Accountants frequently advise their clients with respect to choice of business entity. In the 1990s, the entities of choice other than the sole proprietorship, were primarily partnerships and corporations. Of the latter, about one-half, or some three million, were S corporations. In the new millennium, the Limited Liability Company, or LEG, is surpassing S corporations by replacing general partnerships, while Limited Partnerships, or LPs, so popular as tax-shelter vehicles in the 1960s and 1970s, are used almost exclusively in the estate planning area ("Family Limited Partnerships").
The recent explosion of malpractice lawsuits against accounting firms, involving staggering amounts of potential damages, shows that it is high time for accounting firms to review their choice of business entity. It can be argued that the accounting partnership belongs in the past!
CHOICE OF ORGANIZATIONAL FORM IN TODAY'S ENVIRONMENT
Historically, most accounting firms (including the largest-the "Big Five") have been, and remain, general partnerships. In today's environment, this choice should no longer be considered intuitively obvious. At a minimum, it should be questioned for the following reasons:
* Malpractice lawsuits are proliferating. The potential damage awards are enormous, and all partners (even if retired at the time of judgment) are jointly liable for malpractice by the firm and by another partner. It is crucial for an accountant to avoid being a partner for malpractice liability purposes.
* Types of business entities are proliferating. The classic entity choice, "Corporation or Partnership," has been complicated by the introduction of the S corporation election, including the "QSub" election, Limited Liability Companies (LLCs), including Single Member LLCs (SMLLCs), Limited Partnerships (LPs), and Limited Liability Partnerships (LLPs). In addition, an unincorporated entity, including an LLC, may "check the box" and elect to be federally taxed as a corporation. As explained below, despite the number of seeming choices, only two fundamental alternatives remain, corporation or partnership, and accountants who care about malpractice exposure should not form partnerships!
When revisiting the accountants' old-fashioned partnership, two conclusions emerge: (1) the historical justifications for it no longer exist, and (2) the partnership form no longer serves today's legal and business needs.
WHAT S "MALPRACTICE?"
Malpractice is a tort, or "civil wrong?' In the broadest sense, it occurs when a client sustains damages as a result of a breach of duty owed to that client. It is important to note that malpractice insurance and Limited Liability Partnership statutes do not cover or apply to malpractice liability arising out of behavior that is criminal, intentional, grossly negligent, or shows reckless disregard of the law, rules or regulations. Nevertheless, regardless of the degree of negligence, intent, or even criminal behavior, an accountant is equally liable for the civil damages resulting from the actionable conduct (and so are all the partners of the firm).
Who Is Liable for Malpractice?
Here are some common and major misconceptions regarding malpractice liability exposure:
* All liabilities are created equal. It is frequently believed that a corporation has limited liability for malpractice exposure. While it is true that a corporation's liability for debts is limited to everything it owns, every accountant is personally liable for his/her own malpractice, regardless of legal status as employee, "member," or partner!
* Only the "wrongdoer" is liable. If an employee commits malpractice, the employer is also liable under the doctrine of "respondeat superior," but the other employees are not responsible. In a partnership, all partners are jointly liable for each other's malpractice and for that of the firm. Each jurisdiction has laws concerning who, in substance, is a partner for this purpose. The liable partners include everyone in the world who was a partner in the firm at the time the malpractice occurred--e.g., an Iowa tax partner, even if ignorant of the wrongdoing or even if currently retired or even deceased.
* Only the criminal is liable for criminal behavior. It is true that only a criminal may be incarcerated, but the employer or partner is jointly liable for any damage awards. To add insult to injury, the malpractice carrier does not pay for criminal, or even intentional, behavior, nor does any LLP registration apply. Even bankruptcy protection is unavailable, because debts arising out of criminal or intentional conduct, as one might expect, are not dischargeable!
It is readily apparent, based on the above, that joint liability is hard for a partner to avoid. The lesson is clear: if at all possible, an accountant should not be a partner, but an employee (or sole proprietor).
LLCS AND LLPS: WHAT DO THEY ACCOMPLISH?
The Limited Liability Company
The LLC attempts to limit liability for debts. It remains to be seen if this new and untested entity will, in fact, provide out-of-state liability protection. However, it does not offer, or even purport to offer, any protection whatsoever against joint malpractice liability! In addition to the members being jointly liable for malpractice claims because they are partners in substance and practice, LLCs are treated as partnerships for federal tax purposes and its members as partners for self-employment tax purposes. LLCs also have several other drawbacks, such as being subject to various state and local taxes; the need for one in every state where business is conducted, each with different, untested, statutes; an unresolved employment tax situation; and even being unavailable to professional service organizations in some jurisdictions.
The Limited Liability Partnership
The LLP attempts to limit joint malpractice liability. It does not purport to limit liability for debts (except in a few states). An LLP is not a separate entity. It is a general partnership that has paid for an annual LLP registration in one or more states. The following should be noted:
* A prerequisite to purchasing the LLP registration is the posting of a bond or carrying malpractice insurance.
* Neither malpractice insurance nor the LLP status protects against intentional or criminal acts. In such cases, all partners, in or out of state, would be jointly liable as usual.
* The LLP registration has not been tested in court. Thus, even if the malpractice originated only in one state and constituted merely ordinary negligence, the extent of the LLP's effectiveness remains to be seen.
* A judgment against the firm itself, even if based on ordinary negligence, would render all partners liable.
The bottom line is that the LLP protection may protect partners within a given state from joint liability for ordinary negligence only, and even that has yet to be demonstrated in each state.
Neither the LLC nor the LLP can significantly reduce the accounting partners' exposure to joint liability for malpractice. In light of the above, when all is said and done, accountants are still left with the traditional choice: corporation or partnership? Only with a corporation may joint liability generally be avoided.
WHY DID ACCOUNTANTS FORM PARTNERSHIPS?
Large accounting firms have existed for decades. In the 1940s and 1950s, a partnership was the only choice. During that period, there were several reasons for forming a partnership. However, few, if any, of the following historic reasons are still valid.
* Service corporations were generally not allowed to incorporate until the 1960s and 1970s. Today, Professional Service Corporations(PSCs) and Professional Associations (PAs) are universally available.
* Subchapter S was not introduced until 1958 and allowed only 10 shareholders. Thus, double taxation could not be avoided and corporate tax rates were as high as 46 percent. Today, S corporations are available to professional corporations and may have up to 75 shareholders.
* Social Security taxes for the self-employed used to be less than the sum of the employer and employee shares. Since the distributive share of income to a general partner is self-employment income, employment taxes would be saved. However, today the self-employment tax is twice the employee rate, resulting in no savings for the partnership. However, an S corporation can be used to convert a distributive share into part salary and part distribution, the latter being exempt from employment taxes.
* Qualified Retirement Plans were long available, primarily to corporate employees. Self-employment plans originally had extremely modest allowable funding and contribution limits. In the 1980s, the same plan limits became available to both corporate and noncorporate businesses, eliminating deferred compensation as a decision variable. In addition, many firms wanted plans only for the partners. Since these plans were nonqualifled, the double taxation resulting from the use of the corporate form would be prohibitive. Today, the S election solves the nonqualified plan problem by eliminating the corporate tax!
* Lawsuits against accountants were uncommon until recent years, but now liability for malpractice exposure is a bigger concern than liability for debts. By and large, accounting firms do not have assets and liabilities. However, it is extremely important not to be a partner in the eyes of the law! To reiterate: a partner is liable not only for his/her own malpractice, like everyone else, but also for the malpractice of any other partner and the firm itself.
ENTER THE S CORPORATION
From the above analysis, it is clear that accounting firms should and must be corporations to avoid joint malpractice liability exposure. It is equally clear that an S election must be in effect to avoid corporate level taxation. This is significant for accountants because Personal Service Corporations are taxed at a flat 35 percent. It is ironic that almost all accountants with S corporations today are sole practitioners motivated by the saving of self-employment taxes. This is accomplished by paying a salary short of what would have been net self-employment income and distributing the difference with respect to the stock.
The corporation must be physically created through an actual incorporation. "Checking the box" does not change the legal form of the business under local law, e.g., a partnership or an LLC; it is merely a federal election to be taxed as a corporation.
Although S corporations seemingly are subject to many restrictions, few, if any of these have any real significance. Consider the following:
* The 75 shareholder limitation. There are some 100,000 accounting firms in the United States, but fewer than 15 of them have more than 75 partners! The largest local firms in Chicago and Miami, for example, have about 20 partners. Even in a firm with more than 75 partners, there is no reason for all of them to be shareholders after incorporation. Why is it important to own marketable stock in a closed corporation? A "partner equivalent" should be satisfied to be a Vice President or Senior Vice President, particularly at the "junior partner" level.
* Type of shareholder limitation. An S corporation cannot have as shareholders Corporations, Nonresident Aliens, Partnerships or (most) Trusts. We don't see those as partners in accounting firms now, either (but watch out for Canadians.)
* No restrictions on S corporation activities. While partners and corporations cannot be S shareholders, the S corporation itself may be a shareholder in C corporations and a partner in partnerships, here and abroad. In addition, S corporations may use legally distinct subsidiaries that are disregarded for federal tax purposes, such as Single Member LLCs and Qualified Subchapter S Subsidiaries (wholly owned subsidiaries known in the trade as "QSubs").
* No size limitation. While most S corporations are small, this is because they are misunderstood and underutilized. Thus, there are no limits placed on an S corporation's assets, revenues, number of offices, or number of employees!
ADVANTAGES OF A CORPORATION
Being a corporation, including an S corporation, offers many advantages over a partnership, including the following:
* Employee Status. Employees are not jointly liable for the malpractice of other employees. Not being partners, they will have titles readily accepted in the corporate community, e.g., Vice President or Senior Vice President. In addition, there is no mandatory retirement age. Partners in public accounting firms must retire at the age specified in the partnership agreement, e.g., age 62.
* Corporate tax advantages. Tax advantages unique to corporations include ordinary losses on stocks, the ability to engage in tax free reorganizations, and fringe benefits not includable in the employees' income (available only to two percent or fewer S shareholders), such as medical reimbursement plans and term life insurance.
CHOOSING THE ENTITY
With respect to malpractice liability protection, the entities discussed above would be ranked as follows, from the least to the most desirable:
4th--Partnership. The traditional partnership offers no protection whatever against either joint malpractice liability exposure or debt liability.
3rd--Limited Liability Company. The LLC offers no protection against joint malpractice liability. In addition, its purported protection against liability for debt remains undemonstrated and would, in any event, vary by state.
2nd--Limited Liability Partnership. The LLP registration offers no protection against debt liability (in most states). There is no protection against joint malpractice liability for intentional, criminal or grossly negligent acts and/or judgments against the firm itself. The LLP may offer intrastate protection against joint malpractice liability for ordinary negligence, but this possibility is untested and would vary by jurisdiction.
1st--S Corporation. The S corporation is the only entity that offers protection against joint malpractice exposure as well as debts, while avoiding double taxation like a partnership.
In view of increased malpractice exposure and risk of future litigation, it makes sense to review the choice of entity decision. To safeguard the very existence of the firm, at a minimum the joint liability of all partners must be avoided.
The preceding discussion seriously questions the ability of the LLC and LLP to provide the desired malpractice protection. The underutilized S corporation, with its legal and tax advantages, emerges as a strong contender for top business entity choice for accounting firms.
Rolf Auster, PhD, LLM, CPA, is Professor of Taxation, School of Accounting, at Florida International University in Miami.…