The Tax Season Survival Guide for Law Firms
According to the American Bar Association (ABA), over 1.3 million attorneys were actively practicing in the U.S. as of January 1, 2022. In addition, more than 45,262 solo practitioners are currently employed in the United States. However, whether a lawyer works for a large firm or maintains a solo practice, they all have at least one thing in common: taxes.
Law firms and attorneys are confronted with many unique tax issues and must be keenly aware of the tax rules that apply to them and their practices. In addition, the tax practitioners they work with must understand the specific accounting and tax concerns that lawyers and law firms have.
The Importance of Organization
There are many nuances to practicing law, but when it comes to running a law practice, the challenges are similar. For example, all firms and lawyers must track business expenses to manage their taxes properly. However, if they understand how and where to find the best tax deductions, they can keep more money in their pocket by deducting things like continuing education and travel expenses. This eBook is intended to help lawyers and law firms:
- Understand their tax filing obligations
- Become familiar with the applicable IRS tax forms
- Effectively organize your firm’s financial records
- Maximize deductions and tax credits
- Learn to work with a tax professional
- Develop Tax Planning Strategies
- Remain Compliant with Tax Laws and Regulations
At tax time, there are consequences for how employees are hired, how lawyers and partners are paid, how equipment is purchased, how cash is saved, and more. That is why law firms and lawyers must understand their finances to survive tax season.
Understanding the Tax Filing Requirements for Law Firms
Lawyers have unique tax responsibilities depending on whether you’re a solo attorney or have a small firm. So, the first step is to know when you must report and pay based on your jurisdiction and entity type:
- Sole proprietorships. An unincorporated business owned by one person.
- Partnerships. Two or more people contribute money, property, labor, and skills and share in the profits and losses of a business.
- Corporations. Entities formed by prospective shareholders to exchange money, property, or both for the corporation's capital stock.
- S Corporations. Corporations designed to pass income, losses, deductions, and credits to shareholders for tax purposes.
- Limited Liability Companies (LLC). A business structure allowed by state statute under various regulations. Members may include individuals, corporations, other LLCs, and foreign entities.
Whether an attorney owns a small firm in the form of a partnership, a limited liability company (LLC), an S-corporation, or an E-corporation, they have distinctive tax filing requirements to comply with. Attorneys and law firms are also required to use specific forms when filing taxes, which commonly include:
- Schedule C. Solo attorneys must file firm taxes using Schedule C on their individual tax returns and pay estimated taxes throughout the year.
- IRS Form 1099. Last year, the IRS ruled that personal injury attorneys who pay experts and investigators from client trust accounts must provide documentation via a 1099 form. According to the IRS, the attorney who selected, hired, instructed, and supervised the experts is the "payor."
- IRS Form 1099-NEC. In 2019, the IRS reintroduced the new Form 1099-NEC to allow for the reporting of non-employee compensation. Payments made to attorneys or law firms for professional services are not exempt from being reported on the 1099-NEC. They must be disclosed whether services are provided through a sole proprietorship, limited liability company, or corporation.
- IRS Form 1099-MISC. Businesses report payments not related to non-employee compensation on IRS Form 1099-MISC. However, provided certain criteria are met, some attorney and law firm payments are recorded in Box 10 of Form 1099-MISC and not on Form 1099-NEC.
- IRS Form 1065. A partnership is required to file Form 1065 to disclose information about its operations but is not taxed. Rather, profits or losses are “passed through” to the partners, and each reports their share of the partnership's income or loss on their tax return. Therefore, partners are not employees and shouldn't be issued a Form W-2.
- IRS Form 1120. Domestic corporations must file Form 1120 unless they are required, or elect, to file a special return. This form reports income, gains, losses, deductions, and credits and determines a corporation’s tax liability. If an entity with more than one owner was formed as an LLC under state law, it is generally treated as a partnership for federal income tax purposes, and files Form 1065.
- IRS Form 1040-ES. Unlike W-2 employees who have federal and state taxes withheld from each paycheck to cover any tax liability owed to the IRS or applicable state, numerous lawyers have distinct tax filing requirements, such as estimated taxes. Estimated taxes are due four times annually and are based on income received but not subject to withholding, such as legal fees received by an LLC. Sole proprietors, partners, and shareholders in S-corporations must pay estimated taxes if they anticipate owing more than $1,000 in taxes for the current tax year.
Although different deadlines apply to partnerships and s-corporations, estimated tax payments are due for all on the same dates as follows:
- April 15th: For January 1st – March 31st
- June 15th: For April 1st – June 15th
- September 15th: For June 1st – August 31st
- January 15th of the following year: For September 1st – December 31st
Penalties for late or incorrect filings
Nobody sets out to pay more taxes to the IRS. However, careless mistakes leave many individuals and businesses doing precisely that. The IRS penalizes filers for errors that could have been avoided through compliance with the tax rules, including deadlines.
- Late filings. The filing deadline for the 2022 tax year is April 18, 2023. Late filing penalties can add 25% to your tax bill, although those who cannot file their tax return by the deadline can request an extension of time which will give them until October 15, 2023. Forgetting to sign a tax return is the most common mistake taxpayers make. The IRS won’t accept a tax return that is not signed and considers it the same as not filing at all.
- Creative bookkeeping. If your bookkeeping sets off red flags to IRS employees, you will have to provide a journal detailing every deduction and exemption claimed on your return, and you'll also have to turn over receipts for all other questions they may have. If you cannot prove your case, the IRS will access a 25% accuracy penalty on top of the additional tax and interest on the entire amount.
- Math errors. Math errors are widespread on pen-and-paper tax returns, so check and re-check your math. If the math error results in you paying less tax than you should, the IRS might require that you pay the additional amount of taxes owed plus the interest accumulated after the due date of the return.
- Improper home office deductions. If you use part of your home as your law office, you may take a deduction for your home office. However, you must use your home office “exclusively and regularly” as your principal place of business, and you can only deduct the exact area(s) you use exclusively for business. Expect penalties if the IRS determines you do not qualify for the home office tax deduction. In addition, because the deduction is taken on Schedule C, it may raise your taxable income, and that amount is also subject to self-employment tax, typically 15.3 percent.
- Undocumented charitable donations. Charitable contributions can lead to additional tax deductions; however, the donor must receive an itemized slip from the organization listing what was donated, the condition of the items, the estimated value, and a signature. If you are audited and nothing specific is listed on the slip or the donation does not meet IRS guidelines, the IRS will likely deny the deduction.
Organizing Financial Records and Documents
To set up your practice for financial success, you must review your law firm’s finances periodically, including at the end of the year. At year-end, you should methodically review your records, close outstanding receivables, and budget for the year ahead. This will streamline tax time for you and your accountant and make planning for the coming year much more manageable. Here are some financials every law firm should be tracking:
It’s best practice to collect all accounts receivable in a timely manner, particularly for clients who are slow to pay. Since the chances of collection decrease with time, you should identify long-overdue balances before the end of the year, a task that can be accomplished automatically with time and billing software built for law firms.
Time Entries and Billings
Before collecting, you must ensure the firm is current on time tracking and billing. To achieve this, ensure everyone at the firm has logged their time through the end of November so that subsequent billing can occur at the beginning of December. Billing reconciliation software seamlessly automates recurring invoicing, billable hours, matter management, and reporting functions.
Even if you’re meticulous when dealing with your law firm’s trust accounts throughout the year, you should dedicate time at year-end to double-check that you’ve been diligent about moving money from your trust account to your operating account as fees were earned. You can automate this process, make trust deposits, issue refunds, and set minimum balance alerts with law firm billing software.
Year-end Collection Strategies
Here are some year-end collection strategies that can help law firms improve their financial picture:
- Accept online payments. The 2021 Legal Trends Report found that 73% of firms accepted online payments. Time and billing software for law firms takes the headache out of getting paid by letting your clients pay directly from within their invoices. You’ll get paid faster if clients can pay their preferred way – from a laptop or mobile device.
- Send reminders. Your clients may not be dragging their feet intentionally. Send custom automatic invoice reminders to help streamline the process of collecting payments smoothly and efficiently.
- Set up a payment plan. If your clients cannot pay on time, consider setting up a payment plan to get them back on track. According to the 2021 Legal Trends Report, 81 percent of all legal consumers would prefer to pay their legal fees on a payment plan.
Tax Deductions and Credits for Lawyers
To be as prepared for tax season as possible, make sure you’re taking advantage of all the available tax deductions and credits available to lawyers and law firms, including:
Like any other business, law firms must spend money on advertising and marketing.
Fortunately, most expenses connected to marketing campaigns are tax deductible, including hiring an SEO agency, building a website, running paid advertisements on social media platforms, printing flyers, or outsourcing marketing tasks to qualified external firms.
Businesses, including law firms, often partially fund their employees' retirement accounts, which is an excellent way to incentivize top talent and obtain a tax deduction for the firm. Simple IRAs and 401(k) plans are two of the most popular retirement plans. Simple (Savings Incentive Match Plan for Employees) IRAs are an option for firms that employ under 100 people. Employers typically contribute between 2 and 3 percent of employee compensation into a Simple IRA; however, the 401(k) option allows employers to choose the percentage they want to match.
Lawyers routinely drive to meet clients, interview witnesses, examine evidence, take depositions, and more. The mileage accumulated during these activities is tax deductible and can reduce your tax burden. Here are the options: 1) take the IRS’s standard mileage deduction, which is currently 65.5 cents per mile driven while in the course and scope of employment, or 2) itemize mileage-related expenses like gas, tire rotations, and insurance, and base your deductions on those.
Besides mileage on your personal vehicle, you can deduct numerous other travel expenses, including airline tickets, ridesharing services like Lyft or Uber, meals, hotel accommodations, and laundry services. However, be aware that “travel” means you must travel a substantial distance for an expense to be deductible.
Legal education doesn’t end with law school or passing the bar. Instead, the legal profession is famously analytical, and successfully practicing law requires keeping up-to-date with new legal developments. As a result, attorneys are required to attend Continuing Legal Education (CLE) classes to maintain licensure. While some CLEs are free, others are offered for a fee that can be written off as a tax deduction.
Credit Card Fees
More and more law firms are moving to accept digital payments, a win-win situation for everyone since providing a convenience benefits the client, and offering the option to pay via credit card can substantially reduce the time it takes to get paid. Although credit card companies charge processing fees for handling transactions and these fees can add up fast, they are tax deductible as long as the firm pays them and doesn’t pass them off to clients.
Student Loan Interest
Student loans are not tax-deductible; however, up to $2500 student loan interest is tax deductible annually. To qualify for this deduction, you must have taken the loan out for yourself, your dependents, or your spouse, but you will not be eligible if you are claimed as a dependent on someone else’s return. Student loan interest deductions apply to all student loans, not just those granted by the federal government.
Lawyers can typically deduct 50 percent of the meals and expenses they accrue during meetings to network with clients. In addition, the IRS put some special rules in effect for 2021 and 2022, allowing you to deduct up to 100% of some meals. When claiming this deduction, keep receipts and detailed notes about who the meal was with and what was discussed in the event of an IRS audit.
Regardless of where you work – a spare bedroom, your kitchen, or a dedicated home office – if you operate your law firm from your home, a percentage of your home expenses are tax deductible, including mortgage interest, rent, and utilities, as long as this part of your home is used exclusively for business purposes.
The IRS allows attorneys to deduct any dues required by their profession, such as bar dues or membership fees to a professional or trade organization. If you are self-employed, you may take the full deduction. If you hire an accountant or tax preparer, you can deduct those expenses on your law firm tax return as well.
Phones, computers, and other equipment
According to the IRS, your business expenses must be “necessary, customary, and reasonable” to be deductible, meaning you must use your desktop computer, laptop, or iPad for business. Similarly, if you use your cell phone exclusively for business, then the cost of the phone equipment and the monthly service is tax-deductible. You can claim a partial deduction if you use the phone partly for business.
Working with a Tax Professional
Organizing law firm financials can be overwhelming and time-consuming, particularly at year-end when the firm is busy wrapping things up. However, an experienced accountant is an expert in managing financials, tax planning, tax compliance, and more. Therefore, if you hire a law firm accounting professional to do your taxes, you will have more time to focus on other aspects of your practice while remaining confident that your financials are handled properly.
Attorneys’ taxes can also be highly complex. For the best possible outcome, attorneys and law firms need to hire a tax professional who specializes in working with legal operations. An experienced tax advisor can satisfy all filing requirements, take all available deductions, and adequately document your filings. If you need to file foreign tax returns or are required to file in multiple states and localities, consider hiring an accountant with experience those areas to avoid triggering an audit.
Tax Planning Strategies for Law Firms
When it comes to filing your personal and business taxes, there are many money-saving tips and tricks. Here are some common tax planning strategies to reduce tax liability:
Maximize Section 179
Section 179 of the IRS tax code allows law firm owners to deduct the full purchase price of qualifying equipment and/or software bought during the tax year, allowing you to reduce your overall taxable income. As of 2019, section 179 increased to $1,000,000, but the property must meet three qualifications:
- It must be tangible.
- It must have been acquired for business use.
- It must have been purchased by you (not gifted).
The Section 179 election is made on an item-by-item basis for eligible property. You do not have to take full depreciation on all eligible property purchased during the fiscal year; however, you must make the election in the tax year the property is first placed in service and reported on Form 4562.
Leverage Retirement Plans
Maximizing your tax savings opportunities through your firm’s retirement plan by deferring income until later could result in thousands of dollars in tax savings. If your firm’s program does not offer Mega Backdoor Roth IRAs, check into the possibility – with this type of Roth IRA, you can put up to $37,500 away annually. To qualify, your firm must allow for “after-tax” contributions and yearly “in-service” distributions to a Roth IRA.
When President Biden signed the Inflation Relief Act in August 2022, he effectively removed the SALT tax, and as a result, the cap on itemized deductions rose from 21 percent to 28 percent. In addition, if you’re planning any large charitable donations or events, those can be written off up to 50 percent of your adjusted gross income. Certificated and allocated credits for your state could be another path to substantial tax savings.
Increase Spending to Reduce Liability
Spend more money at the end of the year to get tax deductions? It sounds counterintuitive. Yet, if it makes sense to spend money to receive the tax benefit in the same year, such as much-needed equipment upgrades, go for it.
Staying Compliant with Tax Laws and Regulations
With so many regulations and rules — and recent changes to them — it can be hard to know what tasks to focus on or the best practices for tackling them. However, adhering to basic compliance principles and even breaking them down further into a checklist of regular practices can help make tax compliance much more manageable.
Even for small firms, there are many applicable taxes, and each tax comes with its own compliance requirement and particular due date. As a result, small business owners can quickly get confused and forget to comply with one or more requirements. To ensure that every compliance requirement is followed, take a systematic approach:
- Make a list of all the tax laws applicable to you.
- For every applicable tax law, list all the essential forms and returns required to file, and note the due dates of tax payments.
- Make a list of all the documents required for each type of return.
- Keep your books organized and all supporting documents in order.
- Monitor the changes in tax compliance laws, especially those that affect your practice.
Tax compliance can be challenging, particularly for small firms, because it requires a thorough knowledge of various tax laws and a substantial amount of time and work. Hence, it often makes sense to seek professional help.
Conquer Tax Season With Automation
To streamline your financial reporting activities and survive tax season, tap into the power of law practice management software to automatically collect, track, and analyze your firm’s income. To find out more about how the Lawmatics platform simplifies tax time for attorneys and law firms, request a demo today.