So you've decided to start your own law practice - congratulations! Wondering where to start? The entity selection process is one of the first steps in the formation of any new business, and law firms have several entities to choose from. There are legal, tax, and general business implications of each type of entity that must be carefully evaluated.

To make the process easier, I've outlined the taxation mechanics and general business characteristics of each type of business entity available to law firms:

• The Sole Proprietorship.

  This is the most basic form of business organization, where a single person owns the business, personally takes title of all business property, and is personally liable for all business obligations. The business income and deductions are included with the business owner's individual income tax returns. This means that the owner pays income tax and self-employment tax (social security) on the net taxable income of the business with his or her individual income tax returns.

• The General Partnership.

  This is also a basic form of business, where two or more people are co-owners. The general partners share the business profits, ownership of all business property, and liability for all business obligations in accordance with their partnership agreement. The income and deductions of the partnership are reported on a partnership tax return, and then "passed through" to the individual partners for taxation on their individual income tax returns. This means that the partners pay income tax and self-employment tax (social security) on their allocation of the net taxable income of the business with their individual income tax returns.

• The Limited Liability Partnership or Company.

  This is a special type of general partnership (that exists in most states) for professionals practicing in groups. The Limited Liability Partnership (LLP) and Limited Liability Company (LLC) provide some form of legal liability protection to the professional partners or members for the malpractice of other professionals and certain other liabilities, the level of which differs from state to state. Partner or member agreements can be drafted to define and structure the true essence of most business arrangements. For tax purposes, the LLP and LLC can be treated in the same manner as the general partnership.

• The Corporation.

  This is an entity created under state law for the purpose of one or more professional individuals carrying on a business for profit. Similar to LLPs and LLCs, corporations offer some legal protection to the shareholders for the malpractice of other professionals and certain other liabilities. Shareholder agreements can be drafted to define and structure the true essence of most business arrangements. However, the adoption of certain arrangements can create different classes of stock, which can impact the type of corporation that is allowed.

   

  In general, a corporation can be classified as a C Corporation or an S Corporation:
  
  
  
  • A C-Corp is a corporation that has not elected S status. The income and deductions of the corporation are reported and taxed on the corporate level tax returns. The Federal tax rate for a C-Corp is a flat rate of 21%. In addition to the corporate level tax, any dividends paid out of the earnings and profits of the corporation are taxed to the shareholders on their individual tax returns (double taxation). In an incorporated law firm, the shareholders and officers or key employees are one and the same. Therefore, most of the profits of the business can be distributed in the form of payroll to avoid double taxation. However, excessive compensation rules, the timing and availability of cash flow and several other factors may prohibit elimination of double taxation through shareholder payroll. In most cases, the shareholders will pay income tax and social security on most of their income through regular payroll withholdings. Then, the corporation is liable for the matching of social security tax and the payment of unemployment taxes. The remaining net income taxed at the corporate level is taxed again when distributed to the shareholders.
  • An S-Corp is a corporation that has qualified, timely elected and been approved by the IRS to be treated as a Small Business Corporation. The taxable income and deductions of the S-Corp are reported on the S-Corp return and then "passed through" to the shareholders for taxation on their individual income tax returns. Therefore, the shareholders pay income tax on their allocation of the net taxable income of the business with their individual income tax returns. Unlike partnerships, this net income passed through to the shareholders is not subject to self-employment tax. However, the shareholders actively participating in the firm must be reasonably compensated through payroll prior to any additional amount being deemed shareholder profit "passed through" to the shareholders. For most corporations that qualify, the S-Corp is the most tax beneficial route. To classify as an S-Corp, a corporation must be a "Small Business Corporation", which means:
    
    • The corporation must be a US domestic corporation.
    • It must have 100 or fewer shareholders at any time during the year (husband and wife count as one shareholder).
    • The shareholders may only be individuals, estates, or certain trusts. Partnerships and corporations cannot be shareholders.
    • The corporation cannot have a shareholder that is a non-resident alien.
    • The corporation can only have one class of stock.

Overall, each entity has advantages and disadvantages to be considered. When selecting an entity, it's important not to focus on the short term—changing your entity status in the future can be costly due to potential taxes  on the liquidation of an entity that has accumulated value.

Do you have questions about which entity is right for you? Leave a comment below, or feel free to contact me directly. I'm happy to help!