The Solo Practitioner - Entity Choices and Payments to the IRS

Getting your law firm started is an exciting AND overwhelming task. There are lots of things to think about and decisions to make. This post is going to focus on the structure of the firm and the tax impact of that structure. Just so this stuff does not get too heavy, I am going to break this up into a series of posts. So, welcome to Post #1!

Keep in mind – most if not all of this can change as you grow and evolve; so don’t sweat it if you do not make the optimal choice at this point.

Choice 1: Entity type. If you are a solo practitioner, you basically have two choices: sole proprietor or S corporation.

Let’s start with the easier one: Sole Proprietor – to sum up, a sole proprietor means that you are your firm; there is no legal entity that represents your firm. This structure only applies when you are a sole practitioner, although you can have employees. From an income tax perspective, your income less expenses is going to be reported on your individual income tax return on a Schedule C.

BIG WORD OF CAUTION – your income less expense is subject to TWO kinds of tax.

Tax #1 – Income Tax. When you think of tax, most people think of income tax. Income tax is paid to the federal government (IRS) and in most cases the state as well. If you look at your last paystub, Federal Income Tax was taken out of your paycheck as a deduction and showed up on your pay stub as “FIT” or Federal Tax or some derivation of that. At the end of the year, you filed your income tax return (Form 1040) and either got a refund or had to pay additional tax depending upon the amount of FIT you had taken out of your paycheck. Same process with the state, if you are in a state that collects state income tax.

Tax #2 – Self Employment Tax. This is the one that most sole practitioners are NOT prepared for. Go back to that paystub, in most cases the deduction right after Federal Tax is FICA (Federal Insurance Contributions Act). That represents your contribution to social security and medicare. What you do not see on that paystub, is that your employer pays the same amount to social security and medicare on your behalf.

So, now that you are going out on your own, you are your employer and your social security and medicare tax (self-employment tax) is going to be about 15 percent of your taxable income. That adds up FAST, so if you know about it, you can plan for it and not be surprised at the end of the year when the tax bill comes.

So to summarize – two kinds of tax: income and self-employment:

Example:

Income $100,000

LESS: Business Expenses 20,000

Taxable Income 80,000

LESS:

Income tax (assume 25%) 20,000

Self Employment (assume 15%) 12,000

State tax (assume 7%) 5,600

NET AFTER TAX $42,400

Yes, the numbers are depressing, but knowing them and planning for them helps you going forward. If you know these numbers, you can budget them as an expense, you can incorporate them into your billing rate, and you can plan so that you are not caught off guard.

Okay that is enough for now. Next time, we can start talking about when a sole proprietor should consider an S Corp to save on taxes.