Tax issues for Texas firms generally fall into three categories: federal income taxes, employment taxes and state taxes. Below is a general summary of those three categories, but the application of tax laws is complex and variable from firm to firm based on the specific circumstances. Every firm should hire a qualified tax adviser to guide them.
• Federal income taxes: The mechanics of federal income taxation largely depend on how a firm is structured. Typically, a firm will be structured as a PC, a PLLC or an LLP. Some even may operate as a sole proprietor without any liability-shielding entity (they should probably go talk to a lawyer about that). Based on the structure, a firm will be taxed for federal tax purposes as a corporation, a partnership or a sole proprietorship. All tax return due dates described below assume that a firm operates on a calendar year.
If a firm is a corporation for federal income tax purposes — and note that any of the above-referenced entities can elect corporate status — tax advisers almost certainly will recommend that the firm elect to be treated as an S corporation if all of the S corporation eligibility requirements are satisfied. As an S corporation, a firm will need to file Internal Revenue Service Form 1120-S no later than March 15 each year to report its annual taxable income.
The owners of an S corporation generally will also be employees that are paid a salary. Each owner will pay tax on his or her salary just like any other employee. In addition, to the extent there are profits in the firm, each owner will pay tax on his or her allocable share, whether or not those profits are distributed. The firm itself does not pay any corporate federal income tax.
Firms structured as a PLLC or an LLP that have not elected corporate status will be taxed as partnerships if they have more than one owner. If such a firm has only one owner, however, the entity will be disregarded for federal income tax purposes and the single owner will be taxed as a sole proprietor as if no entity existed. A firm treated as a partnership should report its annual taxable income on IRS Form 1065 no later than April 15 each year. A lawyer operating through a disregarded entity should simply report his or her taxable income from the law practice on Schedule C of their personal IRS Form 1040.
Partnerships and disregarded entities do not pay federal corporate income tax. All income flows through to the owner(s) of the entity. Each owner reports his or her share of the firm’s income on their personal IRS Form 1040. Note that owners of a law partnership or disregarded entity are not treated as employees of the firm, and the firm is not required to withhold any taxes on payments to the owners. Accordingly, each owner is required to personally pay quarterly estimated income taxes to the IRS on April 15, June 15, Sept. 15 and Jan. 15.
• Employment taxes:To the extent a firm has employees, including owners who are treated as employees in firms structured as S corporations, the firm must comply with several reporting and withholding regimes. On the federal level, an employer must generally withhold Federal Insurance Contributions Act (FICA) and Medicare taxes from its employees’ pay at a combined rate of 7.65 percent. But a 2 percent temporary discount applies for 2012. In addition, the employer must withhold federal income tax for each employee at various rates based on the amount he earns and the number of exemptions he claims on Form W-4. Tables describing the amount to be withheld can be found in IRS Publication 15 (Circular E).
As the employer, the firm must remit the employer’s share of federal employment taxes equal to 7.65 percent of employee compensation, and it must pay federal and state unemployment insurance premiums (FUTA and SUTA, respectively). An employer must file IRS Form 941 quarterly to report federal tax withholding from employees, and it must file IRS Form 940 no later than Jan. 31 each year to report FUTA. In most cases, an employer must also quarterly file Form C-3 to report payroll details and SUTA to the Texas Workforce Commission. Failing to remit amounts withheld from employee payroll can subject certain individuals in the firm to personal liability for 100 percent of the amount not remitted.
For noncorporate firms, where the owners are not also employees, each owner must pay self-employment tax at a rate of 15.3 percent, which represents the employee and employer portions of the FICA and Medicare tax. Self-employment taxes are reported on each owner’s personal Form 1040 on Schedule SE. Because such amounts are not withheld by the firm, each owner should make quarterly estimated payments of self-employment taxes along with quarterly income tax payments.
• State taxes:Law firms operating in Texas within an entity that provides some amount of limited liability (e.g. PC, PLLC, LLP, etc.) must report their Texas Margin Tax liability each year. For entities that owe margin tax, Form 05-158 must be filed with the Texas comptroller by May 15 each year. Entities that do not owe any tax should instead file a “no tax due” report on Form 05-163. Additional public information reports also may be required. If the firm practices in any state other than Texas, additional state tax and reporting liabilities may arise for the firm and the lawyers practicing there.
Each attorney must also pay a $200 attorney occupation tax no later than June 1 each year. Note this is a tax levied on each individually licensed attorney, not the firm. The tax can be paid through the State Bar of Texas’ website.
Mark Melton is an associate with Hunton & Williams in Dallas.