Author Topic: S Corp as partner of Law Firm (LLP) instead of Individual  (Read 605 times)

specialkayme

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S Corp as partner of Law Firm (LLP) instead of Individual
« on: July 17, 2017, 09:17:44 AM »
I have a meeting with a few of my law partners to discuss a few items tomorrow, and I wanted to run a tax strategy by them. But before I do I wanted to make sure I fully understood everything, and there wasn't anything I was missing.

Background
In January of 2016 I became an income partner of a small law firm. Before that I was an associate, getting paid w2 earnings. The law firm is set up as a LLP and pays its partners a semi-monthly salary, equal to 65% of a yearly agreed to amount, with the other 35% paid in quarterly installments (typically referred to as the "tax draw" which is paid at the time of, and used to pay the quarterly estimated tax payments to the fed and state). At the end of the year, anything left over in the firm gets divided among the partners in accordance with the partnership percentages.

Last year I learned the "joy" of paying quarterly taxes, and having to pay Self Employment Tax. I got a small distribution at the end of last year, but no year is a guarantee. A big case could walk through the door tomorrow and $100,000 distribution could be generated by year end, or there could be none. Because the year end is so questionable, in order to avoid penalties on estimated taxes you need to pay the lesser of: a) 90% of the tax on what you think you'll earn this year, or b) 100% of last year's tax. Each year is a giant question mark on what you'll earn, so the only way to avoid penalties is to go with option "b."

Going into year two, I realize how incredibly inefficient this system is, mainly for two reasons: One - I'm paying high SE tax, and Two - I'm always stuck with either paying a large tax at the end of the year (because the distribution was larger than last year's, meaning I under estimated in quarterly taxes) or overpaying in taxes (because the distribution was smaller than last year's, and I had to pay 100% of last year's taxes in quarterly installments). This year, I'm not likely to receive a year end distribution (based on current calculations) but I still have to pay 100% of last year's taxes in quarterly installments (in the event a distribution does come), which ends up being greater than the 35% "tax draw." This puts me in a little bit of a crunch quarterly at the moment (which I can cover by being frugal, but still).

Strategy
To avoid these issues, I'd like to propose that each member set up their own "S Corp" and have those S Corp entities be partners of the LLP. The semi-monthly distributions would remain the same, but would be paid to each S Corp instead of to each partner. Each S Corp would be responsible for paying each partner their own "reasonable salary" which could be equal to the 65% regular payments (conceivably) through a payroll service (which would probably cost about $25 a month). At the end of the year, anything the S Corp would have can be turned over to the individual partner (which should equal the 35% estimated "tax draws"). In the end, each partner should save a boatload in taxes in the form of:
1. We'll still be paying the 15% "SE Tax" on the regular 65% (or 7.5% FICA/FUTA and 7.5% SSI/Med with holdings), but wouldn't pay any on the 35% tax draw.
2. The 35% tax draw would be subject to long term capital gains tax as a distribution, subject to 15% taxes rather than ordinary income tax (28% for most of us) AND wouldn't be subject to SE Tax. Tax savings on that amount should be equal to approximately 28% (15% SE savings, plus 28%-15%).
3. You'd avoid the "float" of making estimated taxes on last year's distribution not knowing what this year's distribution is. Instead, if a large distribution comes in, you just pay LTCG tax. If not, you didn't pre-pay anything.

Potential Fights Against
Less money would be generated each month for each partner under this strategy, although significant savings would happen at the end of the year. Using real world numbers:
Old System With No Distribution (using rough numbers)
Draw = $100k ($65k semi monthly, or $2,708.33 per paycheck, and $35k quarterly, or $8,750 each).
Each paycheck = $2,708.33
Yearly tax = $15,000 SE + tax of $16,315 (AGI = $82,150 after Standard Deduction, 1/2 SE tax deduction and 1 exemption)
Total tax = $31,315

Old System with Distribution
Just pay (rough) 43% of any addition distribution in taxes on top of above (15% SE tax, and 28% Ordinary Income) (yes it will be less with deductions, but still)
Distribution = $10,000
Total tax = $35,615

New System With No Distribution (using rough numbers)
Draw to S Corp = $100k ($65k semi monthly, or $2,708.33 twice monthly, and $35k quarterly, or $8,750 each)
Each paycheck before payroll deductions = $2,493.64 ($25 /m payroll service fee + 7.5% FICA/FUTA)
Each paycheck after payroll deductions (of 7.5% SS/Med + Fed Withholdings) = $1,859.62
Year End Distribution = $35,000
*Edit* By not having to pay SE taxes on the $35,000, you save $5,250 in SE taxes, but you lose the 1/2 SE tax deduction on it, meaning you increase your taxes by ~$735, for a net savings of $4,515 (plus not having to worry about the float) or approximately 4.5% of earnings.

New System with Distribution
Just pay 28% of any additional distribution (again looking past any tax deductions)
Distribution = $10,000
Total Tax Savings = $6,750 in SE Taxes (less $945 tax gain) for a net gain of $5,805 or approximately 5.8% of earnings. *End Edit*


I've searched around and can't find anything from the bar association that says it can't be done this way. There might be some legwork that needs to be done with the state privilege license department, and our malpractice insurance carrier, but shouldn't be too difficult.

Does it sound like I have everything about right? Did I miss anything (positive or negative)?
« Last Edit: July 17, 2017, 11:39:57 AM by specialkayme »

CareCPA

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #1 on: July 17, 2017, 09:27:23 AM »
You're misunderstanding distributions from an S Corp.
(Caveat: I didn't read through all your numbers, because your beginning assumptions are off.)

You pay income tax on all income coming into the S-corp, not just on your salary. Distributions are never taxed when made (unless you run through your basis), because they would have already been taxed when earned. So your savings with having an S corp as partner is essentially the 15.3% SE tax rate on the 35% distribution (in your example).
Always happy to help with tax or accounting questions - feel free to private message me.

I am a licensed CPA in Pennsylvania. However, any tax advice I give should be considered general information and not used in the avoidance of tax. There is most likely information about your situation that I do not know, and thus you should do your own additional research.

Yes, in case it confuses you, I did change my forum name.

SeattleCPA

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #2 on: July 17, 2017, 10:55:31 AM »
Without getting into all the details, your idea does work to minimize payroll (SE) taxes...

Here's a long write-up I did at my blog:

http://evergreensmallbusiness.com/s-corporation-partnerships/

Mechanically, you have to do some fiddling. E.g., the S corp partners' employees need payroll... their pension plans need to be integrated with the law firm's pension plan, etc. But it'll work.

BTW, the hidden thing here is that you maybe pick up $10K a year per partner of SE savings... so if your firm has 10 partners saving $10K each, the annual savings get large.

You probably want to do lots more research...
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specialkayme

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #3 on: July 17, 2017, 11:40:39 AM »
You pay income tax on all income coming into the S-corp, not just on your salary.

You're right, I misinterpreted. I edited my post and calculations. Less significant, but still real.

specialkayme

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #4 on: July 17, 2017, 11:44:59 AM »
You probably want to do lots more research...

Biggest hickups I saw were:
1. Malpractice insurance
2. Payroll service
3. 401(k)
4. Health Insurance

All are currently provided by the firm for the benefit of employees. If the partners aren't employees of the partnership, I'm not sure how those items would work out (can an employee of a partner S Corp be a participant in a 401(k) plan? Same for a partnership sponsored health insurance plan?).

I can run all those questions down, but I want to be able to see that it's actually going to save real money before I do all the leg work. If I run it by all the other partners and say "you can save $800 a year by doing all this extra leg work with payroll services and *bla bla bla" I don't think it's going to go anywhere. But a $5,000 a year savings (or 5%) is big enough to bother with it.

In theory, if they say "no" I could still do it for myself. They don't need to have S Corps for me to benefit from the strategy. It makes things a little more difficult for me, but still possible.

SeattleCPA

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #5 on: July 17, 2017, 02:28:58 PM »
what you do in a situation like this is make the partnership the common paymaster for the S corporations that are partners...

This means that payroll for each partner S corporation, health insurance, etc is handled inside the partnership.

In terms of using S corporations as partners, the upside here is partners get to use the S corporation to save on SE taxes...

The downside (which actually isn't much of a downside in many cases) is that partners don't get to contribute as much to the pension. E.g., a 4% match on $80K of wages is $3200... A 4% match on $500K of wages is $20K...
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specialkayme

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #6 on: July 17, 2017, 02:51:38 PM »
what you do in a situation like this is make the partnership the common paymaster for the S corporations that are partners...

My concern at this point is less about how the money will flow to the health insurance and payroll, but whether doing it this way will make the individual owner of the S Corp eligible to be a participant in the health insurance plan, seeing as he is not an employee of the partnership. Same holds true for the 401(k) plan, which holds that in order to be eligible for the plan you have to be an employee.

Both are actually crappy plans, and I'd prefer not to be on them, but they are a condition of employment (or partnership?), so setting up an S Corp and bypassing the rules of membership would be sticking the middle finger in the air to the staff employees or partners who didn't elect to hold their partnership through an S Corp.

SeattleCPA

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #7 on: July 17, 2017, 05:01:45 PM »
The S corporation partner's employees (who are also shareholders of S corporations) will be employees.

And the whole collection of entities (the partnership and the S corporation partners) will be a controlled group of corporations and so need to use the same pension plan, the same health insurance, etc.
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Undecided

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #8 on: July 19, 2017, 11:41:33 PM »
You would organize a partnership of persons (the corporations) who are not attorneys and hold that partnership out for the practice of law for clients? I don't think that works in my jurisdictions, but maybe you've run it to ground in yours.

Your info suggests you're in NC. I'm no NC lawyer and it seems like the professions code
Is very different from mine, but isn't this an issue? http://www.ncga.state.nc.us/EnactedLegislation/Statutes/PDF/BySection/Chapter_84/GS_84-5.pdf

specialkayme

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #9 on: July 20, 2017, 04:54:02 AM »
You would organize a partnership of persons (the corporations) who are not attorneys and hold that partnership out for the practice of law for clients? I don't think that works in my jurisdictions, but maybe you've run it to ground in yours.

Either I'm not understanding what you're talking about, or you don't understand what I'm talking about.

A law firm can be organized as a sole proprietorship, a partnership, or a corporation. There's no prohibition against that. Provided that all of the owners are attorneys. You can also have limited partnerships where the partners are other entities (either other partnerships or corporations) provided those entities are also all owned by attorneys.

The statute you cited talks about corporations practicing law, which is prohibited because the corporation doesn't hold a law license. But neither does a partnership. It isn't the corporation that is practicing law when a member shows up to court. It's the individual.

Provided the individual is licensed, and they aren't governed by individuals who aren't attorneys, a corporation can be the entity a law firm creates.

In fact, the ABA and several other organizations specifically endorse the creation of an LLC or S Corp instead of a partnership or sole proprietorship. https://www.americanbar.org/publications/tyl/topics/solo-small-firm/law-firm-choice-entity.html
https://www.hklaw.com/files/Publication/86409a03-f28a-43d1-9929-e9a413c859ce/Presentation/PublicationAttachment/d7c8f69e-ee28-4829-8db1-f8accaf0b285/0908LawFirms.pdf

SeattleCPA

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Re: S Corp as partner of Law Firm (LLP) instead of Individual
« Reply #10 on: July 20, 2017, 02:03:55 PM »
You would organize a partnership of persons (the corporations) who are not attorneys and hold that partnership out for the practice of law for clients? I don't think that works in my jurisdictions, but maybe you've run it to ground in yours.

Either I'm not understanding what you're talking about, or you don't understand what I'm talking about.

A law firm can be organized as a sole proprietorship, a partnership, or a corporation. There's no prohibition against that. Provided that all of the owners are attorneys. You can also have limited partnerships where the partners are other entities (either other partnerships or corporations) provided those entities are also all owned by attorneys.

The statute you cited talks about corporations practicing law, which is prohibited because the corporation doesn't hold a law license. But neither does a partnership. It isn't the corporation that is practicing law when a member shows up to court. It's the individual.

Provided the individual is licensed, and they aren't governed by individuals who aren't attorneys, a corporation can be the entity a law firm creates.

In fact, the ABA and several other organizations specifically endorse the creation of an LLC or S Corp instead of a partnership or sole proprietorship. https://www.americanbar.org/publications/tyl/topics/solo-small-firm/law-firm-choice-entity.html
https://www.hklaw.com/files/Publication/86409a03-f28a-43d1-9929-e9a413c859ce/Presentation/PublicationAttachment/d7c8f69e-ee28-4829-8db1-f8accaf0b285/0908LawFirms.pdf

Agree with Specialkayme... I see big law firms where "Chuck" isn't actually the partner... rather "Chuck" owns "Chuck PS" and "Chuck PS" is partner in big law firm partnership.

I've been told by guys doing this that it may limit some of their liability... also that some guys do it with a C corp to escape multistate taxation in nonresident states... and know people do with S corps to escape SE taxes.
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