Whether you’re newly licensed or are looking to start your own law firm, the IRS will want its cut. And unfortunately, the rule that says you can’t share fees with non-lawyers doesn’t apply to Uncle Sam. Here’s what you need to know to plan ahead and what tax deductions you can use to reduce what you owe.
What’s Your Employment Status?
How you pay taxes, and what tax deductions you can take, depends on how you’re classified.
Employee
If you’re an associate in a law firm or working for the government or in-house, you’ll likely be classified as an employee. This means that your employer will withhold taxes and send you a W-2 at the end of the year.
Unfortunately, employees can’t deduct things like bar dues. The Tax Cuts and Jobs Act ended deducting unreimbursed employment expenses as itemized deductions in 2018 and beyond.
Contractor
If you’ve signed on as an independent contractor, you’ll receive a 1099 at the end of the year. You must pay all taxes directly to the IRS including income tax and self-employment taxes.
Independent contractors count as sole proprietors and file a Schedule C with their tax return. You can deduct all ordinary and necessary business expenses on your schedule C.
Note: Contractor in this context refers to tax status. Some temporary or fixed-term positions may be called a contract but classify you as a W-2 employee for tax purposes.
Solo Firm
If you start a solo firm, your tax treatment is generally the same as independent contractors. If you organize your law firm as an LLC, you may be able to elect to be taxed as a corporation. Some states also allow law firms to incorporate as professional corporations.
Being taxed as a corporation allows you to pay yourself as an employee. A common tax strategy is to elect S-corporation status. This passes the corporation’s income to your own tax return instead of paying corporate income taxes. You can potentially split your income into wages subject to FICA taxes and dividends that are only subject to ordinary income taxes when you do this. So you can potentially save on Social Security and Medicare taxes.
If you’re using an S-corporation, pay close attention to the IRS reasonable compensation rules. You can’t just pay yourself a low salary and shift all of your income to dividends to avoid taxes. You have to take a reasonable salary. It’s easier to claim more money as dividends if you have employees doing some of your work (attorneys or support staff). This is a move you really want to talk to an accountant about to get it right.
Partnership
In a partnership, each attorney divides up their share of the earnings and expenses in accordance with the partnership agreement. Their share is then taxed on an individual basis similar to a solo firm or independent contractor.
This only applies to the partners. Associates and support staff will generally be paid and pay taxes as employees.
What tax deductions can attorneys take?
Qualified Business Income Deduction under Section 199A
Attorneys who are not employees are usually eligible for the 20% deduction on pass-through qualified business income. The deduction is roughly 20% of your business profits meaning that you pay income tax on about 80% of your profit.
The practice of law is a specified service business, so income limits apply. The income limits cover all of your income including business income, employment income, investment income, and other sources.
| Filing Status | 2022 | 2023 |
|---|---|---|
| Single and Married Filing Separately | $170,050 | $182,100 |
| Married Filing Jointly and Qualifying Widower | $340,100 | $364,200 |
| Head of Household | $170,050 | $182,100 |
If you’re under those income limits, you get the full 20% deduction.
If you’re above those income limits but not over by more than $100,000 for joint filers or $50,000 for other filers, you get a partial deduction.
The partial deduction is prorated by how much you’re over. For example, for a joint filer,
- Over by $25,000 = 15% deduction
- Over by $50,000 = 10% deduction
- Over by $75,000 = 5% deduction
Unlike income tax brackets, this deduction is all or nothing. It’s not 20% on your first chunk of income, 5% on your overage, and 0% on any income over the second limit.
If you’re in the range for 5%, it’s 5% on all your business income. If you exceeded the maximum income and get 0%, it’s 0% on all your business income.
Tax Deductions for General Business Expenses
If you have your own law firm, you can deduct general business expenses such as:
- Office rent or home office expenses
- Mortgage interest if you buy an office
- Office supplies
- Employee salaries
- Marketing expenses
- Software
- Credit card convenience fees
- Phone and internet costs but only to the extent you use them for business. If you use them 50/50 for business and persona, you can only deduct half.
- Travel expenses
- Most other business related purchases
Note: Entertainment expenses are generally no longer eligible for a tax deduction.
Tax Deductions for Bar Review Courses
Bar review courses are not deductible. You can’t deduct education costs that allow you to enter into a new profession.
Tax Deductions for Bar Memberships, Continuing Legal Education, Trade Journals, Legal Conferences, Etc.
These expenses are generally deductible if you have your own law firm or are a contractor to the extent that they are ordinary and necessary business expenses that further your practice of law.
Employees cannot deduct these expenses as itemized deductions under the Tax Cuts and Jobs Act.
Health Insurance Premiums
When you have staff, you can generally deduct the portion of their health insurance costs that you pay.
Your own health insurance expenses generally won’t go on your firm’s books unless you’ve made yourself an employee. Instead, you may be able to take the separate self-employed health insurance deduction. This deduction allows you to deduct your premiums as a separate line item on your personal income tax return.
If you’re not eligible for coverage through an employer or spouse’s employer, you may have the option to buy health insurance from the Health Insurance Marketplace. If you qualify for a subsidy, you can only deduct the portion of your premiums that you’re responsible for.
You may also want to consider a high deductible health plan that lets you open a Health Savings Account. A Health Savings Account lets you make tax deductible contributions. You can then withdraw the money tax-free to pay for qualified medical expenses.
Retirement Planning
Lawyers can make use of several tax-advantaged retirement account options.
Traditional and Roth IRAs
Anyone can open a traditional or Roth IRA as long as you have earned income. It doesn’t matter if you’re an employee, partner, or solo lawyer.
Many lawyers will be near one of the income limits. The easiest way to handle this situation is to wait until the end of the year when you know your income to contribute. If you make contributions during the year and end up not being eligible, the paperwork is messy.
Traditional IRA
You can deduct traditional IRA contributions if you’re under the below income limits. You’ll pay taxes on the money you withdraw in retirement.
If you don’t have an employer plan available to you, such as a 401(k), you can take a deduction even if your income is above the limits.
If you’re above the income limits, you can still contribute to a traditional IRA, but you don’t get a deduction. You won’t pay taxes on the non-deductible portions of your contributions when you retire, but your non-deductible contributions reduce your taxes on withdrawals.
| Filing Status | 2023 | 2022 | 2021 |
|---|---|---|---|
| Single and Head of Household | $73,000 to $83,000 | $68,000 to $78,000 | $66,000 to $76,000 |
| Married Filing Jointly and Qualifying Widower | $116,000 to $136,000 | $109,000 to $129,000 | $105,000 to $125,000 |
| Married Filing Separately | $1 to $10,000 | $1 to $10,000 | $1 to $10,000 |
Roth IRA
With a Roth IRA, you don’t get a deduction now but both your contributions and earnings come out tax-free when you retire. Like traditional IRAs, there are income limits.
| Filing Status | 2023 | 2022 |
|---|---|---|
| Single and Head of Household | $138,000 to $153,000 | $129,000 to $144,000 |
| Married Filing Jointly and Qualifying Widower | $218,000 to $228,000 | $204,000 to $214,000 |
| Married Filing Separately | $1 to $10,000 | $1 to $10,000 |
Backdoor IRA
A backdoor IRA is when you contribute to a traditional IRA and immediately convert it to a Roth IRA. You’re effectively bypassing the income limits for a Roth IRA. Backdoor IRAs allow you to get tax-free growth, whereas non-deductible traditional IRA contributions have taxes on your gains (just not your original contributions).
Backdoor IRAs can get a little technical. It’s nothing too complicated for a lawyer, but you need to carefully review the steps before you do anything. Extra care is needed if you already have money in a traditional IRA.
Saver’s Credit
Anyone can qualify for the Saver’s Credit, but lawyers will typically only be under the income limits if you’re
- Still a law student
- Didn’t work full-time the entire year
- Are very aggressive with your deductions, including retirement contributions
- Have a year with low income (e.g., contigency fee practices that go up and down)
The Saver’s Credit can allow you to get up to a $1,000 tax credit on $2,000 in IRA contributions in addition to the usual deductions.
401(k)
401(k)s generally offer the best tax benefits, because they allow you to contribute more than other options. Plan costs used to be too high for small firms, but with more online providers, you can usually find a cost-effective option. If you’re a solo attorney with no employees, look into a solo 401(k).
Simple IRA
A simple IRA is an employer retirement plan that used to be much more cost-effective than a 401(k). It will often still be cheaper, but the gap is much lower. Simple IRAs largely follow the same tax rules as traditional IRAs (except there are no income limits).
The employer can contribute either 2% of each employee’s pay or match each employee’s contributions up to 3%. There are no other options or flexibility, so simple IRAs might be too simple for your needs.
Employees can also contribute to their simple IRAs with limits that are about 2/3 of what they are for a 401(k).
SEP IRA
A SEP IRA is an employer plan. You can contribute up to 20% of each employee’s salary as the employer. If you’re a partner or solo, your profit share is your “salary” for SEP IRA purposes.
SEP IRAs don’t have employee contributions. SEP IRAs largely follow the same tax rules as traditional IRAs (except there are no income limits other than the 20% maximum contribution).
SEP IRAs with employees can get tricky, so they’re a more common option for solo attorneys who want less paperwork and lower costs than a solo 401(k). Otherwise, many firms will go with a 401(k).
If you have a solo law practice, many retirement plans will allow you to make your personal Traditional IRA contributions into your SEP IRA. This gives you the convenience of having everything in one account. However, the Traditional IRA income limits and other rules still apply to contributions designated as for your personal IRA.
Tax Deductible Retirement Contributions and Income-Based Student Loans
One thing to think about when choosing what type of retirement plan to use is that deductible retirement contributions reduce your income-based student loan payments. Income-based student loans go by your Adjusted Gross Income, and deductible retirement contributions reduce your AGI.
If you’re on track for loan forgiveness or want to reduce your payments, consider putting more money into deductible accounts.
