If your law firm is a C corporation, its federal income tax will be a flat rate of 21%. The Illinois corporate tax rate is now 9.5% (7% income tax, 2.5% replacement tax). So in total, that’s a combined tax rate of 30.5% paid by the corporation.
In addition, amounts paid out as compensation, while deductible to the corporation, are subject to federal income tax and payroll taxes. Dividends paid to shareholders are subject to an additional layer of income and possibly net investment income tax.
Most law firms, like most service organizations, report their income on a cash basis versus the accrual basis. On the cash basis of accounting, you report as income as cash is received and report expenses as cash is paid. While on the accrual basis, income is reported when earned and expenses when incurred, regardless of when cash is received or paid.
The law firm that reports on a cash basis of accounting does not report its uncollected accounts receivable as income or report its unpaid accounts payable as expenses. Typically, accounts receivable far exceed accounts payable and, as such, the cash basis of accounting is much preferred for tax purposes.
Cash basis corporations are also allowed to prepay certain expenses and deduct them in the year paid. For example, one month’s rent can be paid in advance and deducted, as well as various other supplies and expenses that are incurred in the normal course of business.
ORBA’s Law Firm Group can help you monitor your law firm’s cash position at year end to minimize the overall tax liability. In most cases, it will be most efficient to ensure the corporation is as close to a zero tax situation as possible. However, in some cases it will be more efficient to retain earnings for future investment rather than require capital contributions of previously taxed income.
Our advisors can help you review the corporation’s taxable income at year end so that payment of expenses or bonuses to your shareholders results in the most tax efficient outcome. With proper planning, ORBA’s Law Firm Group helps its law firm clients that operate as C corporations eliminate all corporate-level taxation