Owner Wages and Payroll: Why Your Entity Type Changes Everything

When you set up your law firm, you probably spent more time thinking about your practice area and client acquisition strategy than you did about how you'd pay yourself. Fast forward to today, and you're facing questions about payroll, health insurance deductions, retirement contributions, and whether you even belong on your own payroll in the first place.

Here's the reality: how you pay yourself isn't just a matter of cutting a check. Your entity type dictates everything about owner compensation—from tax implications to benefit eligibility to compliance requirements. Get it wrong, and you could face penalties, missed tax deductions, or unnecessarily complicated bookkeeping that makes your CPA cringe.

Let's break down what you need to know about owner wages based on your firm's entity structure, without the tax code jargon or confusion.

Why Entity Type Matters for Owner Compensation

Your law firm's legal structure isn't just a line on your incorporation documents—it fundamentally determines how the IRS views you as an owner and how you can (and must) pay yourself. This impacts:

• Tax treatment of your compensation

• Eligibility for employee benefits and withholdings

• Self-employment tax obligations

• Payroll compliance requirements

• Year-end tax reporting (W-2 vs. 1099 vs. K-1)

Understanding these distinctions is crucial, especially when you're trying to navigate the common accounting mistakes that trip up law firms. Misclassifying your own compensation is one of the quickest ways to create compliance headaches that could have been easily avoided.

Single-Member LLC (SMLLC): The "You're Not an Employee" Entity

Here's the most misunderstood entity type when it comes to owner compensation: the single-member LLC. Many solo practitioners choose this structure because it's simple and provides liability protection. But there's a critical limitation that catches many by surprise:

As an SMLLC owner, you cannot be on payroll. Period.

The IRS treats a single-member LLC as a "disregarded entity" for tax purposes, meaning the business and owner are essentially one and the same. You're not an employee of your firm—you ARE your firm. This creates several important implications:

What This Means for SMLLC Owners:

You cannot:

• Receive a W-2 wage

• Have payroll taxes withheld from your compensation

• Participate in employee benefit plans through payroll withholdings

• Deduct health insurance premiums as a payroll expense

• Contribute to company-sponsored retirement plans as an employee

You must:

• Take owner's draws (not salary) for compensation

• Pay quarterly estimated taxes directly to the state and IRS

• Pay self-employment tax on all net business income

• Report health insurance premiums on your personal tax return (Schedule 1)

• Set up retirement contributions as self-employed plans (SEP-IRA, Solo 401(k))

This is similar to the independent contractor vs. employee distinction we've discussed before—the IRS cares about the actual relationship, not what you call it. You can't just decide to put yourself on payroll because it's convenient.

The Health Insurance Conundrum

Many SMLLC owners discover this limitation when they try to set up health insurance benefits. Since you can't participate in employee benefit withholdings, you must:

• Purchase health insurance individually (not through a group plan)

• Pay premiums out of pocket

• Deduct premiums on your personal tax return as self-employed health insurance

• Remember that these deductions reduce income tax but not self-employment tax

This often surprises attorneys who transition from traditional employment to solo practice, expecting the same benefit structure they had as associates.

Multi-Member LLC and Partnership: The K-1 Scenario

If your firm has multiple owners structured as an LLC or partnership, the compensation rules change significantly—but owners still can't be traditional employees.

Partners and LLC members:

• Receive guaranteed payments (not salary)

• Get distributions based on ownership percentage

• Receive K-1 forms (not W-2s) for tax reporting

• Cannot participate in employee benefit withholdings

• Must make quarterly estimated tax payments to the state and IRS

The key distinction here is between guaranteed payments (similar to a salary, paid regardless of firm profitability) and distributions (profit sharing based on ownership). Both are reported on Schedule K-1 and subject to self-employment tax, however, guaranteed payments are deductible business expenses where distributions are not.

Benefits for Multi-Member Structures:

Partners face the same benefit limitations as SMLLC owners—no payroll withholdings for health insurance, retirement, or other benefits. However, partnerships can offer some advantages:

• Health insurance premiums can be deducted as guaranteed payments

• Retirement plan options include SEP-IRA and defined benefit plans

• Partners can receive other fringe benefits through guaranteed payments

• Cost-sharing for benefits may be possible through the partnership agreement

S Corporation: The "Reasonable Salary" Requirement

S Corporations flip the script entirely. If your law firm is an S Corp, you're not just allowed to be on payroll—you're required to be.

S Corp owners must:

• Pay themselves a reasonable salary through payroll

• Withhold payroll taxes (Social Security, Medicare, federal and state income tax)

• Receive a W-2 for their wages

• Process payroll at least as frequently as state law requires

• Pay quarterly estimated taxes directly to the state and IRS

The "reasonable salary" requirement exists to prevent S Corp owners from avoiding payroll taxes by taking all compensation as distributions. The IRS scrutinizes this closely in professional service firms like law practices.

What's "Reasonable" for Attorneys?

The IRS looks at factors like:

• Compensation paid to attorneys with similar experience and skills

• Time devoted to the business

• Services actually performed

• Firm size and profitability

For context, if comparable associate attorneys in your market earn $80,000-$120,000 annually, you can't justify paying yourself $30,000 in salary and taking $150,000 in distributions. That's a red flag for audits.

S Corp Benefit Advantages:

Unlike SMLLC and partnership structures, S Corp owners are employees who can:

• Participate in employee benefit plans through payroll withholdings

• Deduct health insurance premiums as a business expense

• Access group health insurance plans

• Contribute to 401(k) plans with employer matching

• Receive other employee benefits (HSA contributions, life insurance, etc.)

This is where S Corps shine for many law firm owners—the ability to access traditional employee benefits while potentially reducing overall self-employment tax burden.

The S Corp Payroll Reality:

Here's what you need to manage as an S Corp:

• Regular payroll processing (biweekly, semi-monthly, or monthly)

• Quarterly payroll tax deposits

• Annual W-2 processing

• Quarterly payroll tax returns

• Year-end reconciliation

This administrative burden is significant, which is why many S Corp owners work with virtual CFO services to handle payroll compliance and strategic tax planning.

C Corporation: The Traditional Employee Structure

C Corporations treat owners like any other employee, which provides maximum flexibility for compensation and benefits but comes with the trade-off of potential double taxation.

C Corp owners:

• Are W-2 employees of their corporation

• Can receive reasonable compensation as employees

• Have access to all employee benefits

• May face double taxation (corporate tax + personal tax on dividends)

Most law firms avoid C Corp status specifically because of double taxation concerns, but it remains an option for firms with specific strategic goals.

Real-World Scenarios: Getting It Right

Scenario 1: The Solo Practitioner SMLLC

Sarah runs a successful estate planning practice as a single-member LLC. She tried to set up payroll for herself to withhold taxes and contribute to a 401(k), but her payroll provider rejected her application. Why? Because she's not an employee of her business.

The solution: Sarah takes owner's draws throughout the year, makes quarterly estimated tax payments, and sets up a Solo 401(k) as a self-employed retirement plan. She deducts her health insurance premiums on her personal tax return instead of through business payroll.

Scenario 2: The Partnership Pitfall

Mike and Jennifer are equal partners in a litigation firm structured as a multi-member LLC. They set themselves up on payroll because they wanted consistent paychecks and benefit withholdings. The IRS audited their firm and assessed penalties for improper payroll classification.

The solution: Mike and Jennifer converted to guaranteed payments instead of payroll, established proper partner draws, and worked with their CPA to restructure their compensation properly. They also evaluated whether converting to an S Corp might better serve their needs.

Scenario 3: The S Corp Success

David structured his intellectual property firm as an S Corporation from day one. He pays himself $100,000 in W-2 wages (reasonable for an attorney with his experience) and takes an additional $75,000 in distributions. This structure allows him to:

• Participate in the firm's group health insurance

• Maximize 401(k) contributions with employer matching

• Reduce self-employment tax on the distribution portion

• Maintain full compliance with payroll requirements

The trade-off is managing regular payroll processing, but David views this as worthwhile for the tax benefits and administrative simplicity.

Cash Flow Implications by Entity Type

Understanding how owner compensation affects cash flow is crucial, especially as law firms navigate changing billing models and revenue patterns.

SMLLC and Partnership owners: Can take draws as cash is available, providing maximum flexibility during uneven revenue months. However, this requires discipline with estimated tax payments.

S Corp owners: Must process payroll on a regular schedule regardless of current cash flow, which requires more careful cash management but provides predictability for tax planning. Can also take draws as cash is available.

The cash flow consideration: Many law firms experience irregular income due to contingency cases, delayed client payments, or seasonal fluctuations. Your entity structure should align with your cash flow patterns and management style.

Making the Entity Choice: Strategic Considerations

Choosing or changing your entity type isn't just a tax decision—it's a strategic business decision that impacts operations, compliance burden, and long-term flexibility.

Consider SMLLC if:

• Your firm is pre-revenue or has an annual net income under $100,000

• You're a solo practitioner with no plans to add partners

• You value simplicity over potential tax optimization

• Your income is relatively stable and manageable with estimated taxes

• You're comfortable managing self-employed benefit structures

Consider Partnership/Multi-Member LLC if:

• You have multiple owners sharing profits

• You want flexibility in profit distribution

• You're willing to manage partner compensation structures

• The administrative burden of S Corp status isn't justified by tax savings

Consider S Corporation if:

• Your net income consistently exceeds $90,000-$100,000

• You want access to traditional employee benefits

• The self-employment tax savings justify the additional compliance costs

• You're comfortable with regular payroll processing requirements

Consider conversion when:

• Your income has grown significantly since formation

• You're adding partners or changing ownership structure

• Your benefit needs have evolved

• Your current structure creates ongoing compliance challenges

Getting Help with Owner Compensation

Owner compensation isn't a "set it and forget it" decision. As your firm grows and evolves, your compensation strategy should too. At Accounting Girl, we regularly help law firms navigate these decisions through our comprehensive accounting and CFO services.

We help firms:

• Evaluate entity structure for current and future needs

• Process payroll correctly based on entity type

• Manage owner compensation tax efficiently

• Structure guaranteed payments and distributions

• Plan and execute entity conversions when beneficial

• Ensure compliance with all payroll and tax requirements

The goal isn't just avoiding penalties—it's creating a compensation structure that supports your firm's financial health, provides appropriate benefits, and positions you for sustainable growth.

The Bottom Line

Your entity type isn't just a legal technicality—it's the foundation of how you pay yourself, access benefits, and manage your firm's finances. SMLLC owners need to understand they're not employees and can't access payroll withholdings. S Corp owners must navigate the reasonable salary requirement and regular payroll obligations. Partnership structures fall somewhere in between, offering flexibility with their own complexities.

The key is matching your entity structure to your actual needs, not just choosing what seems simplest at formation. As your firm grows and your circumstances change, what once made sense as a solo practitioner may not serve you well as an established practice with multiple revenue streams.

Don't let entity structure confusion become another source of stress in your practice. With the right guidance and systems in place, you can structure owner compensation correctly from the start—or fix existing issues before they become costly problems.

Ready to ensure your owner compensation is structured correctly for your entity type? Let Accounting Girl help you navigate these complexities with confidence. We specialize in law firm accounting and know exactly how to handle the unique challenges attorneys face with owner wages and payroll compliance.