Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

SOLO LAWYER: I'M NOT AN EMPLOYEE OF MY OWN LAW FIRM

September 18, 2006

Today we offer a quiz:

1. If you walked into the law offices of Regina Felton, PC, who would you expect to be the lawyer working there?

A. Clarence Darrow
B. Alexander Hamilton
C. John Marshall
D. Regina Felton

2. Who is the owner of the law firm Regina Felton, PC?

A. Warren Buffet
B. Steve Jobs
C. The bin Laden Group
D. Regina Felton

3. Who is the chief executive officer of the law firm Regina Felton, PC?

A. Gerald Ford
B. Bill Clinton
C. George W. Bush
D. Regina Felton

If you answered "D" to each question, you agree with the Tax Court.

Regina Felton, PC. is a C corporation. It filed its 2001 and 2002 returns as a C corporation, claiming the benefit of the graduated rate structure of C corporations. Many small corporations file as C corporations to take advantage of the graduated corporate rates that start as low as 15%.

The IRS had one small problem with the returns. "Qualified personal service corporations" are ineligible to use the graduate rates. They pay a 35% rate on every dollar of their taxable income. The IRS assessed additional tax of $7,017.50 for 2001 and $4,962.65 for 2002.

PERSONAL SERVICE CORPORATION: WHAT IT TAKES

To be a "personal service corporation" you must pass (well, flunk) two tests:

1. Substantially all of the stock must be owned by employees, and

2. 95% of employees time must be spent on performing personal services in the fields of health, law, engineering, architectue, accounting, actuarial science, perfoming arts or consulting.

It was clear that all of revenues of Regina Felton, PC were from legal services, so the only issue was whether the stock was owned by an "employee." Regina Felton, arguing for her PC in Tax Court, said she did not "consider herself" an employee (making one wonder just who did the legal work around the shop).

The Tax Court said that it didn't really matter whether she "considers herself" an employee. Common sense was part of the equation - she was the only lawyer there. Also, as the Tax Court explained, corporate officers are considered corporate employees for tax purposes. While she told the court that she does not "call herself an officer," the New York Secretary of State website lists her as "Chairman or Chief Executive Officer."

Bottom line: IRS wins.

HOW TO NOT BE TAXED AT A 35% FLAT RATE

There are three main ways corporations avoid being subject to the 35% tax on personal service corporations.

S corporation election. If you make an S election and have your income directly taxed to the shareholders, the 35% flat rate doesn't apply.

Distribute all of the income in a year-end bonus. Many law firms flush all of their earnings out in year-end bonuses. This works, but it has two inherent drawbacks. First, the bonuses are subject to the 2.9% medicare tax. Second, it requires either a skilled bookkeeper and accurate records or cheating (e.g., backdated paychecks) to get the job done.

Do enough other stuff to avoid being a personal service corporation. An example would be anoptometrist who sells enough eyewear to be considered a retail outlet as well as a health professional office.

Cite: Regina Felton, PC, T.C. Summary Opinion 2006-153

      Bookmark: del.icio.us • Digg • reddit