Should you incorporate?: Choosing an entity for your law practice

March 27th, 2014 by Briana Cummings

If you want to hang your own shingle, or change the structure of your existing practice, one of your first decisions will be whether to form an entity for your business, and, if so, which one.

Note that the law governing entity formation is mostly a matter of state law, so check your local rules.

First some general considerations:

  • Every person or entity doing business in the City and County of San Francisco must obtain a valid Business Registration Certificate from the Office of the Treasurer & Tax Collector. Check whether your locality has a similar requirement.
  • Every person or entity conducting business under a name  other than that person’s or entity’s full legal name must also file a Fictitious Business Name Statement with the County Clerk.
  • In some places, you may not call yourself a firm if you are a solo practitioner, no matter what entity you practice under. (See California Rules of Professional Conduct, Rule 1-100.)
  • Employment requirements under the Labor Code are the same regardless of which entity form you choose.
  • Forming an entity does not protect your assets from your own personal malpractice. Liability insurance is therefore highly recommended, whichever entity you choose.
  • If you are a sole proprietor, partnership, or S corporation, you might want to look into self-employment IRAs for retirement planning.

In California, a solo practitioner may operate as an unincorporated sole proprietor, a professional corporation (PC), or a non-profit organization. Groups of two or more lawyers may work together as a PC, a non-profit organization, or a general or limited liability partnership. (In other states, the limited liability corporation, or LLC, is becoming the legal entity of choice, but that option is not available to lawyers in California.)

Sole Proprietor/”DBA”

If you don’t want to incorporate, you can do business under either your own name or under a fictitious name (“doing business as,” or “DBA”). If you do business under your official name, you don’t have to file a DBA, but you should anyway.

You cannot have partners as a sole proprietor (there can be only one owner), but you can have an unlimited number of employees. If there are any employees in addition to yourself, you must apply for a Federal Employer Identification Number (EIN) by filing Form SS-4 with the Internal Revenue Service.

Pros:

  • The only corporate formalities required are getting your business license, DBA, and, if applicable, your EIN.
  • You pay only individual rates for federal and state income taxes. When you file your personal federal income tax return on Form 1040, you will attach Schedule C to report your profit or loss from operation of your sole proprietorship law practice. Deductions for health insurance, SEP-IRA contributions, or solo 401(k) contributions will reduce your federal income tax.

Cons:

  • No limited liability. With no legal separation between you and your practice, a sole proprietorship doesn’t offer premises or employment liability, which means your personal assets are subject to seizure or lien by creditors. *Note, however, that another way to protect your personal assets, other than the corporate liability shield, is just to take out general commercial liability insurance.*
  • The self-employment tax. In addition to your federal income tax, you must pay a 15.3% self-employment tax (12.4% Social Security tax + 2.9% Medicare tax) on the first $117,000 of your net income. (Some other entities (e.g., the S Corporation) offer lower Social Security and Medicare taxes.) To reduce your net income, increase your business-related expenses.

Professional Law Corporation (PC) 

A professional corporation (known as a professional association, or P.A., in some jurisdictions) is the only for-profit corporate entity available to solos in California. It is also available to associations of attorneys. All owners of the corporation must be licensed attorneys.

To form a professional corporation in California, you must file Articles of Incorporation with the California Secretary of State. You can either compose your own document or use Form ARTS-PC.  The California Secretary of State provides tips for corporate filing. The California State Bar provides tips specific to Law Corporations.

Pros:

  • Limited liability.
    • Shareholders of a corporation do not have personal liability for liabilities that arise in the normal course of business (premises liability, employee liability, etc.). Note, however, that you can get similar protection by buying general commercial insurance. 
    • Shareholders of a corporation also do not have vicarious liability for liabilities that arise from the malpractice of other attorneys in the firm. (Incorporating does not protect your personal assets from malpractice claims against you personally or those you supervise.) Note, however, that you can get the same protection by forming an LLP rather than a PC—except that in an LLP, you lose liability protection  if you forget to file your annual report. If a PC fails to file its annual report, it can get its corporate status reinstated retroactively by paying the applicable reinstatement fee and filing the applicable form.
  • The other main reason to operate your practice as a PC rather than as an LLP or sole proprietorship is that, if your profits are high, you may pay lower taxes as a corporation than you would as a sole proprietor or partnership, by putting more pre-tax profits into qualified retirement plans and adopting medical plans that allow increased deductions and contribution limits.  

Cons:

  • Administrative burden. To maintain liability protections it is necessary to follow all corporate formalities: annual reports, meetings, minutes, separate bank accounts for the corporation and the lawyer’s/lawyers’ personal funds, etc.
  • There is $100 filing fee in California.
  • Two-tier taxation (see below). If your profits are not high, this two-tier taxation will result in you paying higher overall taxes than if you operated in some other form.

C Corporation or S Corporation?

If you form a professional corporation, it is presumed to be a C corporation (named after subsection C of the Internal Revenue Code) unless you specifically elect to make it an S corporation (named after subchapter S of the Internal Revenue Code) by filing Form 2553 with the IRS.

A C corporation has two levels of taxation on all profits: The corporation pays tax on its net income and then individual shareholders pay tax on distributions. You should therefore not operate your PC as a C corporation unless you have little to no profit. To minimize profit, designate income as salary.

An S corporation has a hybrid level of taxation that is usually better for lawyers. A lawyer incorporated as an S corporation can designate a reasonable salary for herself from the corporation’s profits. If the corporation’s income exceeds this salary, the remainder will be distributed to the lawyer as a dividend. The benefit of an S corporation is that this distribution income is taxed at a lower rate than the salary.

Other tax benefits that may depend on the particular circumstances of the individual lawyer(s) are that a C corporation can include greater deductions for health insurance and medical expenses, and an S corporation will have  lower payments for Social Security and Medicare taxes.

C-Corps file federal taxes on Form 1020, and state taxes on the applicable state form. S-Corps file federal taxes on Form 1020S and Form 1020S Schedule K-1, and state taxes on the applicable state form.

General Partnership

A partnership is a business that is not incorporated and is owned by two or more people. If you start a law practice with any partners and do not incorporate, then your law practice is by default considered a general partnership.

All partners in a law partnership must be lawyers, all are owners of the partnership, and all can take an active role in managing the day-to-day affairs of the business. Each partner’s share in the profits and losses is determined by the partner’s percentage interest in the general partnership.

To form a partnership, you must file a partnership agreement with the state, stating how much each partner will put into the venture, how profits and losses will be allocated, how debts will be handled, etc. You can ensure the stability of the partnership by putting in the partnership agreement that the departure of one of the partners won’t automatically dissolve the partnership.

Pros:

  • If profits are low, partners will pay very little in taxes (and no taxes if they make no profit) because partners are taxed on a pass-through basis under state and federal law. That is, the partners pay individual income tax on their respective distributive share of the partnership’s annual profits, as reported to each partner on Schedule K-1, but there is no separate entity-level taxation.
  • Lower administrative burden. Aside from applying for an EIN and filing a federal tax return each year on Form 1065, a general partnership doesn’t have to follow any corporate formalities, such as creating a board of directors and hiring a registered agent.

Cons: 

  • If profits are high, then you might pay more taxes as a partnership than as a corporation.
  • Vicarious disqualification. Having a partner will raise the risk that you will be vicariously disqualified from a matter if your partner has a conflict of interest in the matter.
  • Vicarious liability. Each partner in a general partnership is jointly and severally liable for all liabilities of the law practice business, including for one another’s malpractice. All personal assets of each partner are subject to seizure or lien by creditors. Each partner’s financial risk is therefore unlimited. Because of the liability risk, you should never join a general partnership. If you run a law practice with one or more other lawyers, you should either incorporate or register as a limited liability partnership.

Limited Liability Partnership (LLP)

A limited liability partnership is like a general partnership except that it gives all partners protection from vicarious liability for the malpractice or other tortious conduct of their partners and employees.  A limited liability partnership must be registered with the state bar. In California, partners in an LLP are each required to carry at least a million dollars in malpractice insurance.

Pros:

  • Same as general partnership: pass-through taxation and lower administrative burden than a PC (just have to file an annual report with the state bar).
  • No vicarious liability. Partners are not jointly and severally liable for the malpractice of other partners.

Cons:

  • Same as general partnership (except the joint and several liability): (1) If your profits are high, you may pay more in taxes as a partnership than you would as a PC. Higher taxes than a general partnership, but not really that much higher — something like $800 per year. (2) Higher risk of vicarious disqualification.
  • $70 filing fee.
  • One of the greatest disadvantages of the LLP as compared to the PC is the risk of losing the liability shield if you forget to file the annual report (see above). 

Note that a limited liability partnership is distinct from a limited partnership (LP), which must have at least one limited partner and one general partner (with unlimited liability), or a limited liability limited partnership (LLLP), which is a limited partnership with additional limited liability protections for the general partner(s). I am discussing here only limited liability partnerships (LLPs).

Limited Liability Companies (LLCs)

In some states the LLC (or PLLC, professional limited liability company) is becoming the legal structure of choice, but in California the LLC form is not available to law practices.

An LLC is owned by members rather than by shareholders. It offers the same liability protections as a corporation, but is considered a pass-through entity under federal and state tax law — thus combining the major advantages of the corporate and partnership forms. Or members can choose to be treated as a corporation for tax purposes; or, different members of an LLC can each individually incorporate under a different form (C corporation or S corporation), depending on how they want to individually structure their tax responsibilities.

Nonprofits

Most nonprofits are corporations (though they can also be trusts, unincorporated associations, or LLCs). Nonprofit corporations can limit liability, just as with any corporation.

Not all nonprofits are tax-exempt. To get tax exemption, you need to create a nonprofit legal entity under state law, and then file Form 1023 with the IRS to seek 501(c)(3) status. Tax exemption also requires that the non-profit be formed and operated exclusively for the public benefit.

Pros:

  • Tax benefits. Nonprofits who meet the above criteria are exempt from state and federal income taxes.
  • Other financial perks. Nonprofits are exempt from federal laws regarding unpaid interns and often enjoy other perks such as free software licenses.
  • Access to grant money. Nonprofits are attractive to foundations and other charitable donors because contributions to a nonprofit are tax-deductible.
  • Having non-profit status can give you some legitimacy when working with certain people.

Cons:

  • Administrative burden. A nonprofit corporation must maintain corporate formalities, just like any other corporation. Plus, to maintain tax-exempt status,  a 501(c)(3) must have a Board of Directors, have regular meetings where it keeps records or minutes, and submit annual or biennial reports with the state attorney general. Much of this can be very minimal, but you have to keep the paperwork record clean, especially if you are applying for grants.
  • Wait time. The current wait time for the Form 1023 to get processed is 12-18 months. If you file your Form 1023 within 27 months of formation of the state non-profit entity, once the IRS finishes processing your application, tax-exempt status will be granted retroactively to the date of formation of the entity. However, most donors will be unwilling to donate unless you have already received your tax-exempt status. (Technically they can’t take the exemption until the entity has its status, so they would have to gamble that the status would ultimately be granted, and then go back and amend their tax returns for the year(s) in which the donations were made.)
      • To address this problem, about 9 months ago the IRS introduced the “1023 E-Z” form, which takes about 4 weeks to process. The main challenge is that, to qualify, you have to “project” that your gross receipts will be $50k or less per year for the first 3 years.  If you make more than that in gross receipts that would probably be ok unless you made so much more that your “projection” looked like it was made in bad faith.
      • Alternatively, you can work with an existing legal aid (as your “fiscal sponsor”), which can be easier in terms of paperwork, as long as you make friends with the Executive Director. It can also be a good way to start while you wait for your own 1023 to process.
  • Non-distribution restriction. A non-profit can generate revenue, and can raise grant money by virtue of its tax-exempt status, but it cannot raise equity capital because it cannot have shareholders and cannot distribute assets as dividends. All profits must be put back into the nonprofit.
  • Other restrictions on organizational activities. Tax-exempt nonprofits have other restrictions, including restrictions on political activity or lobbying and, most relevant to lawyers, on taking on contingency-fee cases.

 

Hybrid Forms

Many states have passed legislation creating new hybrid corporate entities — known as benefit corporations or flexible purpose corporations — that combine the corporate attributes of shareholder ownership and equity capital with the nonprofit attributes of operating, in part, for the general public good. As yet, these hybrid forms present no tax advantages over traditional corporate forms; their principal benefits are that, in theory, (1) they are eligible to raise both equity capital and money from foundations and other charitable donors, and (2) their status as benefit corporations signals to socially and environmentally conscientious consumers that they are socially responsible corporations worth patronizing.

Sources:

Last updated: June 16, 2015.

3 Responses to “Should you incorporate?: Choosing an entity for your law practice”

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