Can Your Law Firm Be Organized As A Limited Liability Company?

What Is An LLC?

LLC – Limited Liability Company. This is a relatively new business entity which has become popular in the last few years. An LLC is a hybrid between a partnership and a corporation; it takes the best features of both business entities and combines them with a little of its own to create a new form of limited liability. In other words, LLCs provide limited liability for its members, just as a corporation protects its shareholders from personal liability for corporate liabilities.
LLCs, by statute, provide limited liability for all of their members . However, as a practical matter, an LLC is similar to a corporation in that its shareholders/members cannot use their assets to satisfy corporate liabilities. The big difference between a corporation and an LLC is that an LLC can "pass through" its tax liability to its members, just as partnerships do. So, in addition to limited liability, LLCs also provide the favorable tax treatment found in partnerships. Another major feature of LLCs is its ability to tailor its features to conform to the needs of its members, with the only limit being the statutory requirements imposed on LLCs by various states.

Law Firms Organized As LLCs

Under the Uniformed Limited Liability Company Act, which all but a handful of states have adopted in one form or another, any type of business may be formed as an LLC unless excluded and so qualified by state law. The Uniformed LLC Act only excludes "banks and trust companies, insurance companies, building and loan associations, savings and loan associations and savings banks; any licensed person other than a limited liability company under the provisions of any other act."
Unlike corporations, LLCs are not separate legal entities; they are creatures of statute formed by state authority. Thus, the actual question of whether a law firm may operate as an LLC may well turn on the statutes of each state in the Union. Currently, only Virginia, Alabama, Mississippi, Minnesota, and Texas specifically provide that law firms may operate as LLCs. North Carolina seems well on its way to passing legislation toward that end with a bill on its way to the legislature this session. New York does now allow law firms to be organized as LLCs. See, N.Y. State Bar Ass’n. Opinion 726 (March 7, 2000). In this state, law firms may organize as PLLCs. As discussed below, however, the difference may not amount to much. Other states where law firms are permitted to be organized as LLCs are: Arizona, Georgia, Kentucky, Maine, Maryland, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Utah, Virginia, West Virginia, and Wisconsin. In jurisdictions that do not allow law firms to operate as an LLC, there are alternatives – which can amount to a hybrid between the two forms. For instance, in California, a law firm can organize as a professional or general corporation (but not an LLC) or as a partnership or limited liability partnership. But the laws of California also allow partnerships and LLCs to be "professionalized" through a "Limited Liability Partnership" (or LLP) or a "Limited Liability Company" (LLC), respectively. The California professional corporation (or LLC) and limited liability partnership are governed by several state licensing acts. However, as a practical matter, operating (or forming) as a LLP or LLC is indistinguishable from organizing and operating as a PLLC and provides the same degree of protection to partners/members as a PLLC.

Advantages of Forming An LLC Law Firm

In terms of liability protection, the limited liability company (LLC) is one of the most popular entity types. Since LLCs offer limited personal liability for the members, they make a lot of sense for most business owners. This limited liability also extends to partners in the law firm structured as an LLC. Just like any other business owner, they cannot be held personally responsible for any debts or legal issues (beyond generally their capital investment in the company) related to the firm. An LLC also has reasonable pass-through taxation and can distribute profits in any manner the owners decide (including paying the owners salaries or draws according to their services). This gives professional tax advisors and their clients much more control over their tax treatment than corporations and most LLPs offer. Because of its flexibility, low cost and ease of operation, it appeals to many different types of law firms. Although it does not allow for the different classes of stock that C-Corps do, because of the ability to allocate membership interests among the partners, an LLC can also offer good strategies for passing down an interest from the senior partner to the younger ones. In addition, almost every state has adopted a law (the Revised Uniform Limited Liability Company Act) that clearly states that the partners cannot be held personally liable for another partner’s misconduct or malfeasance.

Forming An LLC Law Firm In Your State

The LLC structure offers several distinct operational and tax benefits to attorneys. As the law currently stands in most states, however, attorneys cannot escape certain regulatory obligations that require professional service providers such as lawyers to organize, register, and conduct their business through a corporation or a limited liability company after they have lawfully formed it. To be eligible to operate as a professional corporation, most states require that at least one attorney shareholder hold a license in that state or operate under the supervision of an attorney who is qualified to practice in that jurisdiction. Similar rules apply to LLCs opting for that particular form of business organization. In some jurisdictions, additional requirements apply to law firms organized as LLCs. In Texas, for example, the Texas Bar rules require each member in a law firm that is an LLC to be licensed to practice in that state. Failure to adhere to these requirements can result in steep fines and disciplinary action against the attorneys involved. Attorneys are also required to comply with advertising and solicitation rules that may be more stringent than the general regulations for other types of businesses. In many states, attorney-organized LLCs are subject to regulations for principal offices located within the state and residency requirements for partners. Attorney general opinions from various states indicate that law firms and individuals might face difficulty in engaging in business or enforcing contracts under an LLC structure in states that do not have a similar organizational form for law firms.

Pros And Cons Of Using An LLC Over A Partnership or Other Business Structure

LLCs vs. Partnerships and Other Firm Structures
Management and Control: The rules governing management & operations of law firms formed as LLCs are less rigid than the management rights spelled out in the state law governing law partnerships. A member-managed LLC operates like a general partnership where all members have equal decision making power, while a manager-managed LLC operates like a limited partnership with designated managers conducting firm business. While management components of an LLC are usually included in the operating agreement, the articles of organization for a partnership or corporation include tax classification, registered agent details, and other factors outlining the firm structure.
Liability Protection: Much like shareholders of a corporation, members of a professional LLC are protected from claims based on the actions of other owners and employees. The corporate veil, however, can be pierced by courts when owners have neglected their duties to the LLC , inappropriately classified employees as independent contractors, or failed to respect the entity form in other ways. Similarly, no protection is afforded if the claim is based on each member’s own negligence, such as malpractice or fraud.
Taxes: Law firms taxed as partnerships report income on their individual members’ returns, allowing any losses to offset members’ other income. This is true even if the LLC elects only to be taxed like a corporation, as long as the income flows through and is not subject to double taxation. The LLC income then becomes taxable to the owners under their local state tax law.
Compliance Requirements: Unlike other types of entities, LLCs are not required to file annual state reports, but the absence of such requirements does not mean they can presume to be bereft of compliance duties. Like other businesses, LLCs may have other entity tax filing obligations depending on their tax classification, employment laws, and various state and local laws.

Essential Steps For Forming A Law LLC

Forming a law firm as an LLC requires following some general steps to ensure compliance with California and local bar rules. A few key points to consider when setting up an LLC legal practice:

1. Compliance with State Bar Rules:

Some states do not allow for attorneys to form a limited liability company (LLC). The California State Bar requires that any legal entity is approved in advance in order to represent clients in California.
A client consultation with your lawyer will help you determine if an LLC is appropriate for your practice as well as how to meet the requirements of the State Bar Professional Conduct Rules that specifically apply to law firms & LLCs.

2. Filing Your Statement of Information:

All businesses in California must file a Statement of Information with the California Secretary of State’s office, as well as have a legal operating agreement and Articles of Organization.
The Registered Agent can be an individual or a business licensed to conduct business in California.

3. Drafting the LLC’s Operating Agreement:

An LLC in California must have a formal operating agreement, which is similar to a corporation bylaws document. It is not required to submit the operating agreement to the Secretary of State, however it is necessary to have the agreement on file internally with the law firm file papers to ensure compliance with your law practice.

4. Choosing a Business Name:

A law firm LLC can have a designated name for its practice. The law firm name should end with ‘LLC’ so clients know that your firm is an LLC, and to distinguish from similar businesses.

5. Registering Your LLC with the State of California:

Besides filing the Statement of Information, you will also need to obtain an Employer Identification Number (EIN) for tax purposes and to hire employees in the future.
You cannot practice law in California without first registering with the State Bar of California.

Potential Downfalls Of Forming A Law Firm As An LLC

When considering the formation of a law firm as an LLC, there are some potential challenges and downsides. First, while it is certainly possible for a law firm to be organized as an LLC, the rules governing the legal profession often limit that ability (as discussed below). Those attorneys seeking to operate a law firm as an LLC may face a constitutional challenge from state bar rules that prohibit this type of business ownership. Professionals are much more likely to be successful in forming their collective professional association as a PLLC.
Second, even where state bar rules allow it, the formation of a law firm as an LLC seems unnecessarily complicated. Unlike other multi-member entities, where the limited liability of the owners might be compromised by the failure of one of the other members, in a law firm where every attorney is required to properly assist every client (or at least their ethical duties prohibit them from abandoning a client), there is no clear breach of the LLC operating agreement by one of the members if an error occurs in a matter. Moreover, each lawyer with knowledge of the error would likely have their own malpractice liability insurance policy covering the claim so that the operating agreement would be unlikely to provide any additional benefit than having a different form such as an LLP or PLLC.
Finally, there are ethical concerns about not only how clients should be handled in a law firm where there is a mix of individuals and entities managers but also about how to handle bad individual employees. Under the relevant state and federal employment laws and the common law, employers have a duty to hire competent employees, train them on appropriate methods, procedures, etc., and then to properly dismiss them. Where, as is not uncommon in a law firm setting, a particular attorney is having an off day and causes a significant error, how is that dismissed employee treated? Do the other attorneys note the attribution of fault by the leaking of confidential client information? Is the discharge notice available to future clients or prospective employed attorneys? A business entity such as a traditional LLC, will likely offer little protection from such troubles.

Conclusion: Are LLCs A Good Choice For A Law Firm?

To recap, the main advantage of forming a law firm as an LLC is tax savings. Namely, that the owners of the firm will not face what is known as "double taxation." This means that the owners do not have to pay taxes on the business’s revenue and also pay taxes on their own personal income from the revenue, as they would if they formed their firm as a corporation.
Additionally, the owners’ personal liability is limited in many situations.
On the downside , more rules exist for professionals when forming an LLC, particularly related to malpractice liability.
To determine whether an LLC is the right fit for your law firm, you should think about these three questions:
The final question is an important point to consider. Even if you spent a lot of time coming to your decision about the structure of your law practice, you don’t have to get stuck with this structure forever. You can always change it as your practice evolves.