Taxes 101 for New Law Firm Owners

Owners in a Partnership

Partners in a partnership do not receive a Form W-2, but receive a K-1 that reports their share of the firm's profits and losses, in accordance with the partnership agreement. The information on the Schedule K-1 will be reported and taxed on the partners' individual income tax returns.

Many law firms organized as partnerships have adopted a two-tier partnership structure characterized by a top tier of partners who hold equity in the firm and the commensurate rights and responsibilities, while the lower tier of partners do not. Non-equity partners may also be referred to as “income partners” or “salary partners.” Unlike equity partners, who share in a firm's profits, non-equity partners typically receive only guaranteed payments. Guaranteed payments resemble a salary, much like an employee receives, but are shown on a separate box on the K-1 rather than on a W-2. Non-equity partners may also receive bonuses, but otherwise generally have no interests in the firm's assets or profits.

A big distinction between guaranteed payments reported on a K-1 and salaries reported on a W-2 is that the guaranteed payments are not subject to withholding for income taxes and employment taxes, so the individual assumes the responsibility for these taxes, typically through estimated taxes, as detailed below.

Equity partners may also receive guaranteed payments, but additionally share in the net profits of a partnership in accordance with the partnership agreement.

This income earned as a partner, whether a guaranteed payment or other ordinary net profits of a partnership, is passed through to the partners and is subject to self-employment tax.

Before becoming owners, as solely W-2 employees, 1.45% of the employees' wages are withheld and remitted to the federal government for Medicare insurance, and 6.2% of wages of up to $110,100 (for 2012) are withheld and remitted for Social Security. The law firm employer matches that amount, so up to 15.3% is remitted for Social Security and Medicare taxes per employee. As a partner, both the employee and employer shares of these taxes are paid on the partners' individual tax returns, and are referred to as self-employment taxes. This is in addition to normal income taxes at a rate of up to 35%. This added tax burden can result in one of the biggest surprises for new owners at tax time!

Owners in an S Corporation

The shareholders of an S corporation will receive both a W-2 and a K-1. The W-2 represents the salary portion of their earnings. The K-1 income represents the return on their investment and share of firm profits after salaries.

The shareholders of an S corporation will incur Social Security and Medicare taxes only to the extent of wages paid to them on their W-2s. The law firm, as the employer, will pay a matching amount, just as was done prior to the associate becoming an owner. The new shareholders also pay income taxes, but not self-employment taxes on their share of the net income of the corporation. Saving the self-employment taxes on the portion of the owners' income that is a distribution of firm net income can be a major tax advantage for partners of an S corporation over those in a partnership.

The question of how much an owner should be paid in salary versus distributions is an ongoing hot topic. The Internal Revenue Service is looking diligently at compensation of S corporation shareholders as part of an enhanced audit program of S corporations. Compensation has to be reasonable in order to be deductible. “Reasonable” generally means commensurate with the employee's duties. However, you also cannot pay an unreasonably low salary to S corporation shareholders and then make large distributions of cash that are not subject to Social Security and Medicare taxes. The IRS would likely argue that these types of distributions are actually disguised wages subject to self-employment taxes.

Additionally, legislation has been introduced in Congress to make the entire net income from an S corporation service business subject to employment taxes as is the case in a partnership. So far, this proposal has not made it far in Congress, but it could be part of future tax reform.

Taxable Income Does Not Equal Cash Distributions

For both partners and shareholders, a common misconception is that the amount of income that the firm passes to them through a K-1 will match the amount of cash distributed to them. Owners pay tax on their ownership share of the taxable income of the firm, not on the total amount of their draws. Paying on this “phantom income,” when less cash is distributed than is reported to the new owners as taxable income, often comes as an unpleasant surprise.

“Phantom income” for partners and shareholders can result from several scenarios:

• The firm may use taxable receipts to pay down debt. This practice does not affect firm income, nor each owner's share of that income that they must pay taxes on, but it does decrease the amount of cash available for draws. This can be a significant issue during times of change in the composition of equity owners, when prior owners receive the effective benefit of bank or other debt incurred, with incoming partners potentially being responsible for the repayment out of taxable proceeds.
• The firm may use cash receipts to invest in assets such as computers or other equipment, leasehold improvements or software. Again, investing in fixed assets does not have a dollar-for-dollar effect on firm income, but it does decrease the amount of cash available to distribute to owners.
• An increase in client costs advanced by the firm that are reflected as a balance sheet receivable until repaid in a subsequent tax period is a common use of taxable receipts that results in phantom income.
• The firm may incur expenses that are not deductible for tax purposes, resulting in cash expenditures that exceed corresponding decreases to taxable income. Examples of some items that are not deductible (and therefore taxable to the owners) are 50% of meals and entertainment expenses, life insurance payments, political contributions, and some other benefits paid on behalf of owners.
• The firm may end the year with a difference between the taxable income passed onto partners or shareholders and the amount of distributions simply as the result of a timing difference. Income can be earned and even received in one year, but not distributed until the next year. Conversely, timing differences can cause distributions to be higher than taxable income in other years.

New firm owners need to be communicating with their firm administrators and their tax advisers to be able to estimate the amount of their share of the firm's taxable income on at least a quarterly basis. This will facilitate planning for and payment of quarterly taxes, as discussed below.

How Firm Owners Pay Their Taxes

Now that a potentially large amount of income is being passed on to a new owner through a Schedule K-1 rather than a W-2, paying in quarterly estimates will probably be necessary. The Internal Revenue Service requires that tax liability be paid throughout the year in order to avoid penalties. Since there is not a vehicle for the firm to withhold and remit taxes on behalf of an owner for income passed through a K-1, most owners will need to pay estimated quarterly taxes to the IRS, and most likely to one or more states as well. These quarterly estimated taxes are generally due on the 15th day of April, June, September and January. The payments can be based on 100% or 110% (depending on prior year income) of prior year taxes, or can be calculated quarterly based on the income the firm earns for each current quarter. Communication with the firm administrators and the use of a good tax adviser can be of great assistance in this calculation, and compliance with IRS and state requirements.

A Change in Benefit Eligibility

Many tax-free fringe benefits available to employees are not available to partners and greater-than-two-percent S corporation shareholders. These include: accident and health insurance, adoption assistance, cafeteria plans, and qualified transportation fringe benefits, among others. Although the firm may still provide these to owners, they need to be treated as taxable compensation, non-deductible expenses, guaranteed payments, or distributions to the new owner.

Out-of-Pocket Business Expenses

Firm owners are often required to pay business-related expenses out of their own funds and are not reimbursed by the firm for these expenditures. Whether paid by a partner or shareholder, the expenses are the same but the tax treatment is different. For a partner, these unreimbursed, necessary and ordinary business expenses can directly offset the income passed through by the partnership to the individual. However, for an S corporation shareholder, these expenses are treated as miscellaneous employee expenses and are subject to 2% of the owner's adjusted gross income. In other words, they only begin to “count” once the unreimbursed expenses, combined with other miscellaneous deductions such as investment expenses, surpass 2% of the owner's income. This can be an advantage for a partner over an S corporation shareholder.

Filing Taxes in Multiple States

For law firms that conduct business outside of their home states, the income of the practice may be apportioned to and income tax returns filed for each state in which the firm has nexus. Partners and shareholders pick up their share of income in each these states whether they ever stepped foot there or not. In some cases, the firm can file composite state income tax returns for these outside states and pay tax on behalf of the partner or shareholder. However, the rules differ from state to state, and sometimes this is not possible or advantageous. In these cases, each individual owner may have to file multiple state tax returns to declare income and pay required state taxes. New owners may be surprised to learn that they are now multistate taxpayers.

Summary

When dealing with the new roles and responsibilities of being a new law firm owner, planning for the changes in one's personal tax situation can easily take the back burner. By preparing new partners with knowledge of the basics, firm administrators and leadership can lessen the sting of some potentially unpleasant tax revelations. Working with a CPA who focuses on tax planning, in addition to compliance, can free up a new owner's time and energies to focus on building his or her career, contributing to the firm, and serving clients.

Amy Petersen is a tax manager with Seigneur Gustafson LLP, a CPA and advisory firm located in Lakewood, CO. She specializes in tax compliance and consulting for service firms and their owners. She can be reached at [email protected] or 303-980-1111.

So your firm is thriving and excited to announce partner promotions. Congratulations!

After years of hard work and sacrifices, your top associates have made it to owner status. While focusing on the responsibilities of being a new owner and taking care of clients' affairs, the last thing on a new law firm partner's or shareholder's mind may be how this promotion will affect his or her personal taxes; that is, until mid-March rolls around. By that time it may be too late to take the sting out of any resulting tax surprises. This article addresses the key items a newly promoted law firm owner should know regarding his or her changed individual tax situation. Understanding how one's tax status has been altered can assist in a smooth transition from being solely an employee to being both an employee and owner of the enterprise.

Whether the firm is formed as an LLP, LLC, PLLC, PC, or other legal structure, it most likely is taxed as a partnership or S corporation. (A small number of law firms are taxed as C corporations, and this article does not address this tax structure. A professional services firm that does not qualify for and make a valid election with the Internal Revenue Service to be treated as an S corporation under Subchapter S of the Internal Revenue Code is taxed as a Professional Service Corporation (“PSC”), where the entity pays tax on its income, as compared with the income flowing out to the shareholders on their respective Schedule K-1 forms.) If the firm operates as a tax partnership or S corporation, owners will receive a Schedule K-1 (“K-1″) from the firm. However, the personal tax ramifications of receiving a K-1 from a partnership versus an S corporation are quite different.

Owners in a Partnership

Partners in a partnership do not receive a Form W-2, but receive a K-1 that reports their share of the firm's profits and losses, in accordance with the partnership agreement. The information on the Schedule K-1 will be reported and taxed on the partners' individual income tax returns.

Many law firms organized as partnerships have adopted a two-tier partnership structure characterized by a top tier of partners who hold equity in the firm and the commensurate rights and responsibilities, while the lower tier of partners do not. Non-equity partners may also be referred to as “income partners” or “salary partners.” Unlike equity partners, who share in a firm's profits, non-equity partners typically receive only guaranteed payments. Guaranteed payments resemble a salary, much like an employee receives, but are shown on a separate box on the K-1 rather than on a W-2. Non-equity partners may also receive bonuses, but otherwise generally have no interests in the firm's assets or profits.

A big distinction between guaranteed payments reported on a K-1 and salaries reported on a W-2 is that the guaranteed payments are not subject to withholding for income taxes and employment taxes, so the individual assumes the responsibility for these taxes, typically through estimated taxes, as detailed below.

Equity partners may also receive guaranteed payments, but additionally share in the net profits of a partnership in accordance with the partnership agreement.

This income earned as a partner, whether a guaranteed payment or other ordinary net profits of a partnership, is passed through to the partners and is subject to self-employment tax.

Before becoming owners, as solely W-2 employees, 1.45% of the employees' wages are withheld and remitted to the federal government for Medicare insurance, and 6.2% of wages of up to $110,100 (for 2012) are withheld and remitted for Social Security. The law firm employer matches that amount, so up to 15.3% is remitted for Social Security and Medicare taxes per employee. As a partner, both the employee and employer shares of these taxes are paid on the partners' individual tax returns, and are referred to as self-employment taxes. This is in addition to normal income taxes at a rate of up to 35%. This added tax burden can result in one of the biggest surprises for new owners at tax time!

Owners in an S Corporation

The shareholders of an S corporation will receive both a W-2 and a K-1. The W-2 represents the salary portion of their earnings. The K-1 income represents the return on their investment and share of firm profits after salaries.

The shareholders of an S corporation will incur Social Security and Medicare taxes only to the extent of wages paid to them on their W-2s. The law firm, as the employer, will pay a matching amount, just as was done prior to the associate becoming an owner. The new shareholders also pay income taxes, but not self-employment taxes on their share of the net income of the corporation. Saving the self-employment taxes on the portion of the owners' income that is a distribution of firm net income can be a major tax advantage for partners of an S corporation over those in a partnership.

The question of how much an owner should be paid in salary versus distributions is an ongoing hot topic. The Internal Revenue Service is looking diligently at compensation of S corporation shareholders as part of an enhanced audit program of S corporations. Compensation has to be reasonable in order to be deductible. “Reasonable” generally means commensurate with the employee's duties. However, you also cannot pay an unreasonably low salary to S corporation shareholders and then make large distributions of cash that are not subject to Social Security and Medicare taxes. The IRS would likely argue that these types of distributions are actually disguised wages subject to self-employment taxes.

Additionally, legislation has been introduced in Congress to make the entire net income from an S corporation service business subject to employment taxes as is the case in a partnership. So far, this proposal has not made it far in Congress, but it could be part of future tax reform.

Taxable Income Does Not Equal Cash Distributions

For both partners and shareholders, a common misconception is that the amount of income that the firm passes to them through a K-1 will match the amount of cash distributed to them. Owners pay tax on their ownership share of the taxable income of the firm, not on the total amount of their draws. Paying on this “phantom income,” when less cash is distributed than is reported to the new owners as taxable income, often comes as an unpleasant surprise.

“Phantom income” for partners and shareholders can result from several scenarios:

• The firm may use taxable receipts to pay down debt. This practice does not affect firm income, nor each owner's share of that income that they must pay taxes on, but it does decrease the amount of cash available for draws. This can be a significant issue during times of change in the composition of equity owners, when prior owners receive the effective benefit of bank or other debt incurred, with incoming partners potentially being responsible for the repayment out of taxable proceeds.
• The firm may use cash receipts to invest in assets such as computers or other equipment, leasehold improvements or software. Again, investing in fixed assets does not have a dollar-for-dollar effect on firm income, but it does decrease the amount of cash available to distribute to owners.
• An increase in client costs advanced by the firm that are reflected as a balance sheet receivable until repaid in a subsequent tax period is a common use of taxable receipts that results in phantom income.
• The firm may incur expenses that are not deductible for tax purposes, resulting in cash expenditures that exceed corresponding decreases to taxable income. Examples of some items that are not deductible (and therefore taxable to the owners) are 50% of meals and entertainment expenses, life insurance payments, political contributions, and some other benefits paid on behalf of owners.
• The firm may end the year with a difference between the taxable income passed onto partners or shareholders and the amount of distributions simply as the result of a timing difference. Income can be earned and even received in one year, but not distributed until the next year. Conversely, timing differences can cause distributions to be higher than taxable income in other years.

New firm owners need to be communicating with their firm administrators and their tax advisers to be able to estimate the amount of their share of the firm's taxable income on at least a quarterly basis. This will facilitate planning for and payment of quarterly taxes, as discussed below.

How Firm Owners Pay Their Taxes

Now that a potentially large amount of income is being passed on to a new owner through a Schedule K-1 rather than a W-2, paying in quarterly estimates will probably be necessary. The Internal Revenue Service requires that tax liability be paid throughout the year in order to avoid penalties. Since there is not a vehicle for the firm to withhold and remit taxes on behalf of an owner for income passed through a K-1, most owners will need to pay estimated quarterly taxes to the IRS, and most likely to one or more states as well. These quarterly estimated taxes are generally due on the 15th day of April, June, September and January. The payments can be based on 100% or 110% (depending on prior year income) of prior year taxes, or can be calculated quarterly based on the income the firm earns for each current quarter. Communication with the firm administrators and the use of a good tax adviser can be of great assistance in this calculation, and compliance with IRS and state requirements.

A Change in Benefit Eligibility

Many tax-free fringe benefits available to employees are not available to partners and greater-than-two-percent S corporation shareholders. These include: accident and health insurance, adoption assistance, cafeteria plans, and qualified transportation fringe benefits, among others. Although the firm may still provide these to owners, they need to be treated as taxable compensation, non-deductible expenses, guaranteed payments, or distributions to the new owner.

Out-of-Pocket Business Expenses

Firm owners are often required to pay business-related expenses out of their own funds and are not reimbursed by the firm for these expenditures. Whether paid by a partner or shareholder, the expenses are the same but the tax treatment is different. For a partner, these unreimbursed, necessary and ordinary business expenses can directly offset the income passed through by the partnership to the individual. However, for an S corporation shareholder, these expenses are treated as miscellaneous employee expenses and are subject to 2% of the owner's adjusted gross income. In other words, they only begin to “count” once the unreimbursed expenses, combined with other miscellaneous deductions such as investment expenses, surpass 2% of the owner's income. This can be an advantage for a partner over an S corporation shareholder.

Filing Taxes in Multiple States

For law firms that conduct business outside of their home states, the income of the practice may be apportioned to and income tax returns filed for each state in which the firm has nexus. Partners and shareholders pick up their share of income in each these states whether they ever stepped foot there or not. In some cases, the firm can file composite state income tax returns for these outside states and pay tax on behalf of the partner or shareholder. However, the rules differ from state to state, and sometimes this is not possible or advantageous. In these cases, each individual owner may have to file multiple state tax returns to declare income and pay required state taxes. New owners may be surprised to learn that they are now multistate taxpayers.

Summary

When dealing with the new roles and responsibilities of being a new law firm owner, planning for the changes in one's personal tax situation can easily take the back burner. By preparing new partners with knowledge of the basics, firm administrators and leadership can lessen the sting of some potentially unpleasant tax revelations. Working with a CPA who focuses on tax planning, in addition to compliance, can free up a new owner's time and energies to focus on building his or her career, contributing to the firm, and serving clients.

Amy Petersen is a tax manager with Seigneur Gustafson LLP, a CPA and advisory firm located in Lakewood, CO. She specializes in tax compliance and consulting for service firms and their owners. She can be reached at [email protected] or 303-980-1111.