Malpractice Exposure and Choice of Business Entity
Auster, Rolf, The National Public Accountant
The last few years have seen a dramatic increase in malpractice claims against service providers such as lawyers, accountants, tax advisers, and even personal financial planners! In part, as a result of this trend, we have also seen the creation of new forms of business for legal and/or tax purposes. These include Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs) and Qualified Subchapter S Subsidiaries (QSubs). Below we briefly examine, compare and contrast these with the traditional general partnerships and C corporations with respect to malpractice exposure.
Liability for Own Malpractice
Contrary to popular belief, an individual is always personally liable for his/her own malpractice, regardless of the legal form of the business. In addition, generally partners are jointly liable for each other's malpractice claims. Avoiding this exposure through being a limited partner is not an option, except for passive investors in the business. Several approaches and entities have been used to insulate a partner from liabilities arising from the other partners' professional negligence. The main techniques are discussed below.
Here, each partner incorporates and makes an S election to avoid double taxation whereupon all corporations form a partnership. Originating with law firms, this practice became obsolete with the emergence of Limited Liability Partnerships (LLPs).
Limited Liability Partnerships (LLPs)
An LLP is not a new type of entity, contrary to popular belief. Rather, each state with an LLP statute allows an existing general partnership, for an annual fee, to register as an LLP which serves the sole purpose of protecting each partner from malpractice claims against the other partners. In addition to paying an annual fee in every state, e.g., $100 per partner, up to $10,000, malpractice insurance is required, e.g., $100,000 per partner up to $3 million or a letter of credit or an escrow arrangement. In some states, e.g., Minnesota, New York and Georgia, the LLP covers debts arising from contracts as well as torts. The "Big Five" are all LLPs, due primarily to their traditional partners status stemming from differences between corporate and non-corporate tax-payers that no longer exist, notably in the deferred compensation area.
Limited Liability Corporations (LLCs)
An LLC is a corporation under local law, with limited liability, but it is taxed as a partnership, i.e., the entity is not taxed. One-member LLCs are treated as sole proprietorships or branches of the member if the member is an entity. In states where LLCs may conduct services, which number more than half (California is not one of them), each partner may form his/her own LLC which then form a partnership. This is the functional equivalent of the multiple S corporation method, discussed above, without the necessity of an S election!
Partnership with LLC Branches
An LLC branch is disregarded for tax purposes, having only one member, the partnership!  Thus, a partnership may form an LLC for some or each of its partners with no tax consequences! However, each LLC has limited liability for debts and is not liable for other LLC's malpractice. Under the Treasury Regulations, the partnership agreement may be as specific and tailormade as desired.  Therefore, each partner may be allocated profits and losses from only one LLC, for example, plus a small override for the overall profits!
S Corporations with LLC Branches
Personal service practices are only sometimes operated as S corporations. The increase in the number of permissible shareholders from 35 to 75 appears to have made little difference. An S corporation offers limited liability without double taxation, but there is no "partnership agreement" to provide the flexibility of special allocations of income, gain, loss, deduction or credit. An S corporation may spin off a division or operation to an LLC, so as to divide liability without tax consequences. …