There are several types of entities that we typically see law firms drawn into. In the US, they are taxed differently, and it is important to be aware of this when considering your law firm’s structure.

Below we will break down the different entity choices:

Sole Proprietorship

Most of us who start a business, begin here. Sole proprietorships are a great way to simplify tax obligations because all profits and losses are considered to be individual income. Sole proprietorships allow a lot of freedom and flexibility, but not a lot of tax savings. A sole proprietorship is one of the easiest business structures to set up, but it has an unlimited personal liability for your debts, which can be a huge problem. Sole proprietorships are not subject to income tax because the income is reported on the proprietor’s personal income tax return.

The income derived from the business is subtracted from the proprietor’s other taxable income. However, if the business generates a loss, the loss carries into the proprietor’s personal return. Sole proprietors can deduct out-of-pocket business expenses, but they are not entitled to certain tax-related allowances that are available to other business entities. For example, sole proprietors are not entitled to the depletion allowance available to corporations.

Partnerships

Partnerships offer a lot of the benefits that an S-Corp offers (see below) – including saving on payroll taxes – but have more to do with partnerships in general, so it’s a little confusing, from a tax standpoint. As a partnership, everything is filed based on individual income. Partnerships are not subject to income tax, but the income derived from the partnership is subject to taxation on the partner’s personal income tax return.

Partnerships are great if you want to be able to pass your company on to your kids or other family members, but they’ll need to be set up as a partnership with an S-election to work much like an S-corp. If you’re going to be going into business with someone, take the time to make a solid contract. In a partnership, there are multiple people and it’s a partnership between the individuals.

PLLC Professional Limited Liability Corporation

PLLC is very commonly used in the legal industry. How does it differ from a straight LLC? The “P” stands for professional. Only certain industries are allowed to use this entity type and only one type of professional service is allowed.

The company is created by two or more shareholders to be operated, managed, and invested in by the partners only. It is a preferred type of entity for professionals who are personally liable for their professional activities. PLLC entities are often used by smaller, closely-held businesses. With this type of entity, the company is more flexible, which might appeal to some business owners. However, this type of entity does restrict potential growth.

PA Professional Association

The PA entity type is where the company does not have shareholders, but has a single member, or has 2-25 members. It is often used by professionals who are not personally liable for their professional activities. A professional association is a Corporation formed with the single purpose of providing a specific professional service. Like the PLLC above, the person using this entity type is for one professional type, i.e. practice law, and must be licensed.

Partnerships with S-Corp election

These partnerships (act like an S-Corp) offer the protection of a corporation and the benefits of a partnership get the same tax benefits you would from an S-Corp, you have to elect to be an S-Corporation. Partnerships with S-elections are great because they act like an S-Corp, which means you’re able to write off any business-related expenses that you incur during the year.

Corporations

There are two types of corporations: S Corporations and C Corporations. S corporations are more attractive in certain industries, like small businesses, and they offer the advantage of not paying annual federal and state taxes and not filing annual reports.

S Corp

If you decide to be an S-Corporation, the earnings of the corporation will be taxed at the individual tax rate of the shareholders. This type of entity is a good choice for a small business where the shareholders do not want to have to pay payroll taxes on their individual returns.

An S-Corporation is a corporation with a maximum of 100 shareholders and a one-class of stock, typically a closely held company. An S- corporation is a corporation that has just one class of stock and no publicly traded shares. The shareholders of an S corporation, as the owners of the corporation, are known as “owner-employees” and can be individuals, corporations, partnerships, trusts, and tax-exempt entities. An S corporation can be a small or medium-sized business. Rather than paying the individual income tax on the profits, the profits of the corporation are instead distributed as salary and bonuses to the owner-employees.

C Corp

If you choose to be a C-Corporation, the corporation will have to pay a shareholders’ share. C Corporations are the default corporate entity and offer the benefits of not paying state and federal corporate taxes, not filing annual reports, and not having restrictions like S Corporations.

If you want to raise venture capital, you’ll need to select a C Corporation. If you’re looking for tax deductions, then you may want to consider a C-Corporation.

Ultimately, when choosing an entity type, legal associates must take into account the tax considerations, insurance needs, and overall financial standing of the law firm. The tax considerations are crucial when thinking about which entity type to choose. The way you operate your law firm will have to be considered in advance to be able to seek out the best entity type for your law practice, along with the guidance of a great tax professional.

For far more detail on this subject, always consult with your accounting team and tax professional. Here is another article written by C. Lynn Northup, CPA, that provides more depth on the subject.  Also, the IRS is always a great source of information.  Here is their article on the different entities.

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