Whether you realize it or not, one of the first decisions you must make before opening your own law firm is the type of legal entity you will form. Each structure has advantages and disadvantages regarding liability protection, tax treatment, and ease of operation.
Keep in mind that the limitation of liability afforded by the structures discussed below applies only to general business liability, not professional liability. Regardless of the structure you chose for your solo practice, you must maintain appropriate malpractice insurance to avoid exposure to professional liability.
This article discusses some potential legal entities, including corporations, LLCs, S Corps, partnerships, and sole proprietorships, and the general benefits and detriments of each. Because the details for each type of entity may vary from state to state, you should check your local statutes before making any determination.
Many law firms operate as professional corporations (PC), and professional corporations require strict formalities. Typically, the entity must have shareholders, a board of directors, and a management team, all operating distinctly from one other. A sole owner can be the only shareholder, the only board member, and the manager of the company, but that owner would have to ensure that she operates in each role separately, and she must keep careful records to show this conformance with corporate formalities. Corporations also must keep track of meeting minutes for board of director meetings, and must file an annual report in most states.
It is easy to add new owners to a corporation, and the separation between ownership and management creates a barrier that protects the corporation’s owners from liability.
The major drawback of a corporation is that, by default, the profit of the company is taxed at the corporate tax rate before it is distributed to shareholders who are then themselves liable for taxes on their corporate gains. Other types of structures avoid this “double taxation.”
Limited Liability Companies
Limited Liability Companies (LLCs) are unincorporated entities, meaning that although they are not incorporated, they are separate entities for accounting purposes. Members of an LLC have more rights to run the business than a shareholder of a corporation. State law and the company’s controlling documents determine the amount of control a particular member has over the LLC.
Not all states allow attorneys to run their law firms as LLCs or PLLCs, but they are an interesting option for a solo practitioner because LLCs have fewer formal requirements to operate than a corporation. Members can be managers of the company, and most default rules can be altered through the company’s controlling documents. To maintain its limited liability status, an LLC must be treated as a separate entity, filing proper paperwork with the state and maintaining separate books, records, and bank accounts from its members.
The tax treatment of an LLC is as a pass-through entity for multiple members or a disregarded entity for a single member LLC. A disregarded entity means that the taxes are all recorded directly on the sole member’s tax returns. A pass through entity is one where the taxes are passed on to the members through the issuance of K-1s. This tax structure is more advantageous than the tax structure of the professional corporation.
Subchapter S Corporations
A subchapter S corporation is strictly a tax election that can be made by the managers of either a corporation or an LLC. This election would override the default tax treatment of the company.
The primary benefit to electing to be taxed as an S corporation is that there is no corporate level taxation. This structure can therefore yield very high tax savings if a significant amount of the profits would otherwise be taxed at the corporate rate.
S corporations, however, are limited in their use. To elect to be taxed as an S corporation, the company must be, among other things, a domestic company; have only non-business, non-foreign owners; have fewer than 100 owners; and have only one classification of stock.
There are several types of partnerships, each with different levels of liability protection. A General Partnership is an unincorporated entity that typically has limited or no filing requirements with the state. Unlike the corporation or the LLC, a General Partnership does not protect its owners from personal liability, meaning that each partner in a General Partnership could be responsible for every debt the General Partnership accrues. General Partnerships typically have no ongoing formalities that must be followed.
Limited Partnerships (LPs) differ from General Partnerships in that typically only one partner needs to be responsible for the debts of the company. The remaining partners can be limited partners, who cannot be held liable for the debts of the company. Some states require that a limited partner cannot have any meaningful control over the company.
Limited Liability Partnerships (LLPs) are also partnerships that afford limited liability protection to the limited partners. In some states, all partners are afforded this protection, just like an LLC.
The protections and availability of LPs and LLPs vary significantly between states, so it is important to check local laws regarding these entities before forming either of them. LPs and LLPs have more formalities and filing requirements than a General Partnership.
General Partnerships, LPs, and LLPs are taxed as pass-through entities. In this type of taxation, the company will issue K-1s to the partners, and those partners will record that income on their personal tax returns.
Sole proprietorships are unincorporated entities that require little or no filing with the state government. A sole proprietorship can have only one member and is taxed as a disregarded entity, meaning that all profits and losses are recorded on the owner’s tax return.
Sole Proprietorships maintain unlimited liability. The owner can be held 100% liable for the actions of the company and any employee of the company.
What’s Best for Your Practice?
- How many owners will you have? If you plan to grow, you either need a strong operating agreement as an LLC, a strong partnership agreement as a GP, LP or LLP, or corporation to protect yourself from potential future liability from co-owners.
- How much is limited liability protection worth to you? Filing fees, tax forms, and annual reports cost money. Sole proprietorships and partnerships have lower operational costs whereas LLCs have medium operational costs, and corporations tend to have higher operational costs.
- How much money do you anticipate earning? If the answer is that you anticipate earning less than what you consider a reasonable salary, then there’s no real benefit to an S corporation.
- How organized are you? Corporations require recording meeting minutes and annual meetings, all of which are additional layers of formalities to manage.
- Do you plan to sell the entity at any point in the future? How do you plan to accomplish that sale? Stock sale? Sale of all assets? Shares are easier and cheaper to sell than the assets of a company. LLC ownership and Partnership ownership is less quantifiable, and therefore, it is typically more complicated and costly to sell an LLC or Partnership.