Law Firm Entity Structure: The PLLC, the Partnership, the S Election, and the Partners Who Can't Be Employees of Themselves

Law firms decide their entity with the ethics rules on one side and the partners' compensation on the other. The ownership rule: the rules of professional conduct in nearly every state prohibit non-lawyer ownership of a law firm (ABA Model Rule 5.4; the exceptions are narrow — Arizona's licensed alternative business structures, Utah's regulatory sandbox, and the District of Columbia's limited allowance for non-lawyer partners), so the entity is a professional corporation, a professional LLC, a limited liability partnership, or a general partnership owned entirely by licensed lawyers — the professional entity statutes exist for exactly this — and a lawyer remains personally liable for their own malpractice regardless of the entity (the entity shields against a partner's malpractice and the firm's other liabilities — the reason the LLP and PLLC replaced the general partnership, where every partner was liable for every other partner's malpractice). The liability floor: malpractice (the individual's — insured, with the entity as the firm's shield against vicarious liability), the trust account exposure (a defalcation or a wire fraud loss — the fiduciary and cyber coverage), the employment claims, the lease, the fee disputes, and the sanctions — the professional entity separates the firm's liabilities from the lawyers' personal assets, with malpractice, general liability, employment practices, cyber, fiduciary, and the umbrella as the first line. The two compensation mechanics — the choice most firms make on. The partnership-taxed PLLC or LLP: partners are not employees of their own partnership — they receive guaranteed payments (fixed compensation for services, deductible by the firm, ordinary income to the partner) and distributive shares of the remaining profit (allocated by the partnership agreement — by origination, hours, seniority, a points system, or any formula the partners agree), all of it subject to self-employment tax (the 15.3 percent below the wage base and 2.9 percent above, plus the 0.9 percent Additional Medicare Tax — the section 1402(a)(13) limited-partner exception doesn't reach a lawyer who practices in and manages the firm, as the Tax Court held for a law firm's partners in Renkemeyer (2011)) with no withholding (the law firm estimated-tax guide); the flexibility is the attraction — unequal partners are paid unequally by formula, new partners are admitted with small shares, retiring partners are bought out through the partnership provisions, and the firm's debt gives the partners basis for deducting losses (the contingency firm's building years). The professional corporation with the S election: shareholder-lawyers are employees — salaries through payroll (withholding, the firm's payroll taxes), with distributions above the salaries free of payroll tax — but distributions must follow stock ownership (the single-class-of-stock rule), so unequal compensation among equal owners must run through the salary differential (a partner who produces twice as much is paid a salary twice as large, with the equal distributions on top) — workable for two or three lawyers, unwieldy for ten; the payroll-tax saving is on the distribution portion at the above-wage-base rates (a salary set at the market for the lawyer's own production already exceeds the wage base), and the shareholders' basis excludes the firm's debt (a loss year is deductible only to basis). The reasonable salary for a lawyer-shareholder: the employed-lawyer market is deep (associate and senior associate compensation surveys, in-house salaries, government salaries at the senior level) — an owner's salary is what the firm would pay a lawyer of the owner's seniority and production plus a management component, documented and revisited, and set honestly (the S corporation lawyer paying themselves an associate's salary on a partner's production is the audit issue). The saving: payroll tax avoided on the distribution portion — a shareholder netting US$420,000 with a US$260,000 salary saves the 2.9 percent Medicare tax on the self-employment base the distribution would have carried (about US$3,700 — a little more where the 0.9 percent Additional Medicare Tax applies); modest, and the reason the mechanics and the retirement plan decide. The specified service phase-out: law is a specified service trade — the QBI deduction phases out above the taxable-income range and is zero for most firm owners, under either mechanic (the SSTB guide); a lawyer in the range has the threshold strategy through the retirement plan. The retirement plan — the instrument: a firm's 401(k) with profit sharing (covering associates and staff at the safe-harbor level) and a cash balance plan for the partners (the dental entity guide's mechanics — actuarially determined contributions of US$100,000 to US$300,000 per partner depending on age, deductible in full) — the largest deduction a high-earning lawyer has, and the plan design (which partners participate, the staff cost, the guaranteed payment or salary the contribution is computed on) is a firm-level decision that the compensation mechanic shapes. The contingency firm — the loss years: a firm building a docket of contingency matters deducts its salaries, rent, and soft costs as paid while its fees arrive in the resolving years (the law firm deductions guide) — the building years are losses; in a partnership, the partners deduct their shares of the losses (to their basis and at-risk amounts — the firm's debt gives partnership basis, but a line of credit counts as at-risk only where the partners personally guarantee it); in an S corporation, the shareholders deduct only to their stock and direct-loan basis (the firm's line of credit gives none — the countertop entity guide's structural point), so a contingency firm financing its docket with firm-level debt is a partnership through the building years, or capitalized by direct shareholder loans if an S corporation. The solo practitioner: a PLLC disregarded (Schedule C — self-employment tax on the net) or with the S election (the salary and the distribution — a new payroll for one unless a paralegal is already on it); the arithmetic (the LLC cost guide) runs on the net after the trust and advanced-cost discipline, and the election pays above roughly US$130,000 of net for a solo with no staff, earlier with staff already on payroll. The models. The solo: the PLLC with Schedule C until the net clears the worksheet; the S election with a lawyer's market salary plus management thereafter; the retirement plan as the instrument. The small partnership (two to five lawyers): the partnership-taxed PLLC or LLP for compensation flexibility and debt basis, or the professional corporation with the S election for two or three equal-ish producers who value the payroll-tax saving and accept the salary-differential mechanic; the retirement plan designed at the firm level. The contingency practice: the partnership through the building years for the loss pass-through with debt basis; the S election revisited when the docket matures and the firm is consistently profitable — or the partnership kept, with the pass-through entity tax election (the estimated-tax guide) as the state-level planning. The exit: a lawyer's practice is sold or transferred under the ethics rules (ABA Model Rule 1.17, adopted in some form in nearly every state, permits the sale of an entire practice or practice area with written notice to the clients and no fee increase), usually as an asset sale with the client files and goodwill (largely personal — the consulting succession guide), and a partner's retirement is governed by the partnership agreement or the shareholders' agreement (the buy-sell); either way, single-taxed through the pass-through. The annual re-run: the partners' compensation formula, the firm's profitability and its debt, the retirement plan's contributions, the taxable income against the threshold (zero QBI under either form above it), and the salary against updated data — revisited each January, with the malpractice renewal and the partnership agreement's provisions alongside.

Key takeaways

• Lawyers own law firms — the professional corporation, PLLC, or LLP owned entirely by licensed lawyers; the entity shields against a partner's malpractice and the firm's liabilities, never the lawyer's own.
• The choice is compensation mechanics: a partnership pays guaranteed payments and distributive shares by any formula with self-employment tax on all of it and debt basis for losses; an S corporation pays salaries with payroll-tax-free distributions that must follow stock ownership, with no basis from firm debt.
• The payroll-tax saving above the wage base is the 2.9 percent Medicare tax (3.8 percent with the Additional Medicare Tax) — modest — so the mechanics, the retirement plan, and the loss years decide.
• Law is a specified service trade: the QBI deduction is zero above the range under either form; the cash balance plan on top of the 401(k) is the instrument.
• Contingency firms are partnerships through the building years — the losses pass through to partners with basis from the firm's line of credit; an S corporation's shareholders would deduct only to their direct investment.
• The exit is an asset sale under the ethics rules or a buy-sell under the agreement — single-taxed through the pass-through.

The law firm's entity worksheet

Ownership rule confirmed; professional entity type. Coverage (malpractice per lawyer with tail planning, GL, EPL, cyber, fiduciary, umbrella). Compensation mechanic: partnership (guaranteed payments + shares by formula; SE tax; debt basis) vs S corporation (salaries by production; distributions by ownership; no debt basis). Reasonable salary if S (employed-lawyer market plus management). Distribution portion; 2.9 percent (3.8 with Additional Medicare) saved. Taxable income vs QBI threshold (zero above). Retirement plan design and the compensation it's computed on. Loss years and basis (contingency). Pass-through entity tax election (state). Buy-sell or partnership provisions for entry and exit. Net result. Fifteen minutes each January, with the partnership agreement open.

Worked example

Three firms. One: a solo estate planning lawyer netting US$210,000 after her retirement contributions with one paralegal on payroll — a PLLC with the S election since year three; salary US$150,000 (a senior associate's market plus management), a US$60,000 distribution saving about US$5,600 (the salary sits below the US$184,500 wage base, so the distribution escapes Social Security tax as well as Medicare), the payroll already in place; taxable income under the QBI threshold (a QBI deduction of about US$12,000 on the US$60,000 distribution — the SSTB phase-out never starts); a 401(k) with profit sharing covering the paralegal and, at 51, a cash balance plan adding US$120,000 of deductible contributions — the plan is the planning, the election is the housekeeping. Two: a four-partner litigation and transactional firm with production ranging from US$500,000 to US$1.4 million per partner — a PLLC taxed as a partnership: guaranteed payments by a points formula weighting origination and hours, remaining profit by the same points, a US$600,000 line of credit giving all four basis, a cash balance plan designed with different accrual rates by partner age, and the state's pass-through entity tax election; the S corporation was modeled and rejected — the salary-differential mechanic across four unequal producers, the loss of debt basis, and a saving under 4 percent didn't justify it. Three: a two-lawyer contingency firm three years into building a mass-tort docket — a partnership: US$380,000 of cumulative losses passed through to the partners (deductible against their spouses' incomes to their basis and at-risk amounts — the firm's US$900,000 litigation-funding line supports basis, the partners' personal guarantees make it at-risk, and each year's loss sits within the US$512,000 joint excess-business-loss cap), US$1.2 million of advanced costs carried as receivables, and the S election on the calendar for the year after the first tranche of settlements makes the firm consistently profitable — with the partnership's flexibility kept if it doesn't. Three firms, one ethics rule, and the compensation mechanic decided the second while the loss years decided the third.

Official sources

The IRS states: “In order to become an S corporation, the corporation must submit Form 2553, Election by a Small Business Corporation signed by all the shareholders.” — Internal Revenue Service, S corporations, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

Publication 538 states: “A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method.” — Internal Revenue Service, Publication 538, Accounting Periods and Methods, https://www.irs.gov/publications/p538

Practitioner note

A law firm's entity decision is made on compensation mechanics more than tax rate: the partnership pays partners by any formula with self-employment tax on all of it and debt basis for the contingency firm's loss years, while the S corporation saves 2.9 to 3.8 percent above the wage base on distributions that must follow stock ownership and gives no basis from the firm's line of credit. Our law firm worksheets confirm the ethics rules on ownership first, model the salary-differential mechanic honestly across unequal producers, and put the cash balance plan at the center — because law is a specified service trade and above the range the QBI deduction is zero under either form.

See also: For related guidance, see S corporation vs. LLC: the tax differences; and browse every small business tax guide, by situation.

Next step

Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles law firm entity planning — professional entity formation under the rules of professional conduct, partnership versus S corporation compensation mechanics, basis analysis for contingency loss years, employed-lawyer market compensation documentation, retirement plan design, pass-through entity tax elections, and partnership and buy-sell agreement provisions. See pricing or book a call.