By David B. Mandell and Carole F. Foos
Are you an owner of a law practice taxed as a flow-through entity…such as an S corporation? As such, you may be paid both as an employee of the practice – receiving a W-2 – and as an owner of the practice – through a K-1 distribution.
The key difference between income earned as employee compensation (W-2) and income earned as a K-1 profit distribution is:
While this is only a 3.8 percent tax, we have seen poor advice here cost attorneys $10,000 or more each year, every year of their career. Over one’s career, this can amount to nearly half a million dollars of lost capital…for no good reason!
Do you see yourself in either of these?
These cases are hypotheticals and any change or deviation from the circumstances discussed above could affect the outcome. Obviously, you would not want to be Smith. Yet, we are continually astounded when we see so many lawyers are in the same position – having all, or most, of their income treated as W-2 compensation when in fact much of it is earned because of the profitability of the practice rather than the attorney’s personal services.
Wouldn’t all of us prefer to be in Jones’ situation? If we are allowed to be – yes. So, the question really comes down to – what are the tax rules that govern this situation?
In discussions with a number of CPAs with over 15 years of experience, the consensus is that a lawyer should follow a simple rule: basically that one can reasonably be paid as a W-2 salary what one would need to pay an associate with the same training to come join your practice. The rest of your compensation can be characterized as distributions. One CPA, practicing for more than 20 years, commented “this is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”
Looking again at the examples above, Smith could attract another attorney to her practice paying $250,000 salary. This would allow her to avoid Medicare tax on $150,000 – saving over $5,500 annually. Not coincidentally, Jones is in the right situation.
As hard as you work, throwing away hundreds of thousands of dollars over a career – for no good reason – is a shame. Yet it happens every day.
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David B. Mandell, JD, MBA, is a former attorney and author of several books, including Fortune Building for Business Owners and Entrepreneurs. He is a principal of the financial consulting firm OJM Group www.ojmgroup.com, where Carole C. Foos, CPA is a principal and lead tax consultant. They can be reached at 877-656-4362 or firstname.lastname@example.org