Key Takeaways:
- Misclassifying income partners, overlooking state tax obligations, and poor distribution planning are just a few tax traps law firms often fall into.
- Proactive planning and tailored guidance can help your firm manage risk and avoid costly penalties.
- From partner succession to underused deductions, staying tax-savvy supports both profitability and long-term growth.
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In today’s complex regulatory environment, law firms face increasing scrutiny from tax authorities — and the stakes are high. From misclassifying partners to overlooking state tax obligations, even well-established firms can fall into costly traps.
Here are five common tax mistakes law firms make, and how to avoid them with proactive planning and the right advisory support:
1. Misclassifying Partners and Employees
Law firms often operate under partnership structures, but the line between partner and employee isn’t always clear. Misclassifying individuals — especially income-earning partners who function more like employees — can result in the assessment of back employment taxes (including the firm’s share of FICA/Medicare), withholding tax liabilities, IRS audits and penalties, and damage to the firm’s reputation.
How to avoid it: Ensure your firm’s classification policies align with IRS guidelines. Review compensation structures, voting rights, and management responsibilities regularly. A CPA firm can help assess risk areas and recommend adjustments to stay compliant.
2. Overlooking State and Local Tax (SALT) Obligations
With attorneys working remotely and firms expanding across jurisdictions, SALT compliance has become a moving target. Many firms underestimate their nexus exposure or miscalculate apportionment, leading to underpaid taxes, as well as late filing and late payment penalties and interest. Additionally, the complexity of pass-through entity taxes (PTETs) is a critical issue as it impacts the firm’s cash flow and partner tax returns.
How to avoid it: Conduct a nexus study to determine where your firm has tax obligations. Implement systems to track where services are performed, and revenue is earned. A SALT professional can help you stay ahead of evolving state rules and avoid surprises.
3. Inadequate Tax Planning for Partner Distributions
Distributions to partners are often made without considering the tax implications — especially when cash flow is tight. This can result in partners owing significant taxes on guaranteed payments and/or distributive share of income shown on their K-1 that they haven’t received in cash.
How to avoid it: Coordinate tax basis and other distribution planning with distribution schedules. Use quarterly projections to estimate partner liabilities and adjust draws accordingly. Also, consider clawback provisions. A CPA can model various scenarios and help your firm maintain both compliance and liquidity.
4. Ignoring Succession and Exit Strategies
Many firms delay planning for partner retirements or ownership transitions. Without a tax-efficient strategy, these events can create financial strain for both the firm and the departing partner.
How to avoid it: Start early. Develop a buy-sell agreement that accounts for valuation, funding, and tax treatment. Consider installment sales or deferred compensation plans to spread out tax burdens. A tax advisor can guide you through structuring options that align with your firm’s goals.
5. Failing to Leverage Available Deductions and Credits
From continuing legal education to technology investments, law firms often miss out on deductions that could reduce their taxable income. This is especially true for firms that don’t regularly review their chart of accounts or expense classifications.
How to avoid it: Conduct an annual deduction review. Look for underutilized areas like Section 179 expensing and R&D credits for legal tech innovation. A proactive CPA can help you identify and document eligible expenses.
Strengthening Your Firm’s Tax Strategy
Tax compliance is more than a year-end exercise — it’s a strategic function that can impact your firm’s profitability, partner satisfaction, and long-term sustainability. By avoiding these common mistakes and working with a CPA firm that understands the legal industry, your firm can stay ahead of the curve and focus on what matters most: serving your clients.
How MGO Can Help
Our Professional Services practice works with law firms of all sizes to navigate complex tax challenges. Whether you’re managing multi-state operations, planning partner distributions, or reviewing deductions, we offer tailored strategies to help your firm stay compliant and financially efficient. Reach out to our team today to start building a stronger tax foundation for your firm.