The business structure you choose for your law practice profoundly impacts your tax liability, retirement planning capabilities, liability protection, and overall financial outcomes. While many attorneys focus intensely on building their legal expertise and serving clients, the financial structure supporting that practice often receives insufficient attention—potentially costing tens of thousands of dollars annually in unnecessary taxes.
At Pyramid Financial Services, we've worked with solo practitioners, small law firms, and multi-partner practices across North Carolina to optimize their tax strategies. The choice between partnership and S-Corporation structures represents one of the most consequential decisions you'll make for your law practice, yet many attorneys operate under structures that no longer serve their best interests as their practices evolve.
This comprehensive guide examines the tax implications, operational considerations, and strategic advantages of both partnership and S-Corp structures for law firms, providing the detailed analysis you need to make an informed decision about your practice structure.
Before exploring the nuances of how each structure affects law practices specifically, let's establish the core differences between partnerships and S-Corporations.
Partnerships are the traditional structure for legal practices, particularly those with multiple attorneys. General partnerships and limited liability partnerships (LLPs) are common in the legal industry.
General Partnership:Two or more attorneys jointly own and operate the practice, sharing profits, losses, and management responsibilities. Each partner has unlimited personal liability for partnership debts and obligations, including malpractice claims against other partners.
Limited Liability Partnership (LLP):Similar to a general partnership but provides liability protection—partners aren't personally liable for malpractice committed by other partners, though they remain liable for their own professional actions. Most law firms with multiple partners operate as LLPs for this liability protection.
Tax Treatment:Partnerships are pass-through entities. The partnership files an informational tax return (Form 1065) but doesn't pay federal income tax. Instead, profits and losses pass through to partners who report their distributive share on their personal tax returns via Schedule K-1.
Critically, partners pay self-employment tax on their distributive share of partnership income, regardless of whether profits were actually distributed or retained in the firm. This self-employment tax totals 15.3% on earnings up to the Social Security wage base ($176,100 for 2025), plus 2.9% Medicare tax on all earnings above that amount, plus an additional 0.9% Medicare surtax on earnings exceeding $200,000 ($250,000 married filing jointly).
An S-Corporation provides pass-through taxation similar to partnerships but with a crucial difference in how owner compensation is treated.
Formation:You can either incorporate as a regular corporation and elect S-Corp status, or form an LLC and elect to be taxed as an S-Corporation. The latter approach is increasingly popular for law firms, providing LLC operational flexibility with S-Corp tax advantages.
Tax Treatment:S-Corps file Form 1120-S and provide shareholders with Schedule K-1s showing their share of income and deductions. Like partnerships, profits pass through to shareholders' personal returns, avoiding double taxation.
The key distinction: S-Corp shareholders who work in the business must receive "reasonable compensation" as W-2 employees subject to employment taxes. Additional profits distributed beyond salary avoid self-employment taxes, creating significant tax savings opportunities.
The primary tax benefit of S-Corporation status centers on self-employment tax reduction. For profitable law practices, these savings can be substantial.
Consider Jennifer, a solo practitioner operating as an LLC taxed as a sole proprietorship (essentially a single-member partnership). Her practice generates $250,000 in net income after expenses.
Tax Liability:
Now suppose Jennifer restructures as an S-Corp and pays herself a reasonable salary of $130,000, with the remaining $120,000 distributed as S-Corp dividends.
Tax Liability:
Annual savings: $8,491
Over a decade, this represents nearly $85,000 in tax savings—money that could fund retirement contributions, pay down student loans, or support practice expansion.
The savings become even more dramatic as income increases. A partner in a successful firm earning $400,000 annually might save $15,000-$20,000 or more annually through S-Corp structuring.
The IRS requires that S-Corporation shareholders working in the business receive reasonable compensation as W-2 employees before taking distributions. This requirement prevents taxpayers from eliminating all employment taxes by characterizing all income as distributions.
Reasonable compensation should reflect what you would pay an unrelated person to perform the same services. For attorneys, relevant factors include:
Practice Area and Specialization:Corporate attorneys in major markets command higher compensation than general practitioners in smaller towns. Your reasonable compensation should reflect your specialization's market rate.
Experience and Credentials:A newly admitted attorney reasonably earns less than a partner with 20 years of experience. Educational credentials (JD from top-tier school, LLM, board certifications) also influence reasonable compensation.
Geographic Market:Attorney compensation in Charlotte or the Research Triangle differs significantly from smaller North Carolina markets. Your reasonable compensation should align with local market rates.
Firm Size and Billing Rates:Solo practitioners might reasonably pay themselves less than partners in established firms, as they're building equity in a growing practice. However, if your solo practice bills at $400/hour and generates $300,000+ in net income, paying yourself $50,000 salary wouldn't pass scrutiny.
Time Commitment:Part-time practice warrants proportionally lower salary than full-time practice. If you work 20 hours weekly, your reasonable compensation should reflect that reduced time commitment.
Research attorney compensation data from sources like:
Document your reasoning for the compensation level you establish. Maintain records showing how you determined reasonable compensation, including market research and consideration of the factors above.
Many law firms work with experienced tax advisors to establish and document reasonable compensation that withstands IRS scrutiny while maximizing tax benefits.
Setting salary too low can trigger IRS reclassification of distributions as wages, resulting in:
The risk isn't worth the marginal additional tax savings. Establish defensibly reasonable compensation from the outset.
While S-Corp status offers tax advantages, partnerships provide unique benefits that matter for certain law firm structures and situations.
Partnerships offer greater flexibility in allocating profits and losses among partners than S-Corporations, which must allocate pro-rata based on stock ownership.
Special Allocations:Partnership agreements can allocate specific items of income, gain, loss, or deduction to particular partners in proportions that differ from their overall ownership interests, as long as the allocation has "substantial economic effect."
This flexibility benefits law firms where:
Example: A three-partner law firm might have ownership interests of 40%-30%-30%, but the partnership agreement allocates the first $100,000 of profits equally (recognizing each partner's baseline contribution), with remaining profits allocated based on each partner's billable hours or origination credit. This sophisticated allocation would be impossible in an S-Corp.
Partnerships provide simpler mechanics for capital contributions and distributions than S-Corporations.
Partners can contribute property to partnerships and take distributions without recognizing gain or loss (subject to certain rules), facilitating:
S-Corps face more restrictive rules around property contributions and distributions that can trigger unwanted tax consequences.
Law firms increasingly use creative compensation structures to attract and retain talent, particularly for non-equity track associates or non-attorney professionals (administrators, legal technologists, business developers).
Partnerships can issue "profits interests"—equity interests in future profits without triggering immediate taxation to the recipient. This mechanism allows firms to provide equity-based compensation to key team members without the complexities and restrictions of S-Corp stock options.
S-Corps can issue stock options or restricted stock, but these face more complex tax consequences and shareholder number limitations (maximum 100 shareholders).
Despite partnerships' flexibility advantages, S-Corporation status provides meaningful benefits beyond self-employment tax savings.
S-Corporation shareholder-employees can implement robust retirement plans with certain advantages over partnership structures.
Solo 401(k) Plans:Solo practitioners operating as S-Corps can contribute both as employee (salary deferral up to $23,500 for 2025, plus $8,000 catch-up if age 50+) and as employer (profit-sharing contribution up to 25% of W-2 compensation). Total contributions can reach $70,000 (or $77,500 with catch-up) for 2025.
While partners can also establish similar plans, the combination of W-2 income and controlled employment relationship in S-Corps simplifies administration and may provide slightly higher contribution calculations.
Defined Benefit Plans:High-income attorneys can establish defined benefit pension plans allowing much larger tax-deductible contributions—potentially $200,000+ annually depending on age and income. These work well with S-Corp structures where the attorney receives substantial W-2 compensation.
S-Corporations can provide certain fringe benefits to shareholder-employees that receive more favorable tax treatment than comparable benefits to partners.
Health Insurance:S-Corp shareholders owning more than 2% cannot receive health insurance as a tax-free fringe benefit (it must be included in W-2 income). However, they can deduct these premiums on their personal returns as self-employed health insurance. Partners have similar treatment.
The distinction becomes meaningful when providing benefits to non-owner employees. S-Corps can offer tax-free health insurance to employees (including attorney associates), while partners in partnerships are treated as self-employed individuals, not employees.
Other Fringe Benefits:Certain benefits like group term life insurance (first $50,000), qualified transportation fringe benefits, and dependent care assistance receive preferential treatment for corporate employees versus partners.
Some attorneys believe operating as a corporation enhances professional image, though this perception varies by market and practice area. More substantively, corporate structures can facilitate succession planning and practice sales.
Transferability:Selling a law practice structured as an S-Corporation involves stock transfer, which many buyers prefer over purchasing partnership interests. The corporate structure also provides clearer framework for bringing in new shareholders as the practice grows or senior attorneys retire.
Valuation and Sale:S-Corp stock sales can qualify for advantageous tax treatment under certain circumstances, and the corporate structure provides clearer valuation methodologies familiar to potential buyers.
Since Pyramid Financial Services serves North Carolina law practices, state-specific factors merit discussion.
North Carolina recognizes both partnerships and S-Corporations for tax purposes, applying the state's flat 4.5% income tax rate (for 2025) to pass-through income.
North Carolina allows attorneys to form:
Professional regulations require that licensed attorneys own professional entities providing legal services. Non-attorneys cannot own equity in law practices, limiting ownership flexibility compared to other industries.
North Carolina imposes franchise tax on corporations (including professional corporations) based on the greater of net worth or appraised property value, at $1.50 per $1,000, with a $200 minimum. LLCs and partnerships avoid franchise tax.
For asset-light law practices, this represents only a few hundred dollars annually, but practices with significant real estate or accumulated capital should factor this cost into entity selection.