Law Firm Capital Structures

One of the first decisions that you will have to make in starting a firm is how it should be structured. This decision will have long-term implications, and you may wish to consult with an accountant and/or attorney to help you select the form of ownership that is best for you. The choice will involve some of the following considerations:

1. The size and nature of the firm, both now and in the future.
2. The level of control you wish to exercise.
3. The level of structure you are willing to deal with.
4. The firm's vulnerability to lawsuits.
5. Tax implications of the relevant structures.
6. Expected profit (or loss) of the business.

Sole Proprietorships

Solo firms are the classic vision of the practice of law. The solo firm is owned by one person. Sole proprietors own all the assets of the firm and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, the owner is one in the same with the solo firm.

Advantages of a Sole Proprietorship

1. Easiest and least expensive form of ownership to organize.
2. Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
3. Sole proprietors receive all income generated by the business to keep or reinvest.
4. Profits from the business flow directly to the owner's personal tax return.
5. The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship

1. Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
2. May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
3. May have a hard time attracting high-caliber staff.
4. Some employee benefits such as owner's medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).

Federal Tax Forms for Sole Proprietorship
(only a partial list and some may not apply)

1. Form 1040: Individual Income Tax Return
2. Schedule C: Profit or Loss from Business (or Schedule C-EZ)
3. Schedule SE: Self-Employment Tax
4. Form 1040-ES: Estimated Tax for Individuals
5. Form 4562: Depreciation and Amortization
6. Form 8829: Expenses for Business Use of your Home
7. Employment Tax Forms

Partnerships

In a Partnership, two or more people share ownership of a firm. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed. Yes, it's hard to think about a breakup when the business is just getting started, but many partnerships split up at crisis times, and unless there is a defined process, there will be even greater problems. They also must decide up-front how much time and capital each will contribute, etc.

Advantages of a Partnership

1. Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
2. With more than one owner, the ability to raise funds may be increased.
3. The profits from the business flow directly through to the partners' personal tax returns.
4. Prospective employees may be attracted to the business if given the incentive to become a partner.
5. The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership

1. Partners are jointly and individually liable for the actions of the other partners.
2. Profits must be shared with others.
3. Since decisions are shared, disagreements can occur.
4. Some employee benefits are not deductible from business income on tax returns.
5. The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

Types of Partnerships that should be considered:

General Partnership

Partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.

Limited Partnership and Partnership with limited liability

"Limited" means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.

Joint Venture

Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such as well as distribute accumulated partnership assets upon dissolution of the entity.

Federal Tax Forms for Partnerships
(only a partial list and some may not apply)

1. Form 1065: Partnership Return of Income
2. Form 1065 K-1: Partner's Share of Income, Credit, Deductions
3. Form 4562: Depreciation
4. Form 1040: Individual Income Tax Return
5. Schedule E: Supplemental Income and Loss
6. Schedule SE: Self-Employment Tax
7. Form 1040-ES: Estimated Tax for Individuals
8. Employment Tax Forms

Limited Liability Company (LLC)

The LLC is a relatively new type of hybrid business structure that is now permissible in most states. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership.

The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued, if desired, by a vote of the members at the time of expiration. LLCs must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.

Federal Tax Forms for LLC

Taxed as partnership in most cases; corporation forms must be used if there are more than 2 of the 4 corporate characteristics, as described above.

Limited Liability Partnership (LLP)

LLPs are organized to protect individual partners from personal liability for the negligent acts of other partners or employees not under their direct control. LLPs are not recognized by every state and those that do sometimes limit LLPs to organizations that provide a professional service, such as medicine or law, for which each partner is licensed. Partners report their share of profits and losses on their personal tax returns. Check with your Secretary of State's office to see if your state recognizes LLPs and if so, which occupations qualify.

Professional Service Corporation (PS)

A PS must be organized for the sole purpose of providing a professional service for which each shareholder is licensed. The advantage here is limited personal liability for shareholders. This option is available to certain professionals, such as doctors, lawyers, and accountants. Check with your Secretary of State's office to find out which occupations qualify.

Limited Partnership (LP)

LPs have complex formation requirements, and require at least one general partner who is fully responsible for partnership obligations and normal business operations. The LP also requires at least one limited partner, often an investor, who is not involved in everyday operations and is shielded from liability for partnership obligations beyond the amount of their investment. LPs do not pay tax, but must file a return for informational purposes; partners report their share of profits and losses on their personal returns.

Non-Profits

These are formed for civic, educational, charitable, and religious purposes and enjoy tax-exempt status and limited personal liability. Non-profit corporations are managed by a board of directors or trustees. Assets must be transferred to another non-profit group if the corporation is dissolved.

Editor's Note: Materials from the U.S. Small Business Administration were used in developing this material.