Small Law Firm Accounting: 5 Tips for Year-End Taxes

Just like any other business, a law firm needs to report year-end taxes. Of course, what this means to your firm depends on a few things, including what kind of business entity you formed, how many owners and employees you have, how much the firm made, and other factors.

With so many things to think about, knowing what taxes you actually need to pay can get confusing. Still, keeping up with your law firm's accounting will always help you set your firm up for success.

In this article, we’re covering the basics of small law firm accounting and providing five useful tips to get the most out of your year-end tax reporting.

Small Law Firm Accounting: A Quick Overview

Law firm accounting is the process of tracking cash flow, transactions, and the value of your law firm. The basic elements of accounting apply to law firms just as they would to any other business. These elements are:

• Assets. Things you own that add value to the company. This can include buildings, equipment, office furniture, and of course, money.
• Liabilities. Liabilities are debt obligations or money that you owe to someone else. These are often business loans, credit card debts, etc.
• Revenue. This is the gross income generated from the company’s activities. For law firms, this is the money paid to you by clients for services rendered. Gross income does not account for business expenses, including costs of services or operating expenses.
• Expenses. Expenses are costs paid by the company to carry out the company’s business activities. Common law firm expenses include legal research software subscriptions, rent, and employee compensation.
• Owner Equity. Owner equity represents the difference between the company’s assets and liabilities.

Law Firms Must Pay Taxes on Taxable Income

Like other businesses, law firms are subject to income taxes. Generally, a company’s taxable income is the profit a company makes after all legal tax deductions are made from the company’s revenue.

Paying Quarterly Taxes

Unlike individual taxpayers, business entities must pay taxes every quarter. Quarterly tax payments are “estimated taxes” because they represent what the company is likely to make during that tax year. Quarterly estimated taxes are calculated based on the company’s tax return from the previous year.

End-of-Year Taxes

End-of-year taxes calculate the law firm’s actual taxable income for that year. Once calculated, the law firm then pays any remaining taxes. If your law firm paid more in quarterly estimated taxes than you ended up owing, you'll be eligible for a tax return.

Not All Law Firm Tax Responsibilities Are the Same…

Tax responsibilities for law firms depend on the type of business entity the partners formed. Partnership entities, such as LLPs or PCs, are taxed differently than other business entities.

In a partnership, the equity partners of the law firm will pay the firm’s income taxes on their individual taxes. To report income for the partnership, partners will receive an IRS Form K-1. S Corporations are similar in that the shareholders will receive a Form K-1 along with a W2 for the salary portion of their income.

So, before you report your firm’s year-end taxes, first make sure you understand the implications of the business entity your firm has formed.

5 Tips for Reporting Year-End Taxes

There are two things law firms want to avoid when reporting year-end taxes: surprises, and a large tax bill. The following tips will help you avoid both.

Legal accounting software automates the law firm’s accounting activities and digitizes important documents like financial statements, receipts, and deposit statements. There are currently dozens of accounting software tools on the market.

Which software tool works for you will depend on the size of your firm, your revenue, and your budget. For example, if you already have practice management software, you may consider investing in separate accounting software, such as Quickbooks online.

Tips for Choosing Law Firm Accounting Software

If you have the budget for it, hire a professional accountant who specializes in small business accounting. An accountant can work through the technical tax issues, save you time, and help you prepare your firm for growth.

Tips for Finding an Accountant

Tax deductions for lawyers are unique because lawyers and law firms have unique overhead costs to consider. Still, like any other business, law firms can make deductions for the cost of services (called “cost of goods sold” by the IRS), and operating expenses. These deductions must be ordinary and necessary.

The following are a few examples of deductions every law firm should look into:

Law firms must keep their client funds separate from the firm’s earned operating funds at all times. To do this, law firms are generally required to open a trust account called an IOLTA account. IOLTA is short for “Interest on Lawyers' Trust Account.”

How IOLTAs Work

Any time a client pays a lawyer ahead of time for services, the lawyer must deposit the funds in the IOLTA account. Once they earn the money and bill the client, they can remove the funds from the IOLTA account and deposit them in the firm’s account.

Any interest that accrues in the firm’s IOLTA account must be given to a charitable organization, usually, one dedicated to social justice and legal services.

How to Open an IOLTA

Every state has a list of financial institutions eligible to host an IOLTA account. If you’re not sure where to find your state’s list, contact your state bar.

How Do I Know If I Need an IOLTA Account?

IOLTA requirements are governed by each state’s rules of professional conduct. Generally, all lawyers need an IOLTA account. Exceptions apply in some states for lawyers who charge only flat fees.

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1. Invest in Law Firm Accounting Software
   • Look for software that integrates with your practice management software. For example, MyCase software integrates with Quickbooks.
   • Make sure that the software you choose can connect with your business bank account.
   • Request a demo and get feedback from your colleagues.
2. Hire a Professional Accountant
   • Make sure they’re a Certified Public Accountant (CPA).
   • Discuss services with more than one accountant.
   • Look for an accountant who has worked with a lawyer before. They should understand how client funds must be handled and know what IOLTA accounts are.
   • Consider bookkeeping services to keep you on track throughout the year.
3. Take Advantage of Deductions
   • Office rent or home office expenses, including furniture, computers, paper, printing, etc.
   • Legal research software subscriptions, and other business subscriptions
   • Contributions to employee retirement accounts (or your own, if you’re a solo practitioner)
   • Continuing Legal Education (CLE) courses
   • Your accountant’s fees
   • Law firm marketing and advertising
   • Books, periodicals, and book subscriptions (usually provided by your state bar)
   • Travel expenses
4. Understand Your Trust Account
5. Just Getting Started? Seek Out Entrepreneurship Assistance

NBI offers a variety of CLE courses designed to help attorneys master the non-legal aspects of everyday practice. Whether you're looking for a guide for accounting or are wrestling with the demands of running a small law firm, check out our law practice management catalog to start learning today!

This blog post is for general informative purposes only and should not be construed as legal/tax advice or a solicitation to provide legal/tax services. You should consult with an attorney/CPA before you rely on this information. While we attempted to ensure accuracy, completeness and timeliness, we assume no responsibility for this post’s accuracy, completeness or timeliness.