You can tell the difference between equity and non-equity partners at Kirkland & Ellis by looking to see if they have “P.C.” after their name. It’s true. See here for an example of an equity partner and here for an example of a non-equity partner. Still skeptical? Google “Kirkland & Ellis partner p.c.” for a longer list of equity partners.
So, what are all the equity partners of K&E doing? They are each forming a professional corporation through which they hold their partnership interest and then making an S election. Why?
To save 3.8% tax on part of their income.
S Corporations
Here’s a little more detail: if a law firm is an S corporation, or if a law firm interest is a partnership interest that is held through an S corporation you can divide your income into salary and business profit.
Specifically, first a lawyer must determine an amount to treat as salary. It’s supposed to be a reasonable amount. This is withheld on by the S corp and shows up on a W-2. Let’s assume that’s $250K.
Even though this gambit is intended to save employment tax, the lawyer will not save any Social Security by using an S corp because the reasonable salary portion (which is subject to employment tax) will usually be over the Social Security wage base which is $137,700 for 2020. However, the profit received (in our hypo, the amount above $250K), while subject to regular income tax, would not be subject to Medicare (2.9%) and additional Medicare (.9%), creating a 3.8% tax savings.
If say, that lawyer makes $600K, that would save $13,300 per year. I calculated that by taking the $350K non-salary portion and multiplying it by 3.8%.
When determining the amount of reasonable compensation to pay yourself from your distributions, divide your income into three groups:
- Income attributable to your services;
- Income attributable to services of other employees (for example, your associates or paralegals); and
- Income attributable to capital and equipment.
Basically, the portion that receives the 3.8% tax savings should only be the skim you get from the associates and paralegals and any amount you can reasonably argue is attributable to capital and equipment. For example, as a law firm owner you own your pro-rata share of forms, have document management infrastructure and research databases, etc., all of which allows you to earn more than if you were an employee of that same law firm. That extra portion should be eligible for the employment tax savings and needn’t be included in your reasonable salary.
Note that S corps have an entity level tax of 1.5% in California, and there may be Texas franchise tax considerations or other state tax considerations. And for lawyers who earn below the QBI thresholds (discussed below), income through an LLC/LP might be better because it could allow for the QBI deduction on the entire amount, whereas a reasonable compensation is required for S corps.
QBI Deduction
There’s an additional way that law firm partners or solos can save tax, but this is only helpful for those with income beneath the below listed thresholds.
Recall that in 2018 a new 20% qualified business income (QBI) deduction came into existence. You probably remember some talk about how there was an exclusion with respect to lawyers, and then you may have forgotten about it.
Here’s a refresh:
Lawyers can take the QBI deduction if they are partners in a law firm (or sole proprietors) and make less than the below thresholds in 2020:
| Deduction | Full | Partial | None |
| Income (Single) | <$163,300 | Between $163,300 and $213,300 | >$213,300 |
| Income (MFJ) | <$326,600 | Between $326,600 and $426,600 | >$426,600 |
For example, if you are single and earn less than $163,300, all of which is qualified business income, you can take a 20% deduction as to all of your income, even if you are a lawyer. If you make more than $213,300, you do not get the 20% deduction on any of your income.
The problem for many law firm partners is that they make more than the thresholds, and thus are not eligible for the 20% deduction on their law firm income. Keep in mind that the $426,600 threshold for married taxpayers filing jointly includes your spouse’s income.
The above thresholds apply to law firms that are organized as sole proprietorships, partnerships or S corps, except that even if you are under the threshold the 20% deduction doesn’t apply to any portion that is a “guaranteed payment” or compensation. All of your income could potentially be qualified income in a sole proprietorship or partnership context, but in the S corp context some amount must be compensation.
Bottom line, you may be able to take the QBI deduction but it depends on your annual income and whether your income comes in the form of a distribution or a guaranteed payment/compensation.
Mike Baker frequently advises with respect to S corporations and the QBI deduction. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.