Should You Change Your Business Entity?
ADAM LEVINE, CPA
Although lawyers have traditionally favored partnership structures, some law firms may benefit from organizing as a different type of business entity. Whether you are launching a new firm or reevaluating the structure of your existing one, do not simply choose the “default” option of a partnership before exploring the alternatives.
Best of Both Worlds
For law practices, a limited liability company (LLC) can offer the best of both worlds: The limited liability of a corporation and the tax advantages of a partnership. An LLC is a separate legal entity, so its “members” are liable for debts of the business only to the extent of their investment. Unlike a partner in a partnership, an LLC member is not personally liable for any contract, tort or other obligation of the LLC by virtue of being a member. This protects a member’s own assets from the firm’s obligations.
An LLC gives attorneys flexibility in structuring financial and management operations, including profit sharing. In addition, your LLC operating agreement can stipulate members’ right to vote, manage day-to-day operations and receive specified information.
For tax and accounting purposes, an LLC is a pass-through entity, meaning that its income and losses are passed on to the members, who report them on their individual returns. But while LLCs pay no federal income tax, there may be state taxes at the entity level.
You do not need to formally dissolve a partnership to convert to an LLC — transferring all of your partnership’s assets and liabilities to the LLC does it automatically. Such conversions are permitted by statute, and the LLC continues the partnership’s business. When you transfer assets and liabilities of a general partnership to an LLC, it is a nontaxable event. No gain or loss is recognized.
Differing Tax Treatment
Like an LLC, an S corporation provides the benefits of limited liability and the favorable tax treatment of a pass-through entity. However, the tax treatment of an S corporation differs in some instances from that of an LLC or partnership.
For example, when a member sells an interest in an LLC or dies, the acquiring member can receive a “stepped up basis” in the assets of the LLC attributable to the outgoing or deceased member’s share of the assets. If this election is made and the practice’s assets are later sold, the acquiring member can avoid income tax. This tax treatment is not available to an S corporation shareholder.
LLCs and partnerships can also determine their percentage allocations of profits and losses in their operating agreement. An S corporation, however, can divide profits and losses only based on percentage of stock ownership. And unlike an LLC or partnership, if an S corporation distributes appreciated property to its shareholders, the corporation recognizes gain that is passed on to its shareholders and taxed.
There is one potentially significant tax advantage of an S corporation: A partner’s or member’s share of the entity’s income generally will be taxable as self-employment income — even if the income is not distributed to the partner or member. But a shareholder’s portion of an S corporation’s income is not subject to self-employment taxes.
The transfer of a general partnership’s assets and liabilities to an S corporation usually is treated as a nontaxable event. To qualify, your partnership’s liabilities cannot exceed its assets and the ownership of the general partnership and the S corporation must be substantially the same.
There are other options. For example, some lawyers form a professional corporation (PC), which typically operates as a C corporation. PC profits, however, are taxed at the corporate level and again at the individual level when the shareholder receives them. And if you convert a PC to another form such as an LLC, you could trigger significant tax liabilities.
Most attorneys will find that a partnership, LLC, or S corporation meets their liability and tax criteria. But because business entities are complicated, it is critical that you discuss your options with your trusted advisor.
If you have any questions or would like to learn more about the formation of business entities, contact Adam Levine at [email protected] or call him at 312.670.7444.
Navigating the Retirement Plan Maze: New Options Can Help Keep Partners Happy
ROB SWENSON, CPA, MST
Law firms weighing their retirement plan options face some tough decisions. Many firms have unfunded or underfunded non-qualified pension plans that place a heavy burden on younger partners. This has led some firms to make the transition to defined contribution qualified plans, such as 401(k) and profit-sharing plans. Other firms are looking to defined benefit qualified plans because they can allow larger contributions for older partners. There are several issues to consider if your firm is trying to decide whether to change its retirement plan offerings.
Non-Qualified: Flexible But Risky
Traditionally, many law firms have opted for non-qualified offerings because they are flexible. Although they do not enjoy the tax advantages of qualified plans, they give a firm considerable leeway in designing a plan that fits its organizational structure. With a non-qualified plan, your firm is free to determine which attorneys and staff receive benefits and how much.
At the same time, non-qualified plans present some drawbacks and risks. For example:
- Benefits are not deductible by your firm until they are paid out to retirees.
- If your firm funds the plan through a protected trust, the benefits are immediately taxable to the participants even though they will not receive them until years — or even decades — later. Therefore, non-qualified plans typically are unfunded to avoid current taxation.
- If your plan is unfunded, younger partners bear the burden of funding future retirement benefits out of future profits to which retired or retiring partners have not contributed.
- It is possible your firm will not be in a financial position to pay retirement benefits when partners and other employees are counting on receiving them.
There are techniques for setting aside money for future benefits without creating a “funded” plan. For example, your firm might establish and contribute to a “rabbi trust,” which helps ensure that funds will be available to pay out benefits. However, the trust assets remain subject to claims by your firm’s creditors, so benefits could be lost should your firm run into financial trouble or file for bankruptcy protection.
Qualified: Inclusive But Limited
Recently, defined contribution qualified plans have become popular with law firms and their non-partner staff. They have some significant benefits:
- Firm contributions are currently deductible by your firm.
- Employees can also contribute, and these “deferrals” generally are pretax.
- Both firm and employee contributions grow tax-deferred until they are distributed.
- Plan assets are held in a trust account that is protected against creditors and bankruptcy.
But because most firms have multiple classes of plan participants — equity and non-equity partners as well as several categories of attorney and non-attorney employees — it can be challenging to design a defined contribution qualified plan that conforms to various limits and requirements and still meets the needs of the partners.
Qualified plans are heavily regulated and must comply with all Employee Retirement Income Security Act (ERISA) requirements. For example, they are subject to strict contribution and benefit limits, minimum coverage rules and funding requirements. Additionally, they must be tested for non-discrimination on an annual basis. This means that benefits for highly compensated employees (as a percentage of compensation) cannot be significantly higher than those for other employees.
Also, your firm and its retirement plan committee (which should be independent of your firm’s management committee) are considered ERISA fiduciaries. They must exercise due diligence in selecting plan vendors and investment advisors must act in the best interests of the participants and are personally liable for breaches of these duties.
Turbocharging Partner Benefits
Perhaps the biggest disadvantage of defined contribution qualified plans is that non-discrimination requirements and contribution limits can make it difficult to generate sufficient benefits for partners, particularly those approaching retirement age. For example, the current combined limit on firm contributions and employee deferrals is only $52,000 annually ($57,500 for participants over 50).
To address this drawback, many law firms are adopting defined benefit-qualified plans — often as a supplement to a maxed-out 401(k) or profit-sharing plan. Contributions to defined benefit plans are deductible by the firm and, as the name suggests, are actuarially calculated to fund a particular annual benefit at retirement (the current benefit limit is $210,000). This enables the firm to make contributions of as much as $200,000 or more per year on behalf of older partners closer to retirement and relatively modest contributions on behalf of younger partners and other employees.
If you are considering offering a defined benefit plan, know that annual firm contributions are required regardless of your firm’s financial performance. Unlike 401(k) and profit-sharing plans, defined benefit plans cannot reduce or suspend firm contributions in tough times. This means you must have confidence in your firm’s ability to meet its funding obligations over the years.
Consider a Cash Balance Plan
One way to enhance retirement benefits for your firm’s partners is to offer a cash balance plan. Technically, a defined benefit qualified plan, a cash balance plan often is described as a “hybrid” because its benefits are expressed as account balances, much like a defined contribution plan.
A drawback of traditional defined benefit plans is that benefits, typically based on a percentage of final compensation, are somewhat uncertain. With a cash balance plan, however, your firm allocates annual pay credits and interest credits to participants’ “hypothetical” accounts, making benefits easier to understand. Pay credits are a percentage of compensation or a fixed dollar amount, while interest credits are based on a fixed rate of return or an indexed rate, such as a 30-year Treasury rate.
In 2010, the IRS approved the use of “market-rate” cash balance plans. Their interest credits are based on the actual performance of plan investments, making contributions more stable and predictable.
Review Your Options
Choosing and administering a retirement plan is complicated. To design a retirement benefits strategy that takes into account your firm’s makeup and needs, work with experienced advisors. If you currently have an unfunded non-qualified plan and you would like to continue offering it, we can help you devise strategies for reducing financial risks.
If you have additional questions about choosing the right retirement plan for your employees, please contact Rob Swenson at [email protected] or 312.670.7444.