Law Firms: Corporations Or Not?

When starting a law firm, one of the most important decisions is choosing the legal structure of the firm. The entity structure has implications for tax liability, liability in running the firm, and more. Law firms can incorporate, and the options available will vary based on the state. For example, many states allow a solo attorney to form a PLLC, or a Professional LLC, but this is not an option in California. In California, solo attorneys can choose a sole proprietorship or a professional corporation. There are several other rules and regulations regarding PLLCs that differ between states. For example, members, managers, and the PLLC may need to hold a license specific to the field of service. There are also different rules about what professions may or must use a PC, as well as what licensing is required for the PC and its members.

Law firm incorporation options vary by state

Law firms can incorporate, but the specific incorporation options available depend on the state. For example, many states allow a solo attorney to form a PLLC (Professional LLC), but this is not possible in California. Instead, solo attorneys in California can choose between a sole proprietorship and a professional corporation. A sole proprietorship is the simplest business structure, as it is owned by a single individual and does not require the filing of special forms with the state. However, the owner is personally liable for all debts, must pay self-employment taxes, and income is reported on personal income tax returns. On the other hand, a professional corporation provides some limited personal liability for shareholders, but in California, this does not include protection from acts of professional malpractice.

In terms of operating in multiple states, businesses must comply with the laws of each state in which they operate. This often includes registering as a foreign entity by submitting documents such as articles of organization or articles of incorporation, and paying applicable fees. Some states, like Delaware and Nevada, are known for their business-friendly laws and lower franchise taxes. However, business taxes can become complicated when operating in multiple states, as tax returns may need to be filed in each state, including federal tax to the IRS and state taxes.

When choosing an entity structure for a law firm, it is important to consider the tax implications. Most firms opt for a structure that limits personal liability and avoids double taxation, such as an LLC or LLP. While an LLC or LLP can eliminate the double taxation of C corporations, the income from the business flows through to the owner's personal tax return, resulting in substantial tax consequences. An S corporation, a type of pass-through entity, can be a tax-efficient option for firms in most states that pay their owners more than $80,000 per year. It allows for distributions to be taken monthly, quarterly, or annually, and provides certain tax advantages. However, there are complex rules regarding who can form an S corporation, and maintaining S corp status requires paying owners a fair salary.

The benefits of forming a limited liability company (LLC)

Law firms can incorporate, but the options available depend on the state. For example, while many states allow a solo attorney to form a PLLC (Professional LLC), this is not an option in California.

A limited liability company (LLC) is a hybrid business entity that combines features of a corporation, partnership, and sole proprietorship. It offers several benefits, including:

Protection of Personal Assets

LLCs provide members with limited liability, meaning their personal assets (e.g., homes, cars, bank accounts, investments) are protected from business debts and acts. However, members can be held personally liable for certain types of misconduct.

Flexibility in Management and Taxation

LLCs offer flexibility in how they are managed; members can choose to manage daily operations themselves or hire an outside manager. Additionally, LLCs can choose how they want to be taxed, such as a C-corporation, S corporation, or partnership. The pass-through taxation feature of LLCs means that profits are taxed as part of the members' personal income, avoiding double taxation.

Ease of Formation and Simplicity in Functioning

LLCs are relatively easy to form and are suitable for small businesses due to their simplicity and reduced complexity in functioning. However, consulting an expert before making a decision is advisable.

Tax Benefits

LLCs offer tax advantages, such as pass-through taxation, which makes filing taxes easier. Profits go directly to the members without being taxed at the corporate level, and members can benefit from lower tax burdens if the business loses money.

The drawbacks of a professional corporation in California

In California, a professional corporation is a popular choice for licensed professionals who provide services that require a license, certification, or registration. However, there are several drawbacks to forming a professional corporation in California.

One significant disadvantage is the lengthy and complex application process. Entrepreneurs must navigate bureaucratic procedures, regulatory requirements, and administrative hurdles, which can lead to delays and frustration. Forming a professional corporation in California involves complying with the California Corporations Code, a comprehensive set of statutes that outline the rules and regulations governing corporate entities. This complexity can be overwhelming, especially for those new to business law, and can result in a prolonged application process as accuracy and compliance must be ensured.

Another drawback is the cost associated with forming and maintaining a professional corporation. Entrepreneurs need to pay filing fees to the California Secretary of State when submitting the articles of incorporation. These fees vary based on factors such as the type of corporation and the number of authorized shares. Additionally, ongoing legal and consulting fees may be necessary to navigate complex governance, regulatory, and contractual matters. Corporations in California have ongoing compliance obligations, which can entail record-keeping, regular reporting, and adherence to corporate formalities, resulting in higher administrative expenses.

Furthermore, while taxation benefits can be achieved through a professional corporation, there are still certain taxation costs to consider. Corporations may require financial resources to manage tax planning, accounting, and tax return preparation. Ensuring accurate and compliant tax filings can be complex and require professional expertise, incurring additional costs.

Additionally, the structure of a professional corporation may not be suitable for all professionals or practices. For example, salaried employees cannot earn their income through a professional corporation, which is often the case for lawyers and accountants in firms. Professionals who are not concerned about liability protection or the separation of personal and professional assets may not find the benefits of a professional corporation necessary.

Lastly, the formation of a professional corporation in California comes with specific requirements and limitations. For instance, the choice of the corporation's name may be restricted, and the bylaws may need to specify who can be officers and own shares. The corporation must also comply with the applicable rules in the California Business and Professions Code, which vary by profession. These requirements add complexity and may limit the flexibility of the business structure.

The requirements of forming an S corporation

Firstly, it is important to note that an S corporation is a corporation that has elected a special tax status with the Internal Revenue Service (IRS). This means that eligible domestic corporations can avoid double taxation, where corporate income is taxed once and payroll is taxed again. To elect S corporation status, Form 2553 must be filed with the IRS.

To form an S corporation, you must prepare and file Articles of Incorporation (also known as a Certificate of Incorporation or Certificate of Formation) with the proper state authorities. This involves paying filing fees and any applicable initial franchise taxes or other fees. The specific information required in the incorporation documents varies by state, and some states have rules limiting ownership of law firms. For example, you must have no more than 100 shareholders, and spouses and their estates count as one shareholder.

After incorporation, S corporations are required to adopt corporate bylaws, hold an initial meeting of directors and shareholders, and issue shares of stock to owners. It is important to note that the corporation name must be distinguishable from any existing business name in the state and cannot be deceptively similar.

Additionally, S corporations must have a 52- to 53-week tax year that ends on December 31. They are also required to file corporate tax returns, but they do not pay taxes at the corporate level. Instead, the S corporation's profits are passed through to the individual tax returns of the shareholders as taxable income.

By understanding and fulfilling these requirements, a business can successfully form an S corporation, taking advantage of the associated tax benefits.

The tax implications of different business structures

The business structure you choose will have legal and tax implications, and it is a critical step in your business's lifecycle. It can affect everything from the ability to attract investors to personal liability and government paperwork. It is important to take time to decide on the right type of business entity. While you may convert to a different business structure in the future, there may be restrictions based on your location, which could also result in unintended dissolution. Consulting with business counsellors, attorneys, and accountants can be helpful.

Sole proprietorships are the simplest of business structures. It is a straightforward structure in that the business is owned by one individual. There is no need to file special forms with the state, although you are required to have all the necessary permits and licenses. The potential downside of a sole proprietorship is that the owner remains personally liable for all debts. Income from a sole proprietorship is reported on personal income tax returns, and the owner must also pay self-employment taxes.

Partnerships are the simplest structure for two or more people to own a business together. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). Limited partnerships have only one general partner with unlimited liability, and all other partners have limited liability. The partners with limited liability also tend to have limited control over the company, which is documented in a partnership agreement. Profits are passed through to personal tax returns, and the general partner must also pay self-employment taxes. Limited liability partnerships are similar to limited partnerships, but give limited liability to every owner. An LLP protects each partner from debts against the partnership, and they won't be responsible for the actions of other partners.

A limited liability company (LLC) lets you take advantage of the benefits of both the corporation and partnership business structures. LLCs protect you from personal liability in most instances, and your personal assets won't be at risk in case your LLC faces bankruptcy or lawsuits. Profits and losses can get passed through to your personal income without facing corporate taxes. However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.

A C corporation is a separate legal entity with limited liability. It is owned by shareholders and is designed for perpetual existence. C corps must pay business taxes on their profits, and their owners are taxed on any dividends they receive, which is referred to as double taxation. They must file corporate tax returns every year and, in fact, must generally file a tax return even if they didn't turn a profit. If they distribute any portion of their profits to shareholders in the form of dividends, the shareholders are taxed on those individually. C corps tend to be larger enterprises and can be costly to set up and administer. Their advantage over other business structures, in addition to their greater liability protection, is that they can issue shares of stock as a means of raising capital, and there is no limit to how many shareholders they can have.

An S corporation is a type of pass-through entity with its own rules. The key differences are the rules of who can form an S-corporation and that shareholders are paid reasonable wages. The rules to qualify as an S-corporation are complex, but they can be a good choice for businesses that would otherwise be a C corp but meet the criteria to file as an S corp. S corps are designed to get around the problem of double taxation by passing their profits and losses through to shareholders, who then become responsible for any taxes.

Frequently asked questions