The type of compensation a law firm owner may receive will vary depending on how the law firm is structured. If a business issues the wrong type of compensation, it may have exposure for failure to withhold state taxes on nonresidents and may also overpay the employer’s portion of Social Security taxes.
S Corporations (Including LLCs Electing to Be Treated as S Corporations)
S corporations are magical entities in the fact that they can issue shareholders both W-2 compensation (to the extent that the shareholder is actively involved in the firm) and shareholder distributions.
Professional service corporations, such as law firms, often choose the S corporation structure for its tax advantages.
The Internal Revenue Service (IRS) requires shareholders who are actively involved in the firm to be paid reasonable compensation via W-2. Shareholders who are not actively involved in the business generally only receive shareholder distributions.
Failure to adhere to these basic rules can lead to significant financial repercussions for law firms. The consequences of not paying reasonable W2 salaries are as follows:
- Increased IRS scrutiny and audits: Underpaying active shareholders in salary while paying significant distributions can trigger IRS audits. The IRS closely monitors S corporations to ensure compliance with compensation regulations.
- Reclassification of income: The IRS may reclassify a portion of the shareholder distributions as wages, subjecting them to payroll taxes. This includes Social Security, Medicare, and federal unemployment taxes. Reclassified income results in back taxes, creating unexpected financial liabilities for the firm.
- Penalties and interest: The IRS can impose penalties for underpayment of taxes and interest on the overdue amounts, increasing the financial strain on the firm.
Partnerships (Including LLCs That Are Treated as Partnerships)
In the world of legal practice, law firms often grapple with complex tax issues due to the nature of their structure. Most law firms are organized as partnerships, which significantly impacts how income and expenses are reported and taxed. A common question that arises is whether a partnership can issue W-2 forms to its partners.
Partnerships are generally prohibited from paying partners W-2 compensation. The Internal Revenue Code requires partnerships to pay all partners K-1 income, constituting a distribution of profits and/or guaranteed payments.
The consequences of issuing W-2s to partners in a law firm structured as a partnership include, but are not limited to, the following:
- Misclassification of partners as employees: Partners are owners of the partnership, not employees. Issuing a W-2 suggests an employer-employee relationship, which is inaccurate. This misclassification can trigger scrutiny from the IRS leading to potential audits.
- Incorrect tax withholding: W-2 forms require withholding of federal income tax, Social Security, and Medicare taxes. Partners, however, pay self-employment taxes and are responsible for their own tax payments through estimated tax payments. This can result in incorrect withholding, complicating partners’ individual tax situations.
- Implications for retirement contributions: Contributions to retirement plans, such as a 401(k), differ for employees and self-employed individuals. Misclassifying partners as employees can complicate contributions and compliance with retirement plan rules.
- Impact on health insurance and fringe benefits: Employees and self-employed individuals are treated differently with regard to health insurance and fringe benefits. Issuing W-2s to partners can create confusion and inconsistencies in how these benefits are reported and taxed.
Sourcing Differences Between W-2 Compensation and Shareholder Distributions
W-2 income is generally sourced to the location where the individual physically worked to generate their compensation. If a Florida resident receives a W-2 showing that he or she worked 100 days in Florida and 100 days in Georgia, Georgia would be entitled to tax one-half of the individual’s compensation. Individuals working in states where they do not reside generally get a credit for taxes paid to a nonresident state in their resident state.
Shareholder distributions are sourced at the entity level. The place where the partner works and/or resides does not determine where the K-1 income is sourced. A Florida resident individual who receives a K-1 showing all the partnership’s income is derived from New York sources will pay New York tax on 100% of their K-1 income.
Examples of Problems Caused by Paying Law Firm Owners the Wrong Compensation
The law firm of Sunshine & Snow LL.P. (“S&S”) has two offices, New York and Florida. The revenue generated by the New York and Florida offices is roughly equal, and half of the partners work in each office. Despite being formed as a partnership, S&S incorrectly pays all the partners more than $200,000 in salary via W-2 compensation, instead of issuing them guaranteed payments via K-1s. The partners of S&S also get more than $200,000 in profit distributions via K-1s.
S&S is subsequently selected for a New York City Unincorporated Business Tax (UBT) audit, and the auditor promptly discovers the S&S partners were paid both W-2 Compensation and K-1 profits allocations. Upon making this discovery, the auditor:
- Adds back all W-2 Compensation paid to partners because the UBT denies a deduction for payments to partners for services or use of capital. The agent thus issues an audit assessment including penalties and interest.
- Notifies the New York State Department of Taxation and Finance to open audits on all S&S Florida partners. The S&S Florida partners incorrectly sourced their compensation to Florida as W-2 wages. However, since their incorrectly issued W-2 compensation should have been guaranteed payments reported on a K-1, one-half of this income is derived from New York sources. All of the FL partners are subsequently assessed New York Tax on one-half of the erroneously issued W-2 compensation, plus interest and penalties.
Furthermore, all the S&S partners received more than $200,000 in K-1 profits allocations and more than $200,000 in erroneously issued W-2 compensation. As such, S&S has overpaid its payroll taxes for all the partners. If S&S had paid out all the compensation on K-1s as a mix of guaranteed payments and profits distributions, it would not be subject to payroll taxes at the partnership level. The partners themselves would have paid self-employment tax on their respective K-1 income. Since the partners still received a K-1 reflecting their respective profits share, they already paid the maximum FICA tax every year.
With regards to the erroneously issued W-2s, the partnership and partners also paid payroll taxes on the W-2 compensation. The partners were able to get a refund of the FICA tax withheld from their W-2 paychecks as they already paid the maximum FICA tax as part of self-employment taxes. S&S paid the employer’s share of the payroll taxes on the partners’ W-2s. As such, S&S has needlessly paid in excess of $450,000 of payroll taxes in the past five years, computed as follows:
| Year | Maximum FICA Tax/Year | Number of Partners | Amount of Erroneously Paid FICA Tax |
|---|---|---|---|
| 2020 | $8,537 | 10 | $85,374 |
| 2021 | $8,854 | 10 | $88,536 |
| 2022 | $9,114 | 10 | $91,140 |
| 2023 | $9,932 | 10 | $99,324 |
| 2024 | $10,453 | 10 | $104,532 |
| $468,906 |
Takeaways
To avoid assessments and overpaying payroll taxes, law firm owner compensation must be paid in the correct form. Law firms that are formed as partnerships (and LLCs treated as partnerships) may only issue the owners K-1s. Law firms that are structured as S Corporations (including LLCs that have elected to be treated as S Corporations for tax purposes) may issue the shareholders both W-2 compensation and K-1 profits distributions.
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For more information on this topic, please contact a member of Withum’s Law Firms Services Team.
