Tax Liability |
| $75,000 | $18,000 | Click here to see state-by-state tables | $11,475 | $29,475 |
| Adjusted Gross Income Paid as Distributions |
Federal Tax (24%) |
State Income Tax (if applicable) |
Payroll Tax (15.3%) |
Total Tax Liability |
| $50,000 | $12,000 | Click here to see state-by-state tables | $0 | $12,000 |
Total Tax Liability = $41,475
Total Savings = $7,650
This is a simplistic example, and there are lots of possible tax scenarios that will vary based on individual circumstances. However, the basic math does not lie: For many firms in most states that pay their owners more than $80,000 per year, the S corporation makes sense.
Other advantages
There are two other advantages to taking the S corp election:
• You can take distributions monthly, quarterly, or annually. This allows for some flexibility in cash flow. Many small businesses have cash flow issues, and this can help provide a cushion.
• You can enhance business operations. The amount of each distribution is based on how the company is doing. This can help encourage all partners to ensure that business is running at peak efficiency.
This raises the question: Why don’t more businesses elect S corp status? Most small businesses are unfamiliar and/or don’t have advisers to explain the options. In addition, most small businesses don’t have the infrastructure to handle the payroll requirements and forms necessary to administer this change. Hiring a professional can help.
Regardless of your business structure, the S corp election can be a good option to lower your tax liability and save money. It is not for everyone, but if you’ve been in business for a while and have built a firm that is bringing in a substantial profit, this election may save you money.
Corrected at 4:00 p.m. on July 16 to state that firms wishing to take an S corp election must not have any non-resident alien shareholders.
Editor’s note: A version of this article was originally published in the December 2020 issue of Colorado Lawyer magazine. It has been modified since its original publication.
John Hermanson is the managing partner of Amicus Curiae Bookkeeping, which specializes in bookkeeping, tax planning, tax filing, payroll, invoicing and bill pay exclusively for attorneys. He has two bachelor’s degrees and two master’s degrees, all from Colorado State University.
Matthew Muncey is a CPA and tax specialist with Amicus Curiae Bookkeeping. He has experience in tax planning, audit support, financial consulting and general business matters impacting individuals, small businesses, corporations, nonprofits, estates and trusts. He has had an active CPA license in Colorado since 2006 and holds an MBA from the University of Colorado Denver.
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