The ABCs of LLCs, S.C.s and LLPs

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LLC, S.C., LLP…

If you don’t practice in the area of business or tax law, you may not know what the alphabet soup after a law firm’s name means — or what it means if there’s no alphabet soup there. Now that you’ve decided to start your own firm, however, choosing a business entity, and the tax ramifications that they may bring, is probably one of your first significant decisions.

There’s no “perfect” entity, agree a number of experts who talked to Wisconsin Law Journal.

So, what’s the best for you?

“It depends. I say that a lot,” says Michael Bark, a CPA with Circore Business Solutions in Milwaukee, while attorney Nancy Trueblood, of Trueblood Law Office LLC in Wauwatosa, says, “Your choice is going to be (made) mostly for a business reason or tax purposes.”

The Sole Proprietorship

The easiest choice, if you’re going solo, is the sole proprietorship. There are no filing requirements with the state, the bar or the I.R.S. Just hang the shingle.

A sole proprietorship is not considered a separate legal entity, and there is no legal separation between you as the sole proprietor and your law practice business. In a sole proprietorship, you are financially responsible for all liabilities of your law practice, and all of your personal assets are subject to seizure or lien by creditors, says Trueblood.

Bark explains that when you file your personal tax return every year on Form 1040, you will attach Schedule C to report your profit or loss. In addition to paying income tax on your earnings, you are required to pay a 15.3 percent self-employment tax, also called “FICA,” on those earnings. (To be precise, the FICA tax rate is 15.3 percent on the first $97,500 of earnings, and after that point, it drops to 2.9 percent, he says.)

The sole proprietorship is the simplest option, because you do not have to file a separate tax return for your business. “The downfall of being a plain schedule C business is, in a lot of cases, you could be paying too much in self-employment taxes,” states Bark.

Sole proprietors also do not have to carry malpractice insurance, as they must with an LLC, for example.

The General Partnership

Trueblood states that, in a general partnership, each partner is jointly and severally responsible for all liabilities of the law practice business, and all personal assets of each partner are subject to seizure or lien by creditors.

Tax-wise, a general partnership must file a federal tax return every year on Form 1065. It is considered a pass-through entity under state and federal tax law, so that a general partnership does not pay tax. The annual profit of a general partnership is reported to each partner on Schedule K-1, and the partners pay income tax on their respective distributive share of the profits reported on that schedule.

The Professional or Service Corporation

A service corporation is formed by filing with the state articles of incorporation, and its owners are called “shareholders,” says Trueblood. As a shareholder in a service corporation, you do not have personal liability for liabilities that arise in the ordinary course of business or from the malpractice of other attorneys at your law firm.

From the tax standpoint, a service corporation is taxed either as a C corporation or an S corporation, explains Bark. Your S.C. will be taxed as a C corporation unless you elect tax treatment as an S corporation. (An S corporation cannot have more than 100 shareholders, and all must be “domestic,” so a huge, international law firm cannot elect S corporation status.)

In contrast to the C corporation, where owners are essentially doubly taxed, an S corporation is a pass-through entity under federal tax law, Bark continues. With an S corporation, the profit distribution is exempt from the FICA tax that is imposed on compensation income.

For example, if you and another attorney/owner garner $100,000 in profits each, as partners, you’ll both pay self-employment taxes on that entire sum. However, as an S corporation, you can take a W2 wage of $80,000 or some other “reasonable compensation” and you’ll pay taxes, including FICA on that sum, but not the $20,000 you receive as a distribution. FICA is taxed at 15.3 percent, which would save you upwards of $3,000 per year, or $30,000 over the course of 10 years.

Bark says, “It’s not a huge tax savings. But, over the course of many years, it adds up.

And if we can do it every year and it’s a noncontroversial election, why not? Then again, some people say, “It’s only $3,000 a year, what’s the big deal?’”

The key here, emphasizes Bark, is to keep the wages “reasonable.” Anything less is a red flag to the IRS.

Other Limited Liability Entities

There are two: the limited liability corporation (LLC) and the limited liability partnership (LLP). As an attorney who is also an owner of a limited liability entity, you’re still personally liable for your own professional negligence. But when the business is “limited liability,” it can shield you from the negligence of another partner.

LLCs have been available in Wisconsin for attorneys since 1997, when the Supreme Court Rules were amended to allow them, says Trueblood. As an LLC owner, you must register with the State Bar and pay an annual fee, and you must have professional liability insurance, the amount of which is linked to the number of lawyers in the firm. In addition, the firm must make “LLC” — the limited liability status — a part of its name, and must give clients and prospective clients a written, “plain-English” summary of what that limited liability means to them.

An LLC is a legal status, rather than a tax status, reminds Bark. The IRS isn’t concerned, per se, about your potential liability.

But one benefit of an LLC is that, under the U.S. Treasury Department’s so-called “check the box” regulations, LLC owners may elect how to be taxed. Either the LLC itself may pay taxes, as would a corporation classified for tax purposes as a C corporation, or pass on its income or loss to the owners, resulting in taxation similar to that of a sole proprietor or S corporation shareholder.

With the LLP, like the LLC, there is liability protection from your law partners’ negligence, and malpractice insurance is required, among other things.

Your LLP might wish to elect C corporation status, because it gives you more flexibility with regard to how profits are allocated. Profits must be distributed evenly in an S corporation; not so with a C corporation. This is helpful with many partners and someone wants to take a sabbatical, or if there’s a two-tiered partnership. If you want to accomplish an uneven compensation with an S corporation, this can still be done by adjusting someone’s W2 wages. But remember to keep those wages reasonable, because the IRS will scrutinize this election, cautions Bark.

Some Commonplace Scenarios

For solos: Sole proprietorship, LLC or service corporation?

If your practice is high-volume in nature, and therefore you plan to hire employees and thereby earn profits off their work, Bark
says that the LLC or an S.C., electing S corporation status, are probably advantageous to sole proprietorship, because you’ll only pay FICA on your reasonable W2 wages.

The requirements to maintain an LLC are not burdensome, Trueblood adds. However, if you prefer the added formalities in operation that an S.C. brings, you might want to go that route. The articles of incorporation, annual reports, and/or limited liability forms can be filed online.

“What I see is that sometimes people file articles of incorporation [to form an LLC], and then forget to put an operating agreement in place,” Trueblood observes.
For law partners: We want to put money back into the business.

Maybe you want to pay off some of the expenses incurred in setting up the firm such as computer networks, office furniture, etc.

Bark says the S corporation might make sense for you, because you can put money back into the business as “previously taxed income,” thereby creating a basis within the corporation. With a C corporation, it is harder to leave money in the business, because you’ll ultimately want it out of the business, and you’ll be doubly taxed because the firm has already been taxed on those dollars.

Or, Bark recommends a general partnership, as it is a pass-through entity, tax-wise. Of course, there is greater liability with a partnership.

I want to change to an S corporation.

According to Bark, the S corporation is a newer development in tax law, and firms that have been around for many years might be C corporations because there used to be no other options. Or, some end up in C corporation status unintentionally, because you’ve neglected to elect S corporation status (You were too busy practicing law, per chance?).

A frequent concern when switching from C to S corporation status is the “built-in gains” tax, he says. Most attorneys use cash-basis accounting, meaning that they recognize their income when the check is in hand, as opposed to accounts receivable, and they recognize expenses when they actually pay them. With built-in gains tax, you are required to restate financials on the accrual basis, so that you list accounts receivable and subtract accounts payable. If the gap between those sums is $100,000, for example, you pay the highest corporate tax rate on that difference, 35 percent, or $35,000, to be paid over four years.

“If your savings on the self-employment tax is not going to outweigh the built-in gains tax, there’s no point in doing it right now.”

The Bottom Line

Every situation is going to be different. There’s no cookie-cutter approach,” ob-serves Bark.

When getting started, you need to have a business plan on paper, complete with compensation goals, he says. Barks meets with his clients quarterly, to talk about their businesses’ financial goals and ascertain if they’re on the way to meeting them.