General Practice, Solo & Small Firm Division
American Bar Association
General Practice, Solo, and Small Firm Division The Compleat Lawyer
Fall 1997 copyright American Bar Association. All rights reserved.
Legal Relationships within the Firm
BY ROBERT R. KEATINGE AND ALLAN G. DONN
Robert R. Keatinge is of counsel with Holland & Hart LLP in Denver, Colorado. Allan G. Donn is a shareholder in Wilcox and Savage, P.C., in Norfolk, Virginia.
One of the most valuable services that a lawyer provides to a client is the selection of a business structure that accomplishes the client's objectives and maximizes business efficiency.
The lawyer also acts as a counselor and sounding board, making sure that the client understands all of the aspects of the structure, including the legal, tax, licensing, and business considerations of the entity. Lawyers confront these same considerations when establishing a law firm.
A Backup Lawyer for the Sole Practitioner
BY ROBERT R. KEATINGE AND DAVID BUTLER
Robert R. Keatinge is of counsel and David Butler is a retired partner and of counsel with Holland & Hart LLP in Denver, Colorado.
The freedom that accompanies the sole practice of law comes with a price. Provisions must be made for the servicing of clients during the lawyer s absence. Solos should be sure that a backup lawyer is available to step in when necessary, and both lawyers should be clear about what the backup's duties will be.
All lawyers are subject to temporary or permanent interruptions in their ability to practice law. Except for junior associates, lawyers generally take an occasional respite from the demands of the practice, and all lawyers are subject to sickness, injury, incapacity, and death. In a firm of more than one lawyer, it is possible to rely on the other members for coverage during expected and unexpected absences. The solo has the same problem, but does not have an easy solution.
Every lawyer should have another lawyer who is ready to step up in the event of death or disability to ensure that the client is not prejudiced. For a solo without professional associates, this involves finding another lawyer who has his or her own separate practice, but is willing to undertake some degree of responsibility for the lawyer s practice. Not only is a backup lawyer ethically and legally essential for a lawyer, but it may also be a condition of errors and omissions coverage.
Selection of the Backup
The relationship between a solo and a backup should be close enough that the backup is likely to be aware of when the solo becomes unavailable unexpectedly. Not only will this help clients become aware of the situation promptly but also someone with a personal relationship with the solo is likely to have greater patience with the problems of the solo and the clients than would a stranger.
Whether the backup should also be competent in the areas in which the solo practices turns on the duties of the backup in the absence of the solo. The relationship between the solo and the backup should be put in writing to ensure that both are in clear agreement with respect to the responsibilities of the backup.
The Backup's Duties
The backup may do as little as communicate with the clients about unexpected absences of the solo, or as much as acting as lawyer in tending to or taking over the solo s cases. If the solo has a practice with controllable demands, and he or she can take short vacations without the need for someone to step into the practice, it may be sufficient for the backup only to be available to assist in the event of an unexpected emergency.
But if the sole practitioner has an active practice with frequent deadlines, it may be necessary to have a backup lawyer to whom the clients or the solo s staff may resort if an issue arises. With the advent of several alternative methods of electronic and telephonic communication, the solo may be able to deal with many of these problems without the need of a backup. In this case, the backup would step in only in the case of the unexpected incapacity of the sole practitioner or during times when the solo will be truly incommunicado.
In all cases, the backup should be granted authority by the solo to take over cases, subject to the choices made by the client, even though the duty to do so may not be imposed. It should be made clear between the sole practitioner and the backup (and, perhaps in some cases, even with the client) whether such a duty is being undertaken (as opposed to the obligation to simply notify the client) by the backup.
If there is a good chance that the backup lawyer will actually be performing services for a client, it is wise to screen major or continuing clients for conflicts with the backup s practice. This may affect the choice of the backup by the solo. One sole practitioner of our acquaintance has an ongoing relationship with another firm and screens his clients for conflicts with the firm. In any case, the backup should deter- mine whether a conflict exists before actually performing services for the solo's clients.
Notification of Clients
It may be appropriate for the sole practitioner to inform clients about the arrangements that have been made, particularly if they raise the question. The backup should review and approve any communication with respect to the relationship, to avoid undertaking liability for the actions of the solo.
Presumably, such a communication would make it clear that the backup is not acting as counsel for the client, will have no participation in the client s case, and will owe no duty to the client with respect to the conduct of the case by the solo. It may be appropriate for the client to authorize the sole practitioner to communicate with the backup about the client s case for the purpose of ensuring that the backup is aware of things that may come up during the solo's absence.
Particularly in these times, one can visualize the possibility that a disgruntled (or opportunistic) client will make a claim against either the backup lawyer or both the sole practitioner and the backup.
For example, the solo may become impaired and make errors or omissions, of which both the client and the backup are unaware at the time the backup attempts to take on the client s matter. Although no agreement between the lawyers may limit the liability of the backup to the client, at the time of the agreement to act as backup, the backup may wish to obtain anticipatory indemnification from the solo for any errors and omissions of the solo.
The Solo's Staff
In the age of computers and paperless communication, many solos practice without full-time or part-time employees or other staff. Obviously, the problems discussed above are particularly acute for these lawyers. A solo with associates should make sure the associates have access to enough information to take over in the event of the solo's absence.
The staff can often deal with many client issues in the lawyer s temporary absence, particularly if kept informed by their employer. Nonetheless, a staff by itself probably does not eliminate the need for a backup lawyer, although the backup s duties can be reduced. Of course, the staff cannot continue the practice during a long or permanent absence, but a knowledgeable staff can be of great assistance to a backup who must step in.
The Backup's Duties to the Client
When a backup lawyer undertakes to continue a representation of the client in place of a deceased or incapacitated solo, the backup should remember that the duty is owed to the client in the same manner as in other circumstances. In some cases, there may be questions about fees, trust fund amounts, and the representation that the client has gotten from the solo. If such a situation arises, the backup should be ready to make full disclosure to the client, and may wish to have a judicial review of the case through the incapacity or probate of the solo or otherwise.
If there appears to have been irregularities or prejudice to the client as a result of the sole practitioner s actions, and the backup would be uncomfortable as a result of his or her relationship with the solo, the backup lawyer should notify the client as quickly as possible to allow the client to obtain new counsel. The backup may be able to reach agreement with the client that as a condition to undertaking the case, the client will not hold the backup liable for errors or omissions of the sole practitioner.
Rule 1.8(h) of the Model Rules of Professional Conduct appears to preclude any prospective agreement to limit the backup lawyer s liability for the backup s own malpractice, but it might be helpful to both the backup and the client to enter into a new engagement that expressly states that the backup is undertaking the matter as a new matter on behalf of the client and is not guaranteeing or otherwise taking responsibility for the work done by the solo. Such an agreement should be consistent with Rule 1.2(c) of the Model Rules.
Of course, the backup would have the obligation to inform the client of any errors or omissions committed by the solo. To the extent that the backup is also the personal representative or guardian of the sole practitioner, the backup lawyer should inform the client of the potential conflict at the outset of representation. Should an actual claim arise, the backup probably will have to decline to represent either the client or the estate with respect to the claim. In selecting a firm structure, legal and tax considerations are important, but it is also essential that all of the participants understand the actual relationship among the lawyers. That relationship should not be lost in the organizational structure.
Historically, selection of a business structure involved the selection of a business entity, generally limited to the corporation (or professional corporation or professional association) or the general partnership. The business organization chosen and the rules governing professional practices determined the relationship of those practicing in the organization. During the past five years, new forms of business organizations such as the limited liability company and the limited liability partnership have been added to the menu.
The principal alternative business entities that are available for the practice of law are:
General partnership. The general partnership has been the most common form of law practice. In a traditional general partnership, each owner (general partner) is jointly and severally liable for the obligations of the partnership. Each partner is an agent of the partnership for the purposes of carrying on the business of the partnership. As a technical matter, the withdrawal of each partner causes a dissolution of the partnership and the creation of a new partnership. Unless the partnership agreement provides otherwise, each partner has an obligation to contribute the partner s proportionate share of any partnership obligations.
Limited liability partnership (LLP). An LLP is a general partnership that, by registering with the state, has eliminated some or all of the vicarious liability of the partners for the obligations of the partnership. In other respects, an LLP is the same as a general partnership. Most states have adopted LLP legislation, and roughly half of those provide that a partner is not liable as such for any of the obligations of the LLP (a full shield statute). The other statutes provide that a partner is not liable for any obligation of the LLP arising from tort but leaving partners individually liable for claims arising from contract.
Limited liability company (LLC). An LLC, like an LLP, is an unincorporated business organization in which no owner, as such, is liable for the obligations of the organization. Unlike an LLP, it is a distinct legal entity rather than a form of general partnership. Owners are known as members rather than partners.
Professional corporation (PC). A PC is a corporation that is authorized to practice a profession. Every state permits lawyers to practice law in corporate form, either using professional corporations or business corporations subject to special rules, depending on the state.
Other alternatives. Under the rules applicable in some states, other business entities such as limited partnerships or partnership associations are permitted to practice law. Because lawyers have sufficient flexibility to structure any arrangement using the more commonly accepted forms, these less common organizations are not used very often.
Business and Professional Considerations
With a few exceptions, a law firm may use any of the four entities listed above in any state (see table 1). In many states, the ownership of the entity and the liability of the owners is prescribed by state law or court regulation of the practice. Under the rules governing the practice of law in most states, only owners practicing in a particular state need be admitted to practice in that state; thus, in a multi-state firm, owners must be licensed only in states in which they practice.
A few states, while permitting practice by limited liability entities, impose vicarious personal liability on owners for legal malpractice or impose such liability if the firm does not maintain insurance (see table 2). Regardless of the form of organization, each owner is liable for his or her own actions, including, in some cases, the actions of subordinates under his or her supervision.
Neither shareholders in a corporation nor members of an LLC are liable for any of the obligations of the entity. Partners in a general partnership are individually liable for all obligations of the entity; the liability of partners in an LLP varies from state to state. Under some LLP laws, partners in an LLP are individually liable for contractual obligations of the partnership but not liable for the partnership s obligations arising from the torts of others. Other LLP statutes afford partners the same liability protection that shareholders and members have.
There is also a subtle difference in the entities with respect to liability of owners for distributions. Under corporate law, salary paid to shareholders is generally treated in the same manner as other obligations of the entity, so that a shareholder should not be liable to return salary even if the firm is insolvent when the salary is paid. Members and partners are generally paid for their services by allowing them to take draws against their share of the profits of the entity.
Under many LLC statutes, a member is obligated to restore wrongful distributions even if the member did not know that the distributions were wrongful. Under most LLP statutes, the partners are obligated to restore only distributions that would constitute fraudulent conveyances or fraudulent transfers, which, considering that most distributions are made to partners who are providing services, would probably require not only knowledge of the insolvency of the organization, but also an intent to hinder, delay, and defraud creditors.
The legal ethics rules impose a greater obligation on owners to supervise than on other lawyers in the firm, regardless of whether the owners are partners or shareholders (Rule 5.1.). In other respects, the statutes governing different business organizations provide sufficient flexibility to allow the firm to establish whatever management relationship it desires. For example, the management committee of a partnership, the managers of a limited liability company, or the directors of a corporation can function in roughly equivalent ways. Thus, the choice of entity is often driven by tax considerations and intangibles.
In converting from a general partnership to a limited liability entity such as an LLC, LLP, or PC, the owners should bear in mind that, although they may be eliminating vicarious liability for the obligations of the firm, they are also giving up the personal obligations of the other owners to contribute. Under most general partnership agreements, if a partner is held liable for simple negligence, the other partners will contribute their share of the liabilities. In a limited liability entity, each owner is on his or her own with respect to liabilities. Although the owner may be entitled to look to the firm itself for indemnification, if the firm s assets are insufficient to pay the claim, the owner will be without contribution from the other owners unless they decide to help the owner with the claim.
For tax purposes, there are three types of entities: Organizations treated as partnerships for federal tax purposes (tax partnerships), S corporations, and C corporations.
Tax partnerships. Under new, clearer tax rules, all unincorporated business organizations including general partnerships, LLCs, and LLPs are treated as partnerships for federal income tax purposes unless they affirmatively elect to be treated as corporations.
In a tax partnership, income and other tax items of the partnership are not taxed at the entity level, but passed through to the partners who report their proportionate share on their individual returns. Partners are not taxed on distributions of income that was taxed when earned. Income reported from a partnership will ordinarily be treated as net earnings from self-employment and subject to self-employment taxes, including a 2.9 percent Medicare tax on all of the net earnings without the income limit applicable to other employment taxes. Although these taxes are deductible (which, for example, reduces the effective rate of the Medicare tax to 2.4 percent), they are a cost of doing business.
A partner is considered to be self-employed for purposes of fringe benefits including health insurance. A corporation may deduct health insurance and other benefits for employees, including employees who are shareholders. In contrast, a self-employed person, including a partner, is currently entitled to deduct only 40 percent of health insurance (increasing to 80 percent in 2006). Unlike a corporation, in which health insurance premiums on shareholder-employees are not taxed to either the corporation or the shareholder, between 20 and 60 percent of health insurance premiums will be paid with income that has been taxed to the partner.
When a person characterized as a general partner retires from a tax partnership, the payments made by the partnership are deductible to the partnership and includible in the income of the retired partner. Because an LLP is a general partnership under state law, it is more likely that a partner in an LLP will be treated as a general partner for this purpose than a member in an LLC.
S corporations. An S corporation, like a partnership, is a passthrough entity, generally not taxed at the corporate level. The shareholder-employees are paid salaries that are subject to the same withholding rules that apply to all other salaries. Any amount in excess of the salaries is passed through as dividend income and is not subject to self-employment taxes. Shareholder-employees who own 2 percent or more of the stock are generally subject to the same limitations on excluding health insurance and fringe benefits from income as are partners. In a larger firm, one with more than 50 members but less than 75, if the stockholdings are equal, it might be possible to obtain the benefits of corporate fringe benefit rules while obtaining pass through taxation.
C corporations. The principal tax benefit of not making an S election is that health insurance and fringe benefits may be provided to employees on a tax-free basis. The corporation may deduct the insurance premiums and the cost of such fringe benefits as employee parking, while the shareholder-employee does not have to include the value of these benefits in income.
The cost of such treatment is that the corporation pays an entity-level tax on its taxable income (income less deductions, which includes salaries paid to the shareholders to the extent that those salaries represent reasonable compensation). In a C corporation, it is important to reduce the taxable income to as close to zero as possible to avoid double taxation, which requires year-end computation, and often the payment of bonuses.
If the shareholders do not reduce the income to zero or if the IRS successfully attacks the salaries being paid to owners as unreasonable compensation, which would reduce the deduction for those salaries, any net income will be subject to corporate tax. Because personal service corporations are not entitled to use graduated tax rates, all corporate income is subject to the flat 35 percent tax rate.
What's in a Name?
Owners tend to refer to each other as partners regardless of the form of entity chosen. This may be a result of the historical predominance of partnerships as the form of practice, or it may simply be that partner is a simple way of referring to the relationship between one owner and another. While one may state, she is my partner, the phrase she is my co-shareholder or she is a member of our LLC tends to be awkward and stilted. In some cases, this distinction may be enough to encourage lawyers to select an LLP over a professional corporation or LLC, particularly when all other considerations are equal.
Positions within the Firm
Not only are there several business entities available to the professional firm but also there are several titles within the firm. These titles reflect the hierarchical relationship within the firm: managing owners (managing partners, managers, and directors), other owners (partners, members, shareholders), counsel, and associates. These positions also entail certain legal and ethical responsibilities that should be considered in taking a position within a firm.
Partner. In a general partnership or limited liability partnership, all owners are known as partners, although all partners are not necessarily owners of the firm. A partner generally has the right to share in the profits of the firm, although in some cases, a contract partner or non-equity partner may not have interests in the profits or capital of the firm. In addition, in a general partnership, each general partner is individually liable for the obligations of the partnership.
Shareholder. In a professional corporation, the owners are known as shareholders. Those making policy decisions for the professional corporation are known as directors.
Associate. Regardless of the form of organization, an associate is an employee of the firm. An associate may be a person who is working his or her way to ownership or may be a contract associate who is a permanent employee. The contract associate is often not subject to many of the pressures applicable to associates who are on a partnership track.
Of counsel. The title of counsel (or variants of that title) generally identifies a person who is neither an owner nor an associate. The word counsel can be used to identify the relationship of a lawyer or law firm with another lawyer or firm, as long as the relationship between the two is a close, regular, and personal one and the use of the title is not otherwise false or misleading (ABA Formal Opinion 90-357 (May 10, 1990)).
Temporary lawyer. A temporary lawyer is a lawyer engaged by a firm for a limited period, either directly or through a lawyer placement agency, but does not include a person engaged for an extended period of time (ABA Formal Opinion 88-356 (December 16, 1988)). The rules applicable to conflicts of interest and disqualification of the lawyer and the firm are not entirely clear. ABA Formal Opinion 88-356 suggests that the degree to which the temporary lawyer and the firm will be limited by those rules turns on the breadth of the temporary lawyer s involvement in the firm s practice. This opinion should be consulted in any situation involving a temporary lawyer.
Joining a small firm. The legal consequences of joining a firm are generally secondary to the important considerations of the financial and personal relationships among the participants. It may be appropriate to have a period of time during which the lawyer and the firm get to know each other before making the commitment to actually merge the practices. Billing practices, working style, and personality should be considered, as should fundamental business considerations such as the expenses and debts of the firm and the business that each party will be able to contribute.
In some cases, the merger of law firms involves the combination of two roughly equal firms into a newer and larger firm; in other cases, a larger firm acquires a smaller one. In the latter situation, most of the change will be borne by the smaller firm, while if the firms are more equal in size, both will have to deal with change.
While most large firms are partnerships, LLPs, or LLCs, and thus treated as partnerships, many smaller and mid-sized firms are organized as corporations. A professional corporation may experience a tax cost on a merger with another firm, particularly one that is not organized as a corporation.
A merger of a firm treated as a corporation for tax purposes (even one treated as an S corporation) must recognize gain on liquidation of its assets to the extent of the difference between the fair market value of the assets and their adjusted basis. The two types of assets that may be particularly troublesome in this respect are accounts receivable of a firm that has operated on a cash basis of accounting (which virtually all personal service businesses use) and goodwill. In both cases, these assets may have considerable value but not tax basis.
Setting up business entities. The establishment of a new firm involves both the normal requirements for the establishment of the entity as a matter of state law (and qualifying it under other state laws if the firm is to practice in more than one state) as well as compliance with the court rules applicable to practice through a business entity.
The rules governing the practice of law generally do not require any particular action for a firm practicing as a general partnership, but in some states, firms practicing in any other form must register with the court or other body regulating the practice of law. The organic documents should be properly drafted and should reflect the agreement and practices of the firm. They should address all of the issues that are important to the owners, such as sharing of income, vacation policy, bonuses, and the breadth of the firm s practice.
Because the law, like any business, tends to change, the manner of making decisions with respect to changed circumstances such as the growth or contraction of the firm should be spelled out. It is also appropriate to make clear what happens when an owner leaves the firm voluntarily, is expelled pursuant to the partnership agreement, or is incapable of carrying on the practice as a result of death or retirement. These agreements will often be situational in the particular firm.
Relationships among lawyers practicing together, like many other forms of business relationships, cover a broad spectrum extending from office sharing arrangements to the traditional partnership. There are important differences among the legal forms of practice, but these differences should not obscure the more important considerations of the personal relationship among the lawyers, the consensual agreement on the management of the organization, and a clear understanding of the commitments and financial expectations of the lawyers.