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Who Can Wield The LLP Shield
Periodical: Los Angeles Daily Journal
Date: March 18, 1996
As
noted in Katrina M. Dewey's March 4 article in California Law
Business ["Buying Protection With LLP"], more than 250
law firms in California have applied to the State Bar to convert to
LLP status as a result of legislation signed by Gov. Pete Wilson last
October. This raises the obvious and important question: Under what
circumstances should a law firm convert to an LLP?
Many
lawyers familiar with the provisions of the new law will tell you that
virtually every firm eligible for conversion that can satisfy the
malpractice insurance ($100,000 per lawyer up to a limit of $7.5
million) or alternative security provisions of the law should do so.
The reason: to limit the personal liability of partners for the
debts of the firm and their fellow partners.
This
focus on personal liability has intensified in recent years as a
result of massive claims, settlements and judgments against many law
firms. The new law
enables partners in law firms (and accounting firms) to be shielded
from personal liability in a manner analogous to that available to
members of a limited liability company under legislation enacted in
California in 1994. Of
course, an LLP does not provide liability protection to a partner from
third parties for that partner's own malpractice or tortious conduct
or prevent partners from expanding their liability by contract, e.g.,
guaranty of a lease or bank loan.
Not
all attorneys in private practice, however, will be able to avail
themselves of the LLP. Sole
practitioners are not eligible to convert, because, like all
partnerships, an LLP requires at least two partners.
In addition, attorneys practicing through professional
corporations ("PCs") will need to weigh the tax consequences
of converting. It is also
permissible for a partner that operates through a PC to continue as a
PC following conversion of the partnership to an LLP.
A
principal tax advantage of an LLP over a PC is the flow-through tax
treatment of a partnership. Unless
its shareholders elect Subchapter S status, PCs currently are subject
to federal income tax at the flat rate of 35 percent and a state rate
of 9.3 percent. Although
firms usually seek to avoid this tax by distributing out most of their
earnings as salaries, it is difficult to "zero out" all
income as a result of certain non- or partially deductible expenses,
such as repayment of debt principal and certain client development
expenses.
A
tax advantage of a PC over an LLP is the treatment of employee fringe
benefits. For instance, a
PC unlike an LLP, can offer certain fringe benefit plans to its
employees tax-free and fully deduct expenses of medical reimbursement
plans and certain kinds of insurance, including disability, key man
and split dollar life insurance offered to all employees.
To the extent employers curtail these employee benefits, the
tax incentives to continue to maintain a PC are reduced.
Practitioners should be cautious in converting their PCs to
LLPs, however. Law corporations taxed as "C" corporations (as
distinct from smaller PCs operating in partnerships of individuals and
PCs) will most likely incur substantial tax liabilities in converting
to LLPs. This conversion
will result in a liquidation of the law corporation; one consequence
is that its accounts receivable must be included in its taxable
income, and its shareholders must recognize gain on the receipt of
such receivables. Lawyers
in existing law corporations may conclude that the significant tax
consequences of a conversion to an LLP outweigh the benefits afforded
by the new law.
For
existing partnerships, the LLP should be an attractive option.
Conversion can be done quickly and relatively cheaply (although
the Secretary of State, the State Bar and the Franchise Tax Board will
all be entitled to collect annual fees from the LLP as a result) and,
absent unusual circumstances, should not generate adverse tax
consequences. The filings
with the Secretary of State and the State Bar are straightforward.
The partnership agreement that currently governs the firm will
continue to operate, although such agreements (including provisions
relating to liability, liquidation, contribution and indemnification)
must be carefully reviewed before converting to insure that they do
not contain provisions that undermine the liability protections of the
LLP. Firms that do not
have written partnership agreements will need to reduce their
agreements to writing in order to insure that certain provisions of
the Uniform Partnership Act applicable to general partnerships will
not apply to the LLP.
One
potential area of concern that should be addressed by partners before
converting to an LLP is the resulting impact upon the culture of the
firm and possible conflicts of interest and divisiveness among the
partners. Partners who
practice in high risk fields often command higher fees which in turn
are shared with their partners who, as general partners, also share in
the risk. In an LLP, the
partner who undertakes such matters may face an increased risk of
individual liability and thus may seek a larger share of profits.
Also, certain partners may seek to avoid working on potentially
risky matters of a colleague in order to insulate themselves from
personal liability.
A
related and potentially contentious issue is how a firm addresses
allocation of responsibility for uninsured risks.
Apart from compensation issues, this may be among the most
sensitive and potentially divisive topics that partners need to
discuss. In firms in
financially distressed circumstances, partners with potential exposure
to malpractice claims will want firm assets utilized to pay the claims
for which they may ultimately bear personal responsibility and may
desire a contribution agreement from all partners if firm assets or
insurance coverage are insufficient to satisfy the deductible or the
uninsured portion of the claim. Other partners may resist this notion as contrary to the
central purpose of limited personal liability afforded by the LLP.
It
is unlikely that such concerns, which some may view as more
theoretical than real, will dissuade most eligible firms from
converting to an LLP. It
is probable that the rapid movement to convert to LLP status will
continue unabated in the future.
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