Updated 2/2/18: Under new IRC §199A, owners of passthrough entities including a law practice organized as a partnership or professional corporation may deduct 20 percent of qualified business income, excluding reasonable compensation for the business owner. No deduction is allowed for passthrough income from personal services, including legal services, and the deduction is limited to 50 percent of wages paid to employees, but these limitations are phased in above an individual income threshold ($157,500 for single taxpayers, $315,000 for married taxpayers filing jointly). Taxpayers below the income threshold may deduct 20 percent of law practice income derived from the services of paralegals, associates, and other employees.
You’ve decided to open your own law office and are ready for your clients’ cases, but are you also ready to handle the tax issues that go hand-in-hand with running your own business?
Here’s an overview of some tax issues to keep in mind when starting your law practice:
- Withhold from employee pay. If you hire an employee for your practice, you’ll have to follow all the special provisions of the tax laws on employees. As an employer, you’ll be required to make deposits of withheld income tax, Social Security contributions, and backup withholding on reportable payments. The Employment Development Department administers the state’s personal income tax withholding functions.
- Don’t withhold from independent contractor pay. Unlike for employees, you don’t withhold California income tax, unemployment insurance contributions, or disability contributions for independent contractors. See Un Ins C §§926, 1275, 2652, 13005. In fact, the withholding of such amounts generally indicates that a service provider is actually an employee, not an independent contractor.
- Make federal and state unemployment tax deposits. The Federal Unemployment Tax Act (FUTA) (IRC §§3301–3311) imposes a tax of 6.0 percent of payroll on all employers, including attorneys. IRC §3301. But if the Secretary of Labor certifies that the law of a state meets certain criteria (IRC §§3301, 3304), then employers in that state are entitled to a credit of 5.4 percent against the tax, leaving a liability of only 0.6 percent of payroll. Not surprisingly, to escape this tax on employers, all states have passed laws conforming to the federal requirements for certification.
- Note extra requirements for corporations and limited partnerships. In deciding the form of business enterprise by which to conduct a law practice, keep in mind that corporations and limited partnerships must pay fees on formation. An annual minimum tax is also imposed on these entities (no minimum tax in the first taxable year for corporations formed after January 1, 2001). Rev & T C §§17935(a), 17941(a), 23151, 23153(d)(1). For corporations, the minimum tax is a credit against income taxes, whereas limited partnerships must pay the minimum tax for the privilege of doing business in California.
- Make any required estimated tax payments. In addition to filing an annual income tax return, corporations, partnerships, and individuals operating a business as a sole proprietorship may need to make quarterly estimated tax payments. These payments are due April 15, June 15, September 15, and, with respect to the last quarter of the year, January 15 of the following taxable year. IRC §6654(c).
- Pay your payroll tax. All employers, including attorneys, must comply with federal, state, and local payroll tax and withholding tax laws. Failure to pay tax withholding to the state or federal government will result in imposition of a penalty equal to the amount of the taxes not paid. On the federal penalty, see IRC §6672. The IRS aggressively asserts the 100-percent penalty against corporate officers responsible for the payment, and the entire 100-percent penalty may be assessed against each such person. See IRC §6672. Criminal sanctions may also be imposed. IRC §7215.
Opening a law practice is like opening any other business. Always consult with a certified public accountant (CPA) or other tax adviser before you decide on the form of enterprise (i.e., corporation, partnership, or sole proprietorship), set up an accounting method, or hire employees.
For more on these tax matters and everything else you need to know about opening a law practice, turn to CEB’s California Basic Practice Handbook, chapter 1, a must-have for anyone new to practice or going solo. And although you may not think of yourself as an employer, once you start a practice and hire someone to work for you (e.g., legal assistant, administrative assistant), you’ve stepped into that role and need to be up on employment-related issues with CEB’s Advising California Employers and Employees.
If you’re new to practice or going solo, check out CEB’s Basics Conference coming up in September with a session on how to get your law practice up and running.
Other CEB blog posts you may find useful:
- Employee Versus Independent Contractor: Get It Right, or Pay the Consequences
- Before You Get a Website, Get a Development Agreement
- Contracting for Contract Attorney Work: Reap Benefits and Avoid Pitfalls
- Should You Go Solo?
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