Law firm owners often face critical decisions about their business structure that can significantly impact their tax obligations and long-term financial health. One common question that arises is whether a law firm can operate as an S Corporation (S Corp).
This is an important consideration as the right business structure can lead to substantial tax savings and provide appropriate liability protection.
The short answer is yes, law firms can indeed elect S Corp status for tax purposes, as long as they meet specific eligibility requirements set by the IRS and comply with state regulations for professional corporations.
In this guide, we'll explore the implications of S Corp status for law firms, examine the potential tax advantages, outline the additional costs involved, and help you determine if this business structure is appropriate for your legal practice.
What Is an S Corporation?
An S Corporation is not actually a distinct business entity type but rather a special tax election available to qualifying corporations and limited liability companies (LLCs).
When a business elects S Corp taxation, it becomes a pass-through entity for federal income tax purposes, meaning the business itself doesn't pay federal income taxes. Instead, company profits and losses "pass through" to the owners' personal tax returns.
Unlike C Corporations that face potential double taxation (once at the corporate level and again when dividends are distributed to shareholders), S Corps avoid this issue entirely.
Additionally, S Corps differ from sole proprietorships and partnerships in that they allow owners to be treated as employees of the business, receiving both a reasonable salary and distributions that aren't subject to self-employment taxes.
This distinction forms the foundation of the primary tax advantage that makes S Corps attractive to many law firm owners. Law firms can absolutely operate as S Corporations, though they must meet specific eligibility requirements.
Eligibility and Formation
Before pursuing S Corp status for your law firm, it’s important to understand the foundational requirements and steps involved. The process hinges on both federal tax rules and state-specific regulations that govern professional legal entities.
From entity structure to IRS filings, careful planning ensures compliance and smooth transition. Below, we break down the key considerations to help you determine if this tax election aligns with your firm’s goals.
Entity Type and Shareholder Restriction
Most states require law firms to charter as professional corporations (PCs) or professional LLCs (PLLCs) before seeking S Corp status. In California, for example, a Professional Law Corporation may elect S Corp taxation just as a General Stock Corporation can.
To qualify for S Corp election, your law firm must meet these requirements:
- Be a domestic corporation
- Have only allowable shareholders (individuals, certain trusts, and estates)
- Maintain no more than 100 shareholders
- Issue only one class of stock
- Not qualify as an ineligible corporation (including certain financial institutions and insurance companies)
Additionally, all shareholders must be U.S. citizens or residents. For law firms specifically, state laws typically require that all shareholders be licensed attorneys, which aligns with S Corp ownership restrictions but adds a professional licensing element to the requirements.
IRS Election
If you decide that S Corp status is right for your law firm, you'll need to make this election by filing Form 2553 (Election by a Small Business Corporation) with the IRS.
For new businesses, this must generally be done no later than two months and 15 days after the beginning of the tax year the election is to take effect. For existing businesses, the election made before March 15 can be retroactive to January 1 of that same year.
Before making this election, ensure your firm meets all federal requirements for S Corp status and check state-specific requirements, as some states automatically recognize the federal S Corp election while others require separate filings.
Additionally, if your law firm is currently operating as a sole proprietorship or partnership, you'll first need to form either a corporation or an LLC (depending on your preference and state laws) before you can elect S Corp taxation.
This process typically involves filing articles of incorporation or organization with your state, creating corporate bylaws or an operating agreement, issuing stock or membership interests, and obtaining any necessary business licenses.
It’s worth noting that all shareholders must consent to this. Once effective, income, deductions, and credits flow through to shareholders’ personal returns.
S Corp Tax Benefits
Electing S Corp status can offer law firms meaningful tax advantages, particularly in how income is classified and taxed. These benefits stem from the unique structure of S Corporations, which differ from both traditional corporations and pass-through entities like sole proprietorships.
Understanding these potential savings can help you determine whether this tax election aligns with your firm’s financial strategy. Below, we explore the key tax benefits that make S Corps an attractive option for many law practices.
Self-Employment Tax Savings
The primary financial benefit of electing S Corp status for your law firm is the potential for significant savings on self-employment taxes.
When operating as a sole proprietorship or partnership, all of the firm’s net income is subject to self-employment taxes, which fund Social Security and Medicare.
As of 2025, the combined self-employment tax rate is 15.3% on net earnings up to the Social Security wage base limit of $176,100:
- 12.4% for Social Security (OASDI), and
- 2.9% for Medicare (HI).
Earnings above the wage base are not subject to additional Social Security tax but continue to be taxed at 2.9% for Medicare. Additionally, an extra 0.9% Medicare surtax applies to income above $200,000 (single) or $250,000 (married filing jointly).
Under S Corp taxation, only wages paid to shareholder-employees are subject to Social Security (6.2%) and Medicare (1.45%) taxes, amounting to a total of 7.65% for the employee portion, matched by the employer.
The remaining business profits can be paid out as distributions, which are not subject to self-employment tax, escaping the 12.4% OASDI and 2.9% Medicare taxes altogether.
This strategic split between reasonable salary and distributions can lead to thousands of dollars in tax savings annually.
For example, if your law firm nets $150,000 and you pay yourself a reasonable salary of $90,000, the remaining $60,000 can be taken as distributions (free from Social Security and Medicare taxes).
In this case, the potential tax savings could exceed $4,000 per year, depending on your overall tax situation and state requirements.
Qualified Business Income (QBI) Deduction
S Corp owners may benefit from the Qualified Business Income (QBI) deduction, a provision of the Tax Cuts and Jobs Act that allows eligible taxpayers to deduct up to 20% of their qualified business income on their personal tax returns.
For S Corps, this applies to the pass-through portion of profits, not the salary portion. While this deduction can significantly reduce taxable income, it’s subject to various limitations, especially for specified service trades like law.
For law firms, the deduction begins to phase out once taxable income exceeds certain thresholds, $191,950 for single filers and $383,900 for joint filers in 2024 (adjusted annually).
Above these limits, the deduction may be reduced or eliminated unless the firm meets certain wage and capital investment tests.
That makes proper salary planning and entity structuring even more critical for firms trying to maximize this benefit. Keep in mind: unless extended by Congress, the QBI deduction is set to expire after 2025.
Avoiding Double Taxation
One of the key tax advantages of an S Corporation is its pass-through taxation structure. Unlike C Corporations, which pay corporate income tax on profits and then again at the shareholder level when dividends are distributed, S Corps avoid this double layer of taxation.
The corporation itself does not pay federal income tax on its earnings. Instead, profits (and losses) are passed directly to shareholders, who report them on their individual tax returns.
This setup allows income to be taxed once at the shareholder’s personal rate, which can be especially beneficial if the shareholders are in a lower individual tax bracket. It also provides more flexibility in tax planning compared to the rigid structure of C Corporations.
However, shareholders must still pay personal income tax on their share of profits even if the business retains some of that income, which is an important consideration for cash flow management.
Administrative Costs and Compliance
While S Corp status offers tax advantages, it also introduces additional administrative responsibilities and expenses. Law firms must carefully weigh these ongoing requirements against the potential benefits before making an election.
The structure demands formal payroll systems, regular filings, and professional services that don't apply to simpler business forms. Below we examine the key operational considerations that accompany S Corp status for legal practices.
Formation and State Fees
Forming an S Corporation requires filing incorporation documents with your state, and fees can range from $300 to over $1,000 depending on where your firm is located.
In addition to the initial filing, many states impose annual report fees, franchise taxes, or both, which are recurring costs you’ll need to budget for each year to maintain good standing.
If you hire a lawyer to assist with formation, expect to pay anywhere from $500 to $2,000, depending on the complexity of your structure and whether you need custom bylaws, shareholder agreements, or ownership restrictions.
While these legal services aren’t mandatory, they’re often recommended for law firms to ensure compliance with ethical rules and to prevent future disputes among partners.
Payroll and Tax Preparation
As an S Corp owner, you're required to pay yourself a reasonable salary, which means running formal payroll even if you're the only employee. This typically requires hiring a payroll service, with fees ranging from $50 to $200 per month, depending on the provider and level of support.
You’ll also need to handle regular tax withholdings and issue a W-2 at year-end, which adds complexity compared to a sole proprietorship.
In addition to monthly processing, you must file quarterly payroll tax returns (Form 941) and annual employment forms like the W-3 and state equivalents. S Corp tax returns (Form 1120-S) are also more involved than a Schedule C and may lead to higher accounting costs.
However, all payroll and tax prep expenses are fully tax-deductible, helping to soften the financial impact.
Unemployment and Workers’ Compensation
Once you're on payroll, your wages become subject to federal and state unemployment taxes. The Federal Unemployment Tax Act (FUTA) rate is 0.6% on the first $7,000 of wages, which equals just $42 annually per employee if you're eligible for the full credit.
State rates vary: for example, Arizona's SUTA rate starts around 2%, or roughly $140 annually, though this can change based on your industry and claim history.
You may also be required to carry workers’ compensation insurance, which is mandatory in most states, even for firms with only one employee. Some states offer limited exemptions for owner-only businesses, but these are the exception, not the rule.
It’s important to verify your state’s requirements to remain compliant and avoid penalties.
Accounting and Advisory Fees
Filing taxes as an S Corporation is more complex than filing a Schedule C as a sole proprietor. The Form 1120-S requires detailed financial records, shareholder distributions, and payroll documentation, which means most firms need a professional tax preparer.
As a result, annual tax preparation costs typically range from $1,000 to $3,000, depending on the firm's size, number of shareholders, and the quality of bookkeeping.
In addition to tax filing, many law firms rely on ongoing advisory services to stay compliant with S Corp requirements, especially around reasonable compensation, profit distributions, and tax planning.
These services can add another $2,000 to $5,000 per year, but they help avoid costly IRS scrutiny and keep the firm aligned with its long-term financial goals.
Key Considerations and Drawbacks
While there are significant tax advantages to electing S Corp status for your law firm, there are potential drawbacks to consider as well.
The additional administrative burden can be substantial; you'll need to maintain more formal business records, hold regular board meetings, keep minutes, issue stock, follow corporate formalities, and manage payroll.
These requirements add complexity to your firm's operations and may necessitate additional administrative support. Furthermore, S Corps face restrictions on ownership that may limit your future growth or succession plans.
State tax implications also vary significantly. Some states don't recognize S Corp status or impose additional taxes on S Corps. Before making your election, research how your state treats S Corps for tax purposes, as this could impact the overall financial benefit of the election.
Reasonable Compensation Requirement
One critical requirement when operating a law firm as an S Corp is the obligation to pay yourself "reasonable compensation" as an employee before taking any distributions.
The IRS closely scrutinizes S Corps to ensure owners aren't avoiding payroll taxes by taking minimal salaries and large distributions.
This is particularly relevant for service-based businesses like law firms, where the primary value comes from the professional services of the owner-attorneys. Failure to comply can trigger back taxes, penalties, and interest.
What constitutes "reasonable compensation" depends on multiple factors, including your experience, qualifications, the specific legal services you provide, comparable salaries for attorneys in your geographic area and practice area, and the overall financial performance of your firm.
The IRS may consider what you would pay another attorney with similar qualifications to perform the same services, or what you might earn if employed by another firm. Documentation of how you determined your salary is crucial in case of an audit.
Generally, for law firms, a significant portion of the firm's income should be allocated to salary rather than distributions, given the professional service nature of the business.
Health Insurance Premiums
If you're a shareholder who owns more than 2% of your S Corporation, any health insurance premiums paid by the business on your behalf must be included in your taxable wages.
While this increases your reported income, it allows the business to deduct the premiums and gives you the opportunity to take a self-employed health insurance deduction on your personal return—effectively offsetting the tax impact.
However, these premiums may also be subject to employment taxes, depending on how they’re reported and reimbursed. This adds another layer of administrative complexity and may reduce some of the tax benefit of operating as an S Corp.
It’s important to structure this correctly to remain compliant and avoid IRS scrutiny.
Net Investment Income Tax (NIIT) Proposals
Under current law, S Corp distributions are generally exempt from the 3.8% Net Investment Income Tax (NIIT), making them a tax-efficient way to receive income compared to wages or sole proprietorship profits.
However, the Biden Administration’s FY 2025 Green Book proposes expanding the NIIT to include all pass-through business income for individuals with adjusted gross income (AGI) above certain thresholds.
Additionally, the proposal includes raising the NIIT rate to 5% on incomes exceeding $400,000, further narrowing the tax benefit of S Corp distributions.
If enacted, these changes could significantly impact high-earning law firm owners by reducing or eliminating the current S Corp tax advantage, especially for those relying on large distributions to minimize employment taxes.
While not yet law, these proposals signal a potential shift in how S Corps are taxed in the near future.
QBI Deduction Sunset
The Qualified Business Income (QBI) deduction, which allows eligible S Corp shareholders to deduct up to 20% of pass-through income, is scheduled to expire after the 2025 tax year unless extended by Congress.
This change could significantly reduce the after-tax appeal of the S Corp structure, especially for law firms currently benefitting from the deduction.
Without the QBI deduction, pass-through income from S Corps would be taxed at the owner’s full ordinary income rate, increasing the effective tax burden.
Law firm owners considering an S Corp election should factor in this potential change when making long-term entity planning decisions.
State-Specific and Ethical Rules
Many states enforce professional ethics that restrict non-lawyers from controlling law firms. Using a PC or PLLC ensures compliance. California, New York, and other jurisdictions have their own PC statutes; always verify with the state bar or corporate law office.
Some states impose additional taxes or fees on S Corporations, which can affect the overall tax savings. For instance, certain states require S Corporations to pay franchise taxes or have specific filing requirements.
It's essential to consult with a tax professional familiar with your state's laws to understand the full impact.
Final Takeaways: Evaluating S Corp Status
For many law firm owners, electing S Corp status can result in significant tax savings, primarily through the reduction of self-employment taxes.
The ability to split income between salary and distributions creates a powerful tax planning opportunity that can potentially save thousands of dollars annually as your firm grows.
However, this decision should not be made lightly. The additional costs, administrative requirements, and ownership restrictions must be carefully weighed against the tax benefits. Each law firm's situation is unique, and what works for one may not be optimal for another.
We strongly recommend consulting with both a tax professional and an attorney who specializes in business formations before making this election.
These professionals can provide guidance tailored to your specific circumstances, practice area, income level, and long-term business goals.
With proper planning and professional advice, structuring your law firm as an S Corp could be a strategic move that contributes significantly to your practice's financial success.
