You have decided to set up your own firm - now what? One of the next steps to take is to determine the type of entity in which you will provide your services. This is a critical step that will determine how your income is reported to the tax authorities and your liability and asset protection. Choosing an entity haphazardly and without the advice of an accountant and tax attorney could result in you or your firm paying more taxes than necessary, which is the hardly a desirous result for a startup firm. This is certainly an area where you do not want to be a "pennywise and a pound foolish"! Because both state and federal laws influence your choice of entity decision, even business attorneys need the advice of a competent accountant and/or tax attorney to navigate these complex waters.
State Law: Entity Types and the Pros and Cons
There are four basic entity types: (1) the sole proprietorship, which is not really an entity at all; (2) a corporation; (3) a partnership and its subsets; and (4) a limited liability company ("LLC"). Each of these entities are available for law firms to use in almost all states.
A note about liability protection: No entity protects an attorney from his or her own professional liability. While you cannot protect yourself from your own professional liability, you can protect yourself from the professional liability of your co-workers, provided you are not found liable for failing to supervise or to prevent the conduct.
The following is a brief summary of each of the entities and their salient positive and negative features:
- Sole Proprietorship: This is not an entity, but is the term used when an individual does business on his own, directly, and not through a separate and distinct legal entity. A lawyer who is a sole owner of a law practice and who has taken no steps to organize his practice as a corporation or an LLC, is a sole proprietor.
- Liability and Asset Protection: A sole proprietorship does not provide any liability or asset protection. For this reason alone, sole proprietorships should be avoided.
- Formation and Operation: Sole proprietorships are very easy to form. State filings are not required. There are no annual filings required.
- Unlike corporations, sole proprietorships are not required to hold annual meetings.
- There are no internal management agreements, such as bylaws or an operating agreement, required.
- Management and Control: A sole proprietor has complete control over her business.
- Corporations: The venerable corporation is an entity, which is separate and distinct from its owner. Please note that a "C-corporation" or an "S-corporation" are not different types of corporations. Rather, they are only different methods of taxation of entity taxation. The method of taxation does not influence the state law issues, aside from state tax issues, which is beyond the scope of this article and is usually of minimal consequence.
- Liability and Asset Protection: Aside from personal professional liability for the responsible attorney, a corporation provides excellent liability and asset protection. A shareholder is not personally responsible for any of the corporation's liabilities. This includes the vicarious liability of a co-shareholder. Liability is typically limited to the corporation's assets, not any shareholder's personal assets. I say typically because of the doctrine of "piercing the corporate veil" - remember this from law school? - which is infrequently available to a plaintiff who can prove that the corporation has failed to observe the required corporate formalities (see below) and the corporation's existence is only a sham.
- Formation/Operation: A corporation is one of the most complex entities to form and operate. Formation requires the filing the articles of incorporation with a state's Secretary of State's office or other business filing office.
- Operation: If there will be more than one shareholder, an internal management agreement is highly advisable. This could be either bylaws or a shareholders' agreement.
- Annual Requirements: Annual reports and a fee must be filed and paid to the state. Some states' fees are higher than others, which might dictate that another entity type be chosen. Fees can also be a determining factor in the capital structure chosen, i.e., the number of shares authorized. Annual director and shareholder meetings are required.
- Management and Control: Unless altered by the bylaws or a shareholder agreement, corporations are governed by their boards of directors. The board can delegate day-to-day management responsibility to the corporation's officers.
- Professional vs. Non-Professional Status: All states have enacted professional corporation statutes. These statutes are beneficial as they cut off vicarious liability. In addition they have the prestige of the word "professional" and in most states it is ethically required as the professional corporation statutes limit share ownership to licensed professionals.
- Partnerships: If two or more lawyers are going to open shop together, they can operate as a partnership. There are four different types of partnerships available in almost all states. They are the (1) general partnership, (2) limited partnership, (3) limited liability partnership, and (4) limited liability limited partnership. Because limited partners in limited partnerships have no right to participate in the business and lawyers are essentially the business, limited partnerships and their cousin, limited liability limited partnerships, are not viable entities for law firms.
- Liability/Asset Protection.
- General Partnerships: General partners are personally liable, jointly and severally, for all obligations of the partnership. This includes vicarious liability for the professional liability of your partner. This factor alone makes a general partnership a very unattractive choice of entity. Each partner could form his or her own LLC to be a general partner to avoid some of the liability concerns.
- Limited Liability Limited Partnership: An LLP is identical to a general partnership with one substantial exception: Partners are not vicariously liable for their partner's professional liability. Each LLP partner will continue to be personally liable for all other obligations of the practice. This factor is also a negative factor in choosing an LLP as an entity for your firm.
- General Partnerships: There are no formation requirements for a general partnership. A partnership is formed when two or more persons associate to carry on as co-owners a business for profit. No documentation is required. However, most partners enter into a partnership agreement to allocate management and control, partnership termination, and withdrawal from the partnership.
- Limited Liability Partnerships: To form an LLP, a general partnership must be formed first. Then, the general partnership can file an application, usually with the Secretary of State, to become an LLP. This usually requires the payment of a registration fee.
Annual Requirements: General partnerships do not have any annual requirements. LLPs, however, must renew their registration annually.
- Other than Annual Registration Requirements for LLPs, Partnerships are not required to hold annual meetings.
- Limited Liability Companies: This is a relatively new hybrid entity combining the best features of partnerships and corporations. As with corporations, an LLC can elect professional status ("PLLC") in most states. This election will curtail a member's vicarious liability for another members professional liability. An LLC may have as little as one member.
- Liability/Asset Protection: LLCs are excellent from an asset protection point of view. Except for a members personal professional liability and if a plaintiff is successful in piercing the LLC's veil, a member is not personally liable for any of the LLC's liabilities.
- Formation/Operation: An LLC is formed by filing with the appropriate state agency Articles of Organization. If the LLC elects to be a professional LLC, an additional paragraph must be added to the articles. The articles must set forth whether the LLC will be member or manager-managed (see below).
- The states vary as to other annual filings: You should check with your specific state to determine this. Some states also impose fairly hefty annual fees, sometimes referred to as franchise fees.
- Management and Control: LLCs can either be managed by its members or by managers. Managers need not be members according to the LLC statutes. However, as an ethical matter, a non-lawyer cannot have the right to direct or control the professional judgment of a lawyer. Also, because members in a manager-managed LLC are expected to remain passive, it is rare for a law firm to be manager-managed unless centralized management is desired.
- Management and Control of an LLC Pursuant to an Operating Agreement: In the absence of such an agreement, the default provisions of the LLC Act will govern.
Federal Tax Issues Affecting Law firm of Choice of Entity
Federal taxation plays a major factor in your choice of entity. Not only does federal taxation influence how you pay and report your income, it also influences how you are paid compensation and what types of fringe benefits you can receive. There are four methods of taxation. They are: (1) disregarded entity/sole proprietorship, (2) C-corporation, (3) S-corporation, and (4) partnership. With only a few exceptions, any of these state-law entities can elect its own method of taxation. The first exception is that a sole proprietorship, which, of course, has only one owner, cannot elect to be taxed as a partnership. Second, an entity having two or more owners cannot elect to be taxed as a disregarded entity/sole proprietor. Third, a corporation must be taxed as either a C- or an S- corporation. This election is made by filing IRS form 8832. A discussion of the pros and cons of each method of taxation follows:
- C-Corporation: This is the default method of taxation for all corporations and other entities that elect to be taxed as a corporation. Income is first taxed at the corporate level. Then, when the shareholders receive compensation, whether it is wages or dividends, the shareholders are taxed. This is referred to as "double taxation" and is a major, but not insurmountable, drawback to C-corporation taxation.
- Income Taxation:
- A law firm C-corporation pays income tax at the corporate level at a flat rate of 35% as a result of the personal service corporation rules. This means that, unlike individuals, proprietorships/disregarded entities), S-corporations and partnerships, a C-corporation is unable to take advantage of the graduated rate structure.
- Double Taxation: Double taxation can be avoided by a C-corporation zeroing out its taxable income. This requires complex year-end tax planning and the assistance of a qualified accountant.
- Compensation and Taxes:
- Shareholders are compensated by the payment of wages and distributions. Most profit distributions will be dividends, which are taxed at lower rates than wages, but are not deductible by the corporation. Corporations must pay reasonable compensation. A corporation cannot pay shareholders distributions in lieu of wages.
- Employment taxes: C-corporations are required to withhold both income and FICA taxes on wage payments to shareholders. Profit distributions, however, are not subject to FICA. Shareholders are not considered self-employed for self-employment tax purposes.
- Fringe Benefits: C-corporation shareholders are eligible to participate in the corporation's fringe benefits plans, including health insurance, health savings accounts, flexible benefit ("cafeteria") plans, and retirement plans.
- S-Corporation. Any entity, other than a state-law sole proprietorship, can elect to be taxed as an S-corporation. If the entity is not already a state-law corporation, then it must first make an election to be taxed as a corporation by filing IRS form 8832. Then, the S- election is made by filing IRS form 2553. An S-corporation cannot have more than 75 shareholders and, generally speaking, the shareholders must be individuals. An S-corporation shareholder can include an irrevocable trust. An S-corporation can only have one class of stock, although there may be differences in voting rights as long as the economic rights are not thereby affected.
- S-corporations are generally not subject to tax at the corporate level. Rather, all firm income, gain, loss, deduction, and credits are attributed to the shareholders in proportion to their stock ownership. As a result, S-corporations avoid the double taxation burdens of C-corporations. There are special rules if the S-corporation has C-corporation history.
- S-corporations do not file a tax return, but rather only file an information return annually. The S-corporation must also notify its shareholders of their tax items to report on their personal returns.
- S-corporation shareholders must pay taxes on their share of the corporation's income, even if the corporation does not distribute its earnings to the shareholders.
- Compensation and Employment Taxes: Shareholders who are also employees will receive wages subject to FICA and income tax withholding. Shareholders can also receive distributions which are generally not subject to tax, including FICA withholding. Again, the IRS will not allow taxes to be avoided by the corporation paying little or no wages and classifying the shareholders' compensation as all distributions. Distributions are generally not subject to tax at the shareholder level because the shareholder pays tax on its share of the corporation's earnings regardless of whether the earnings are distributed.
- There is no personal service corporation tax in an S-corporation as all of the shareholders are taxed on all of the corporation's earnings.
- Fringe Benefits: S-corporation shareholders who own 2% or more of the corporation's stock do not enjoy many of the same fringe benefits that C-corporation shareholders enjoy. This rule also applies for sole proprietors and partners. This is not to suggest that S-corporation shareholders, sole proprietors and partners do not have access to these benefits completely, but they are either unavailable or sharply limited as compared to a C-corporation shareholder. The retirement plan options, however, are similar for C- and S- shareholders.
- Partnerships: Partnership taxation is very similar to S-corporation taxation, but more flexible. For example, profit and loss distributions are not required to strictly follow the partners' ownership percentages, although the allocations must still have substantial economic effect. Unless a tax election is made to be taxed as a corporation, partnership taxation is the default method of taxation for partnerships and multi-member LLCs. For federal tax purposes, a member of an LLC taxed as a partnership is considered a partner, although there are till some unknowns about LLC member and manager treatment.
- Income: Similar to the S-corporation, there is no income tax at the partnership-entity level. Rather, each partner reports their distributive share of the partnership's income, deductions, losses, and credits.
- Compensation and Employment Taxes: A partner does not receive wages. Consequently, the regular "salaries" are not subject to income or FICA withholding. The partners' reportable share of profits from the partnership is subject to self-employment tax, only one-half of which is deductible by the partner.
- Like S-corporations, a partner is generally not taxed on distributions from the partnership as the partner already pays tax on his share of the partnership's profits whether the partnership actually makes any distributions.
- Fringe Benefits: Fringe benefits are limited to the same extent as the 2% or more S-corporation shareholders.
- 2% or more S-corporation shareholders, partners, and sole proprietors can now deduct 100% of the health insurance premiums paid during a tax year for themselves and their spouse and dependents, so long as such amounts do not exceed the taxpayer's earned income for the taxable year.
- Disregarded Entities/Sole Proprietorships: A single-member LLC or a state-law proprietorship will, by default, be deemed a disregarded entity for federal tax purposes. This means that the single-member LLC or sole proprietorship does not exist for federal tax purposes. Consequently, the member or sole proprietorship must include the firm's tax items on his personal tax returns directly via a Schedule C thereto. Thus, an LLC to enjoy state-law liability protection while not having to prepare a separate federal tax return. This will not make a firm's bookkeeping any easier, however.
- Income: A disregarded entity's income is taxed directly to the member or proprietor as it is earned directly by the individual. Income is taxed at the individual, graduated tax rates. Contrary to the advice of some
- Compensation and Employment Taxes: A disregarded entity owner's income is their's to keep. There is no distinction between wages or distributions. All of the entity's income is subject to self-employment taxes, one-half of which is deductible by the owner.
- Fringe Benefits: The fringe benefits available to the owner is similar to 2% or more S-corporation shareholders and partners.
What is the best entity for your new law firm? The answer is, "it depends." There is no "one-size fits all" solution. Notwithstanding, a solution that works for most is to form a limited liability company unless you are in a state where the practice of a law in limited liability companies is unavailable or is undesirable for state law purposes, such as taxes. In that event, a corporation should be formed for liability protection purposes. A sole proprietorship or general partnership is an unlikely choice for lawyers - what lawyer is not concerned about liability? As for the method of federal taxation, most tax advisors agree that an S-corporation is the good choice for a service business. The disregarded entities/sole proprietorship option is unattractive as all income is subject to self-employment taxes. On the other hand, "old school" advisors still recommend C-corporations for service entities as they can take advantage of all fringe benefits and can pay additional compensation in the form of dividends, provided the firm is able to zero-out its taxable income. Whichever entity you chose, however, it is highly advisable to retain the services of a very competent tax advisor.
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About the Author
André E. Carman, Esq., LL.M.-Tax, is an associate in the Prescott office of Gallagher & Kennedy, a Professional Association. He provides counsel to both individuals and business in the areas of tax, real estate, business and estate planning law. He provides legal counsel to individuals and businesses in Arizona. He is a Minorities In the Profession Scholar of the ABA Young Lawyers Division.
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