Tax Law

The Simple Practice: Setting Up An S-Corporation For Your Law Practice

In the final analysis, tax planning is about saving money.

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According to the Wall Street Journal, in 2017 and 2018, President-elect Joe Biden avoided paying payroll taxes on $13.3 million in income by setting up an S-corporation for his royalty and speaking fees. Presidential candidate John Edwards similarly avoided payroll taxes in on $26 million in income by setting up an S-corporation for his law practice. This technique saved him $600,000 in Medicare taxes.

Around this time, many small businesses — including law firms — are contemplating starting a separate entity in the new year. The most popular entity for a solo law practice and a few small firms is the S-corporation. They are relatively easy to start up, and there is no double taxation, unlike C-corporations.

Today’s column discusses only some general principles to think about when starting an S-corporation. I am avoiding calculations and comparisons since every small business is unique, and state laws are different. Instead consider the issues below and decide whether it is worth it for your practice to become an S-corporation.

Limited liability protection is … limited. While corporations are famous for providing shareholders, directors, and officers with limited liability protection from lawsuits and judgments, that is not always the case. Lawyers cannot use a separate entity to protect themselves from malpractice.

Also, courts can pierce the corporate veil under certain conditions. While these conditions vary by state, most states will do so for the following reasons: using the corporation to perpetuate fraud, not following corporate formalities, commingling corporate and personal funds, being undercapitalized (usually due to looting corporate funds in anticipation of a lawsuit), or if the court feels that not holding the shareholders or officers liable will promote an injustice.

The best way to maximize your chances of limited liability protection is to follow all corporate formalities such as annual shareholder meetings and taking minutes. Even if your corporation qualifies as a “close corporation” and by law does not have to follow corporate procedures, it is best to do it anyway to keep a record. Also, avoid commingling personal funds with corporate funds.

Potential tax savings. For tax purposes, self-employed businesses are sole proprietorships by default. Self-employment taxes are basically the equivalent of employee payroll taxes for business owners. This means you report your income and expenses on the Schedule C. Your remaining net profit is subject to self-employment tax on top of the income tax. For 2020, the first $137,700 of income is subject to a 15.3% self-employment tax. Any income above that is subject to a lower 2.9% self-employment tax.

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An S-corporation’s net income passes through to the shareholders. But this net income is not subject to the self-employment tax. Keep in mind that shareholders will be taxed whether they personally receive the money or not.

However, the IRS is aware of this tax avoidance tactic so they require all S-corporation shareholders to be paid a “reasonable salary” as an employee. This means that a shareholder of the corporation (particularly if they are managing the business as an officer) must be treated like an employee of the corporation and paid as such. This means issuing paychecks with income and payroll taxes withheld.

The shareholder’s salary is deductible from the corporation’s tax return as a business expense. But the salary is included in the shareholder’s income on their personal tax return.

How much is reasonable? That depends. The IRS generally looks at how much others in the same position are paid. However, what the IRS really wants is all distributions from the corporation to the officer-shareholders to be treated like a salary subject to payroll taxes.

The problem is that every small business is different and, in theory, reasonable compensation should be considered based on individual circumstances. For example, what if a business incurred substantial debt and the owners want to use the profits to pay off the debts as soon as possible? An argument can be made that management salary should be lower under this condition.

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So the strategy for an S-corp shareholder is to receive a salary that is high enough to meet the “reasonable salary” standard but not too high so that all of the corporate net income will be subject to payroll taxes.

So let’s say you anticipate your S-corporation will save you $2,000 in taxes per year. That isn’t too bad for a small business on a cumulative basis. But there is another factor to consider.

Costs of maintaining a corporation. Costs will vary depending on the state in which you practice but for the purpose of simplicity, I’ll use a few common costs and estimates. As noted above, shareholders must be paid a reasonable salary as an employee. This means hiring a payroll company or purchasing payroll software annually. For one employee, this can run about $300 per year at a minimum. Which should include filing all federal and state employment taxes.

Since you have an employee, there are also additional employee payroll taxes. This includes state unemployment, and disability insurance taxes. Your state may have other taxes. These taxes vary although most tend to max out at $1,000 per year.

The federal government also has an employee unemployment tax. For most small businesses this is paid annually as the tax is not a large amount, usually up to $42 per employee annually. However, this tax can increase if your state government borrowed money from the federal government to pay unemployment benefits and did not pay it back. Presently, due to the pandemic and government shutdown orders, 20 states have borrowed money and most are not likely to pay them back anytime soon. So if your state is on the list, your FUTA tax may increase on average between $100 to $200 per employee.

Your state may have annual corporation fees. In California the annual corporation fee is $800, even if you did not do any business at all that year. Also, there is a $25 fee when submitting the annual list of directors and officers to the state.

Also, there are tax return fees. Corporations file separate tax returns that can get complicated. For example, if your corporate income receipts for the year exceed $250,000, the corporation has to file a Schedule L which lists the corporation’s balance sheet. This translates into higher fees for tax returns and additional fees for tax planning.

For simplicity, let’s say all of the taxes and fees described above total to $3,000. This means you will need to save at least $3,000 in taxes to break even.

So is it worth it to set up an S-corporation? In the final analysis, tax planning is about saving money. If you are paying $3,000 in annual corporate maintenance costs to save $2,000 in taxes, you are doing it wrong.

Even if you are breaking even, the additional work required to maintain a corporation may not be worth it. Most self-employed people hate being on payroll because of the filing and withholding requirements. It’s a lot easier to make owner draws instead.

In my opinion, the earliest time to consider starting an S-corporation for tax purposes is when your business consistently earns over $100,000 per year and has at least one employee. If you have a payroll account, it is not hard to add an additional employee. Also, if your business profit is high enough, you can adjust shareholder salaries so that they meet the IRS “reasonable salary” requirement without subjecting all of the business income to payroll taxes. Ideally, the savings should more than enough to pay for annual corporate maintenance costs.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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