Law Firm Partner Tax Planning: Office Buildings, K-1s and QBI

Tax planning for a law-firm owner who also owns real estate starts with two separate questions: how is the legal practice taxed, and when are deductions from the property usable on the owner's return? A partnership K-1, an S-corporation payroll and rent from a separately owned office building do not follow the same rules.

This guide focuses on coordinating those decisions. For engagement scope and next steps, see tax planning for attorneys. A deduction should follow a sound business or investment decision, not justify an otherwise unattractive property purchase.

Start with what you can control at the law firm

• Equity partner in a firm taxed as a partnership: review the partnership agreement, allocation provisions, guaranteed payments, tax distributions and firm-sponsored retirement plan. Many decisions must be made by the partnership rather than by one partner.
• Owner of a firm taxed as an S corporation: coordinate reasonable wages, distributions, payroll compliance and employer retirement contributions at the corporation.
• Solo owner reporting on Schedule C: evaluate available entity choices against actual service income, administrative cost and professional requirements. There is no universal profit threshold that makes an S election the right answer.

The business's legal name does not establish its federal tax classification. Confirm the filed returns and elections, and have legal counsel address professional-entity, licensing and ownership requirements before restructuring.

K-1 income, guaranteed payments and cash distributions are different

A partner generally reports allocated partnership income whether or not the firm distributes enough cash to cover the tax. Guaranteed payments for services generally enter the individual partner's self-employment tax calculation. A general partner's ordinary business distributive share generally does as well, subject to the relevant rules. Do not assume that an LLP or LLC label, or describing a payment as a distribution, eliminates self-employment tax for an active service partner.

Review the K-1, its supporting statements and the agreement together. Amounts designated as guaranteed payments, allocations of profit and withdrawals of capital can have different consequences. An assignment of a partner's income to a separate corporation is not a routine substitute for analyzing who earned the income and who owns the partnership interest. The IRS partner instructions explain reporting categories; Publication 541 distinguishes partnership income and distributions.

S-corporation planning requires a defensible compensation file

If the practice is an S corporation, wages should reflect the shareholder's legal work, management duties and other services, considering the source of firm revenue. Receipts produced by the owner's personal services are different from returns attributable to other employees, capital or equipment. The IRS compensation guidance requires reasonable compensation before non-wage distributions to a shareholder-employee.

Maintain duties, time commitments, comparable compensation and payment records. Neither a fixed percentage of profits nor a stable salary chosen solely to minimize tax establishes reasonableness. Model payroll taxes, state costs, retirement contributions and QBI together. For the analysis rather than a universal salary formula, see reasonable compensation services.

Buying the law office: ownership and lease questions come first

Before closing, compare ownership in the operating entity with a separate property entity, including liability, financing, co-owner rights, future admission or departure of partners and sale plans. A separate LLC may serve business purposes, but it is not automatically a separate federal taxpayer or a tax-saving structure.

For a related-party lease, document who owns each entity, who uses the space, a supportable rental rate, payment terms and responsibility for improvements and expenses. Keep the property books separate from firm operating expenses. A change in ownership percentages can affect more than the rent calculation.

Self-rental does not automatically make a building loss deductible against legal income

When you rent property to a business in which you materially participate, the self-rental rule generally recharacterizes net rental income as nonpassive. It does not apply the same automatic conversion to a net rental loss. Consequently, accelerating depreciation can produce a loss that remains suspended even when the attorney spends substantial time working in the law firm.

A valid grouping of a rental and operating activity may matter, but it is subject to the appropriate-economic-unit standard and specific rental/business restrictions. Common ownership alone is not sufficient for every grouping. Review eligibility, consistency, required disclosures and future sale consequences before relying on it. Real estate professional status, where relevant, has separate personal-service tests and still requires material participation in the relevant rental activity.

The IRS passive-activity guidance and grouping regulation should be applied to the actual ownership structure. See self-rental rules and rental losses against business income for the separate steps.

Evaluate cost segregation using usable deductions, not a promised percentage

A cost-segregation review separates eligible shorter-lived assets from the building and nondepreciable land. The results depend on the actual property, purchase allocation, improvements and documentation. There is no reliable universal percentage for every law office.

Bonus depreciation eligibility depends on the assets, acquisition and placed-in-service dates, applicable elections and other requirements. An existing building may require an accounting-method review rather than simply inserting a new deduction on the current return. After the depreciation calculation, test owner basis, at-risk exposure, passive treatment and other applicable loss limits. Consider state conformity, expected holding period and potential recapture on sale.

Ask the preparer to show three separate amounts: the depreciation deduction, the amount usable this year and the projected tax effect. The practice-building cost-segregation guide explains the property review.

Law-firm QBI and office rent must be reviewed together

Legal services are a specified service trade or business (SSTB) for Section 199A. Whether an owner can use the qualified business income deduction depends on taxable income, filing status, the applicable year's phase-in rules and the other requirements. Wages and guaranteed payments for services are not QBI simply because the recipient owns the firm.

Moving the office into a different entity does not necessarily create unrestricted non-SSTB QBI. Regulation 1.199A-5 expressly addresses a law firm that separates its office building: property supplied to a 50%-or-more commonly owned SSTB can retain SSTB treatment for related parties. An unrelated-tenant portion can require a separate analysis. See rental QBI and the operating business.

Retirement deductions or allowable depreciation may affect taxable income, but they can also affect QBI. A suspended rental loss cannot be assumed to reduce current taxable income. Model the complete return rather than promising that a particular deduction restores a fixed QBI benefit.

Coordinate retirement funding with people, cash flow and entity income

A partner's plan participation must be coordinated with the partnership's plan. An S-corporation shareholder's eligible compensation generally comes from wages, not distributions. If the owner also has a property business or another operating company, review controlled-group and affiliated-service-group rules before assuming a new entity permits an independent owner-only plan.

A cash balance plan requires actuarial design, employee coverage review and an ongoing funding analysis. Contingency-fee firms should stress-test weaker collection years, not only a large settlement year. Compare the required funding and staff cost with a defined-contribution alternative, using the actual employee census and plan documents. IRS Publication 560 explains the small-business plan framework; the defined-benefit versus 401(k) guide addresses the choice.

Reimburse expenses through the correct arrangement

An S corporation can reimburse properly substantiated employee business expenses under an accountable arrangement that satisfies business connection, substantiation and return-of-excess requirements. A policy does not convert personal expenses or ordinary commuting into business costs, and a home-office claim must satisfy its own eligibility rules.

Partners are not treated as employees for all of these purposes. Review partnership reimbursement obligations and any required unreimbursed expenses under the agreement instead of applying an employee policy unchanged. Keep invoices, purpose, mileage records and proof of reimbursement. See accountable plans for the employee arrangement and its governing requirements.

What to prepare before a coordinated review

1. Firm returns, recent K-1s or payroll records, ownership percentages and the partnership or shareholder agreement.
2. Building purchase and loan documents, lease agreements, fixed-asset schedules and prior cost-segregation or grouping records.
3. Retirement-plan documents, employee census and a realistic cash-flow forecast.
4. Expense reimbursement policy, unresolved owner-paid expenses and estimated-tax payments.
5. Plans to buy, refinance or sell the property, admit a new partner or leave the firm.

Review these together before changing compensation, commissioning a study or selecting a new entity. This article is general federal tax education, not advice for a particular firm or a representation that its tax position has been professionally reviewed.

Frequently Asked Questions

Can a law-office cost-segregation loss offset my partnership income?

Not automatically. Self-rental rules can make net rental income nonpassive without converting a net rental loss to nonpassive. Review grouping, participation and the remaining loss limitations before counting on an offset.

Should every profitable attorney use an S corporation?

No. Evaluate reasonable compensation, payroll and state costs, retirement funding, ownership eligibility and professional rules. A partner receiving a firm K-1 cannot simply relabel that income as personal S-corporation distributions.

Are law-firm guaranteed payments subject to self-employment tax?

Guaranteed payments for services generally enter an individual partner’s self-employment tax calculation. Distributive-share treatment depends on the applicable rules and the partner’s facts; cash distributions are not a substitute for that analysis.

Does a separate office-building LLC avoid the law-firm QBI restriction?

Not necessarily. Property provided to an SSTB with 50% or more common ownership can be treated as a separate SSTB with respect to related parties. The qualifying rental activity, ownership and tenant mix need review.

What should I bring to a law-firm and real-estate tax review?

Bring the partnership agreement and K-1s or payroll records, retirement-plan documents and employee census, building closing statement and depreciation schedule, related-party leases, loan records and any prior grouping elections.