Mike is interviewed by law journal

Choosing a business entity is significant decision when starting your own firm
by Jane Pribek
Dolan Media Newswires
MILWAUKEE, WI -- LLC, S.C., LLP...
If you don't practice in the area of business or tax law, you may not know what the alphabet soup after a law firm's name means — or what it means if there's no alphabet soup there. Now that you've decided to start your own firm, however, choosing a business entity, and the tax ramifications that they may bring, is probably one of your first significant decisions.
There's no "perfect" entity, agree a numdber of experts who talked to Wisconsin Law Journal.
So, what's the best for you?
"It depends. I say that a lot," says Michael Bark, a CPA with Circore Business Solutions in Milwaukee, while attorney Nancy Trueblood, of Trueblood Law Office LLC in Wauwatosa, says, "Your choice is going to be (made) mostly for a business reason or tax purposes."
The Sole Proprietorship
The easiest choice, if you're going solo, is the sole proprietorship. There are no filing requirements with the state, the bar or the I.R.S. Just hang the shingle.
A sole proprietorship is not considered a separate legal entity, and there is no legal separation between you as the sole proprietor and your law practice business. In a sole proprietorship, you are financially responsible for all liabilities of your law practice, and all of your personal assets are subject to seizure or lien by creditors, says Trueblood.
Bark explains that when you file your personal tax return every year on Form 1040, you will attach Schedule C to report your profit or loss. In addition to paying income tax on your earnings, you are required to pay a 15.3 percent self-employment tax, also called "FICA," on those earnings. (To be precise, the FICA tax rate is 15.3 percent on the first $97,500 of earnings, and after that point, it drops to 2.9 percent, he says.)
The sole proprietorship is the simplest option, because you do not have to file a separate tax return for your business. "The downfall of being a plain schedule C business is, in a lot of cases, you could be paying too much in self-employment taxes," states Bark.
Sole proprietors also do not have to carry malpractice insurance, as they must with an LLC, for example.
The General Partnership
Trueblood states that, in a general partnership, each partner is jointly and severally responsible for all liabilities of the law practice business, and all personal assets of each partner are subject to seizure or lien by creditors.
Tax-wise, a general partnership must file a federal tax return every year on Form 1065. It is considered a pass-through entity under state and federal tax law, so that a general partnership does not pay tax. The annual profit of a general partnership is reported to each partner on Schedule K-1, and the partners pay income tax on their respective distributive share of the profits reported on that schedule.
The Professional or Service Corporation
A service corporation is formed by filing with the state articles of incorporation, and its owners are called "shareholders," says Trueblood. As a shareholder in a service corporation, you do not have personal liability for liabilities that arise in the ordinary course of business or from the malpractice of other attorneys at your law firm.
From the tax standpoint, a service corporation is taxed either as a C corporation or an S corporation, explains Bark. Your S.C. will be taxed as a C corporation unless you elect tax treatment as an S corporation. (An S corporation cannot have more than 100 shareholders, and all must be "domestic," so a huge, international law firm cannot elect S corporation status.)
In contrast to the C corporation, where owners are essentially doubly taxed, an S corporation is a pass-through entity under federal tax law, Bark continues. With an S corporation, the profit distribution is exempt from the FICA tax that is imposed on compensation income.
For example, if you and another attorney/owner garner $100,000 in profits each, as partners, you'll both pay self-employment taxes on that entire sum. However, as an S corporation, you can take a W2 wage of $80,000 or some other "reasonable compensation" and you'll pay taxes, including FICA on that sum, but not the $20,000 you receive as a distribution. FICA is taxed at 15.3 percent, which would save you upwards of $3,000 per year, or $30,000 over the course of 10 years.
Bark says, "It's not a huge tax savings. But, over the course of many years, it adds up. And if we can do it every year and it's a noncontroversial election, why not? Then again, some people say, "It's only $3,000 a year, what's the big deal?'"
The key here, emphasizes Bark, is to keep the wages "reasonable." Anything less is a red flag to the IRS.
Other Limited
Liability Entities
There are two: the limited liability corporation (LLC) and the limited liability partnership (LLP). As an attorney who is also an owner of a limited liability entity, you're still personally liable for your own professional negligence. But when the business is "limited liability," it can shield you from the negligence of another partner.
LLCs have been available in Wisconsin for attorneys since 1997, when the Supreme Court Rules were amended to allow them, says Trueblood. As an LLC owner, you must register with the State Bar and pay an annual fee, and you must have professional liability insurance, the amount of which is linked to the number of lawyers in the firm. In addition, the firm must make "LLC" — the limited liability status — a part of its name, and must give clients and prospective clients a written, "plain-English" summary of what that limited liability means to them.
An LLC is a legal status, rather than a tax status, reminds Bark. The IRS isn't concerned, per se, about your potential liability.
But one benefit of an LLC is that, under the U.S. Treasury Department's so-called "check the box" regulations, LLC owners may elect how to be taxed. Either the LLC itself may pay taxes, as would a corporation classified for tax purposes as a C corporation, or pass on its income or loss to the owners, resulting in taxation similar to that of a sole proprietor or S corporation shareholder.
With the LLP, like the LLC, there is liability protection from your law partners' negligence, and malpractice insurance is required, among other things.
Your LLP might wish to elect C corporation status, because it gives you more flexibility with regard to how profits are allocated. Profits must be distributed evenly in an S corporation; not so with a C corporation. This is helpful with many partners and someone wants to take a sabbatical, or if there's a two-tiered partnership. If you want to accomplish an uneven compensation with an S corporation, this can still be done by adjusting someone's W2 wages. But remember to keep those wages reasonable, because the IRS will scrutinize this election, cautions Bark.
Some Commonplace Scenarios
For solos: Sole proprietorship, LLC or service corporation?
If your practice is high-volume in nature, and therefore you plan to hire employees and thereby earn profits off their work, Bark says that the LLC or an S.C., electing S corporation status, are probably advantageous to sole proprietorship, because you'll only pay FICA on your reasonable W2 wages.
The requirements to maintain an LLC are not burdensome, Trueblood adds. However, if you prefer the added formalities in operation that an S.C. brings, you might want to go that route. The articles of incorporation, annual reports, and/or limited liability forms can be filed online.
"What I see is that sometimes people file articles of incorporation [to form an LLC], and then forget to put an operating agreement in place," Trueblood observes.
For law partners: We want to put money back into the business.
Maybe you want to pay off some of the expenses incurred in setting up the firm such as computer networks, office furniture, etc.
Bark says the S corporation might make sense for you, because you can put money back into the business as "previously taxed income," thereby creating a basis within the corporation. With a C corporation, it is harder to leave money in the business, because you'll ultimately want it out of the business, and you'll be doubly taxed because the firm has already been taxed on those dollars.
Or, Bark recommends a general partnership, as it is a pass-through entity, tax-wise. Of course, there is greater liability with a partnership.
I want to change to an S corporation.
According to Bark, the S corporation is a newer development in tax law, and firms that have been around for many years might be C corporations because there used to be no other options. Or, some end up in C corporation status unintentionally, because you've neglected to elect S corporation status (You were too busy practicing law, per chance?).
A frequent concern when switching from C to S corporation status is the "built-in gains" tax, he says. Most attorneys use cash-basis accounting, meaning that they recognize their income when the check is in hand, as opposed to accounts receivable, and they recognize expenses when they actually pay them. With built-in gains tax, you are required to restate financials on the accrual basis, so that you list accounts receivable and subtract accounts payable. If the gap between those sums is $100,000, for example, you pay the highest corporate tax rate on that difference, 35 percent, or $35,000, to be paid over four years.
"If your savings on the self-employment tax is not going to outweigh the built-in gains tax, there's no point in doing it right now."
The Bottom Line
Every situation is going to be different. There's no cookie-cutter approach," observes Bark.
When getting started, you need to have a business plan on paper, complete with compensation goals, he says. Barks meets with his clients quarterly, to talk about their businesses' financial goals and ascertain if they're on the way to meeting them.
I chose our business structure because…
"I chose an LLC format because I wanted the pass-through of the financials to my personal level of taxation. I also consulted with a corporate lawyer and was advised to use the LLC, rather than the S.C. status. I don't view there as being a significant difference on the liability of my organization. Also, it's just me at this point, and it suits me fine for my needs."
— John E. Thiel,
Thiel Law Office LLC, Appleton
"My law partner and I previously practiced in a three-person firm where a partner left. Although there were a number of circumstances that influenced our decision, it was just easier from an accounting and tax standpoint to continue with the same business entity as the firm was originally formed, namely, a C corp. It made for an administratively less disruptive and a smoother transition.
"Many established law firms were formed prior to the existence of the limited liability company. I suspect that rather than change their accounting set-up, letterhead, ownership documents and other administrative items, these established firms have decided to keep the status quo.
"However, if we were starting a new firm now, we'd probably elect to form an LLC, in which there are the benefits of an entity with fewer formalities, and a number of tax-status elections from which to choose."
— Jeffrey Alan Santaga,
Hanson & Santaga S.C., Wauwatosa, and
chair of the Law Office Management Section of the State Bar of Wisconsin
"We've been a general partnership since my father started the firm in 1940. It's been our tradition, although we're considering other entities, the LLC or the LLP. On the tax issue, both are treated as a partnership, and there might be an advantage if you had a generalized retirement program. We don't. My dad practiced five and a half days a week until he passed away at age 94, and I guess I plan on doing the same. So a retirement-deductible program is not a consideration. Also, my law partner is my son, so there's less of a concern about liability, and that's what our malpractice insurance is for."
— Terry Rose,
Rose & Rose, Kenosha
"There are several reasons why I elected sole proprietor status for my law practice.
"By default, it was the easiest way to set up my practice when I first began. I wasn't sure how long I would be practicing as a solo, so I took the path of least resistance.
"As time went on, I began looking at other forms of organizing my business. Keep in mind that I have no employees, no staff and no other attorneys with whom I practice. There were two overriding questions that needed to be answered. First, could I, as a sole practitioner, get any liability protection by using a business entity? If so, what would be the ‘cost?' Secondly, could a business entity provide tax savings to a sole practitioner?
"Although I could, on paper, form an entity of some sort to limit my liability, the Supreme Court rules, namely SCR 20:5.7, provide little, if any, relief from personal liability, and no relief for errors and omissions. Furthermore, the rules require attorneys to notify their clients of the limited liability under which they are organized. Such a letter to clients may do more harm than good by scaring off potential clients who think their lawyer is trying to absolve himself of any bad legal advice. Is this being overcautious? Perhaps. But it comes into play, at least for a true solo practitioner.
"As far as tax relief, I have found little advantage to forming a business entity. Some solo attorneys create entities that allow them to pay themselves a lower salary, subject to FICA taxes, and to take the rest of their income as a distribution or dividend issued by the entity. But the question arises whether their salary is ‘reasonable compensation' as viewed by the IRS. Since I have no paid staff, and I am the sole source of revenue for the practice, what I pay myself out of the practice is most likely what the IRS would deem to be ‘reasonable compensation.' Again, I am being cautious."
— Thomas A. Heyn,
Thomas A. Heyn Attorney at Law,
Cottage Grove,
and member of the Law Office Management Section Board of
Directors of the State Bar of Wisconsin
"We chose the LLP for a number of reasons. Mostly, it's conducive to growth, and there's the flexibility of a partnership. Also, there is some liability protection for lawyers, vis a vis their partners. When you get into management issues, however, there isn't a tremendous difference between the corporate forms anymore."
— Jerry Gonzalez, Gonzalez, Saggio & Harlan LLP, Milwaukee
"I went with the sole proprietorship for complete simplicity. It's by far the easiest. I do criminal defense, a lot of public defender cases, so I'm not too worried about liability, although I do carry malpractice insurance. Eventually, I'll probably form an LLC. But for now, I work out of my home, and for tax and paperwork reasons, it just makes sense to keep it simple. I can use my own checkbook."
— Michael E. Covey,
Covey Law Office, Madison