How to Decide on a Business Structure for Your Law Firm

Introduction

In the past, deciding on a law firm business structure was a fairly straightforward task with limited options. You could practice on your own as a sole practitioner, you could share resources and costs with other lawyers through an association, or you could establish a general partnership with one, two, or more lawyers. The choices were clear and the decision, as a result, was fairly simple.

But regulations and legislative changes over the past decade have prompted a shift in the way many Canadian lawyers organize and operate their firms. In addition to traditional structures, today’s lawyers can practice through professional corporations, limited liability partnerships, multi-discipline practices, virtual firms, or through a combination of one or more of these structures. But how do you determine which structure is right for you?

This Guide provides a brief overview of traditional structures and in-depth analyses of newer structures, including benefits and disadvantages, case studies and points to consider for each.

Traditional Law Firm Structures

a) Sole Proprietorships

There are many advantages to working on your own as a sole proprietor, not least of which is having total responsibility and control over every facet of your practice. It also allows for quick and efficient decision-making.

A sole proprietorship is also a great selling point for those potential clients that are intimidated by larger firms, and who are more comfortable with intimacy and direct contact. As well, no separate legal entity need be established with a sole proprietorship—instead, the company is an extension of its owner and its income, assets and liabilities belong to him/her.

However, sole responsibility under this structure also extends to expenses, whereas a partnership can split the cost in two, three or more ways. The owner of a sole proprietorship also faces unlimited liability, exposing personal assets to business obligations and vice-versa.

b) Associations

The middle-ground between a sole proprietorship and a partnership is an association—a firm where several lawyers work in tandem without going so far as having a partnership agreement.  By practicing in association, the lawyers involved can project a greater firm profile, offer expanded client services and share expenses.

But unlike a partnership, where lawyers have profit-sharing agreements in place, lawyers in association work for themselves. As a result, there is sometimes a disincentive to share information and clients. Lawyers in association must also take additional precautions to ensure that they are not liable for risks associated with each other’s practices.

Clients must be informed and educated about the differences between an association and a partnership. All stationery, financial accounts, promotional material, etc. should explicitly state that members are acting in association and not in partnership. This can minimize the inherent risk potential linked to operating in association.

In terms of financials, lawyers in association can split all overhead costs, but must file their own individual taxes for their amount earned that year.

c) Partnerships

In short, a partnership is a business relationship between persons, other than a corporation, which is characterized by a profit-sharing arrangement. A partnership requires a written agreement between all partners, outlying the profit-sharing model to be used, the management of the firm, the responsibilities of each partner, as well as the process of welcoming new partners and withdrawing existing partners.

There are many different types of partnerships, which are differentiated mainly by the profit-sharing model and management setup. In general, partnerships promote cooperation, as there is a common vested interest for members to share clients and information.

In a general partnership, every partner is jointly liable for all debts and obligations of the firm sustained while the person is partner. As such, the hazards each partner faces as a result of the acts of the other partners and employees are quite significant.

Newer Law Firm Structures

By having gained greater attention and acceptance by Canadian lawyers and law societies in recent years, professional corporations, limited liability partnerships, multi-discipline practices and virtual firms (or a combination of one or more of these and traditional structures) have become viable options for new and existing firms. Each of these structures has unique financial and legal implications, which are examined here.

a) Professional Corporations

Professional corporations (PCs), like all other corporations, are legal entities separate and apart from the shareholders. Establishing a PC won’t change the way you run your firm, but it can have a significant financial impact. If certain financial conditions are met (which vary from province to province), incorporating your practice can allow for two significant tax advantages: the small-business deduction and the capital gains exemption for qualifying small businesses.

Under the small-business deduction, a PC could generate a significant tax deferral, as long as the lawyer retains a specified amount income inside the PC. Personal taxes are still payable on the salaries lawyers pay themselves, which are tax-deductible to the corporation.

PCs are typically best suited to smaller firms since the tax savings must be shared among all shareholders in the corporation. Having several owners in a PC, or several PCs in a firm, severely diminishes potential tax savings. For example, the current maximum profit a firm can have to be a considered for the small business deduction in Ontario is $225,000.

It is important to note that the money not paid to the government at the end of the year is not a tax saving, but a tax deferral. The money will eventually have to be paid out for non-business purposes (such as future salary or dividend) and will be taxed at the appropriate rates. However, the deferral period could be many years and the PC can make long-term investments in the meantime. The other possible significant tax advantage from incorporation is the capital gains exemption, for those that qualify.

In terms of liability, many of the traditional protections against personal liability associated with the use of a corporation do not apply in the case of PCs. Responsibility for the acts of a PC falls directly on the shoulders of its shareholders. In any case where a professional liability claim is made against the lawyer, the shareholders in the PC are the ones held liable. If the PC is a member in a partnership, its shareholders have the same liability as they would if they were partners in the firm.

Patrick Hofbauer, president of Burlington, Ontario-based intellectual property firm Hofbauer Associates Professional Corporation, changed his 13-year-old firm from a sole proprietorship to a PC this past January. While it has not altered the firm’s daily operations, the change has influenced the way the financial side of the business is carried out.

“The tax planning benefits are an important reason why I chose to structure my firm as a PC,” says Hofbauer. “Since I am the sole owner, I get the whole share for the small-business deduction, which allows me to reinvest money in the firm and defer my taxes. The other major benefit that affects the operation of the firm is the ability to stagger the fiscal year. So instead of having to work over Christmas and New Year’s to prepare my taxes for year-end, I can do it, instead, at a more convenient time.”

Hofbauer says another factor that influenced his decision was the succession laws associated with PCs, which make it easier to sell the firm and take advantage of the capital gains exemption. This could save him a significant amount of money when he decides to sell his business and retire.

He does warn others, however, to analyze the firm’s figures and determine whether the PC model is right for them. For starters, you should be in a position to maintain upwards of $25,000 in the PC every year. In addition, you must get used to paying yourself a salary and issue quarterly or yearly dividends based on the firm’s performance. Client confusion over the structure can also present a challenge.

b) Limited Liability Partnerships

A limited liability partnership (LLP) is a hybrid between a general and limited partnership. The partners maintain the same economic relationship as they enjoyed while running a general partnership, but an LLP can limit each partner’s individual liability for their own wrongdoing.

In essence, a partner in an LLP is not jointly liable for the debts and liabilities of the partnership if the issue occurs as a result of the acts of another partner, employee, or representative of the partnership. A partner is responsible only for his or her own negligent acts or those of any person directly under his or her supervision. However, the limited liability benefit does not come into effect if the liability issue is not as a result of a partner’s carelessness. This includes matters of office lease, payroll obligations and any misuse of funds in the firm’s hands.

Gerry Riskin, co-founder of global law firm consultancy Edge International, says that an LLP limits the liability placed on each partner while necessitating essentially no change whatsoever in terms of structure and operation.

Javad Heydary, managing partner at Toronto-based Heydary Hamilton LLP, changed his practice from a general partnership to an LLP in mid-2003, a year and a half after opening the business and information technology firm. His decision came after a thorough analysis of all possible firm structures.

“The LLP was very close to what we were used to, so it wasn’t too difficult to adopt,” says Heydary. “The main reason we chose the LLP is because we could still have the same tax benefits we did with a partnership but we limit each partner’s potential liability.”

Heydary says that adopting the model was relatively easy; with insurance coverage remaining the same between partners, the only things that needed to be done were filing the proper regulatory paperwork and changing all company stationery and promotional material to include the mandatory LLP label. “There was an administrative cost in doing this, but it was not that substantial,” he says. “Between filing all necessary paperwork and changing all our material, it ranged from $500 to $1,000 per lawyer to adopt this model, but the cost all depends on the size of the business and overall, it’s not a huge investment.”

In terms of tax implications, with an LLP there is no opportunity to reduce or defer tax as there would be with a PC. But like a traditional partnership, the LLP is not considered a legal entity and is therefore not subject to tax. Profits are calculated and shared amongst the partners, based on the profit-sharing model adopted for the firm. Each lawyer then has the responsibility to pay his or her own taxes. Being considered self-employed, lawyers then contribute to the Canada Pension Plan but are not required to contribute to the Employment Insurance fund.

c) Multi-Disciplinary Practices

A multi-disciplinary practice (MDP) is a partnership or an association of a lawyer, or lawyers, with non-lawyers whose practice supports or complements the law practice, thus providing clients with a full range of services.

MDPs have, until this point, failed to take off with the same vigor as many of the other newer firm structures. Since they surpass the realm of law, they are very tricky and have many legal ramifications. Until now, the main proponents of the MDP model have been major accounting firms looking to add a legal component to their businesses.

The Enron scandal and related controversy surrounding the acts of a multi-national accounting firm was a huge blow to the MDP movement. It vindicated the concerns of MDP critics, who say that in working for a major accounting firm, legal professionals face an enormous risk of non-lawyer influence and conflict of interest scenarios. The scandal showed the potential conflict lawyers face under such a scenario.

“On one side, there are clients who have needs that transcend one profession and since the accounting and legal professions are close to one another, why not provide one-stop shopping?” says Gerry Riskin. “But on the other hand, experience has shown that they haven’t worked too well.”

Riskin says there are two main reasons why MDPs between accountants and lawyers run into trouble: first, due to the independent nature of the legal profession, accountants are having a difficult time managing lawyers, and; second, due to conflict of interest potential, there are many liability issues associated with such practices. In 1998, a Report on MDPs by the Law Society of Upper Canada stated that “as lawyers, we are not simply at one with other professional and service providers being guided by a need to serve with due care and skill… if we fail, we not only do ourselves discredit but, more important, we undermine the values themselves and place important societal interests at risk.”

Despite the challenges associated with the MDP model, Riskin says that MDPs can be successful if they are specialized and offer a combination of services for specific individuals or industries.

The Toronto immigration law firm of David Rosenblatt & Associates offers this type of service and specialization. Rosenblatt, managing partner of the firm, ventured into international employment recruitment during the IT boom in 2000 and founded the Passportal Group—a network of companies offering international recruitment, immigration and business services.

Client companies, who used his firm to attain work visas and immigration papers for their employees, started asking Rosenblatt if he could help them find skilled workers from overseas. He responded by launching a number of Web sites, namely: caregiver.ca (nanny and caregiver recruitment), brainiacs.com (IT recruitment), and Cv.tv (an online database of resumes that includes video profiles of jobseekers). In the case of Cv.tv, once an employer chooses a potential employee, the law firm steps in to complete the necessary paperwork to bring the worker to Canada.

“What we’re doing is not the traditional definition of an MDP,” says Rosenblatt. “What we’re doing instead is forming an association of different employment-related companies offering a variety of services in order to fill worker shortages with internationally trained, skilled workers.”

The success of Rosenblatt’s model can be attributed largely to its highly specialized nature. “As a result of the international recruitment side of the business, the firm is getting a lot more clients because employers want to bring more skilled workers to Canada and many workers want to come here to live and work,” he explains. “We charge a smaller recruitment fee than traditional recruiters, but the payoff is that in two years we expect to have 200 per cent growth in business for the law firm.”

d) Virtual Law Firms

We’ve all heard about virtual law firms, but what are they exactly? Picture a scenario where going to the office involves logging into the firm’s private Web site, with confidential information stored on secure Internet servers and client communications come in via e-mail. The overhead savings realized by not having an office can then be passed on to the client.

“The brilliance of a virtual law firm is not only in the reduced costs and savings, but in the ability to pull together lawyers from anywhere in the world and form a dream team of lawyers who are specialists in certain fields and industries,” says Gerry Riskin.

A case in point is American virtual firm Axiom Legal (www.axiomlegal.com), which has brought together business and technology attorneys from some of the United States’ most respected law firms. The secret of the firm’s success is that it eliminates two of the most expensive legal costs: overhead and partnership profits. Therefore, all a client pays for is the attorney’s income and access to the firm’s Web resources.

“It takes a lot of discipline to work well in this fashion, but it’s a very elegant system and those with the work ethic could definitely make it into a great success,” says Riskin. “One of the things lost with this model is the office environment where lawyers discuss and share insights. To top it off, it would definitely be more difficult to manage than a traditional firm. But when you see a virtual firm like Axiom, formed by people at the top end of the profession, the structure not only gains greater recognition, it also convinces others to look at it seriously.”

Markus Cohen is a pioneer in the realm of virtual law firms. The Toronto-based lawyer established and trademarked Markus Cohen Law Office: The Virtual Law Firm®. When he started the firm under the virtual law firm structure, he didn’t do it with today’s current model in mind.

“When most people think of a virtual law firm, they think it’s a Web site with secure electronic transfer of information and monetary funds where clients interact with lawyers via e-mail,” Cohen says. “The ‘virtual’ in my firm refers to a flexible model where I, as a sole practitioner, form a team of lawyers in different disciplines to tackle each individual case specifically.”

Although Cohen’s system is quite different from the modern virtual firm structure, it is similar in that it’s a fluid structure where a “dream team” of lawyers comes together to tackle specific cases. Once completed, the team disbands, ready to come back together when needed. “So far, this system has worked beautifully,” Cohen says. “Since I go out and handpick specific lawyers for particular cases, clients can always make sure that they have a solid team working on their behalf.”

Cohen works as a sole practitioner and hires from a list of 40 to 50 lawyers in various disciplines. He says the model offers a lot of benefits when it comes to management. At the end of the day, he’s taxed as a sole proprietor and provides clients with one bill for all the charges.

Cohen says that those looking to start a virtual law firm should base the practice on a niche area of expertise, in an area where they have a certain amount of experience and a respected reputation. In addition, they should have well-developed relationships with other firms and lawyers in the area of practice.

e) Combined Firm Structures

In many cases, by combining various business structures, firms can achieve greater management, tax and liability benefits. The most common example of such a combination is a smaller firm that chooses to become an LLP with one or more firm lawyers forming PCs, which act as partners. In doing so, the lawyers involved gain the information-sharing and prestige linked to partnerships, the tax advantages of a PC and the liability protection offered by the LLP.

Dale Doan and Richard Cleveland established White Rock, B.C.-based Cleveland & Doan Barristers & Solicitors as a partnership between two professional corporations. “We made it our job to explore all the models that were out there and available to us,” says Doan. “We decided that because of the income splitting potential and the possibilities for tax deferral, this was the model that suited us best.”

The firm is structured in such a way that the two PCs share the firm’s income, with each lawyer being paid a salary through the PC. The other two lawyers at the firm — one an associate and another an employee — have other incentives since they do not get the tax benefits accorded to the two principals. These incentives range from year-end bonuses to company-paid trips to conferences and conventions. If the associate or employee is one day offered partnership, they will be encouraged (but not be required) to open a PC.

But the main reason for adopting the PC model had more to do with the tax benefits—specifically tax deferral. In B.C., the increase of the small business deduction in recent years has benefited both Cleveland and Doan, since they are forced to share the deduction.

In terms of liability, the partnership is responsible for the actions of its employees. Since it is a traditional partnership, both partners (the PCs) must share liability. Since the acts of a PC fall directly on the shoulders of its shareholders, both partners are liable (as is the case with a regular partnership).

Doan says that lawyers have to be inquisitive and knowledgeable when deciding on a specific structure or combination of structures. “There are a lot of questions to ask when deciding on a firm structure, such as do you want to establish a partnership or association? Does your tax advisor feel a PC will be useful from a tax saving or planning perspective?” explains Doan. “The key is that lawyers today must be more open-minded and open to change when considering a long-term structure for their law firms.”

Conclusion

No two lawyers are the same and there is no secret formula to selecting a firm structure. So it is essential to research every potential model (or combination of models) and consider the benefits and drawbacks of each, based on the objectives and needs of your firm. You should also contact your law society to get up to speed on provincial laws and regulations relating to different law firm structures.

Deciding on a law firm structure requires careful consideration of a number of factors, including the need to limit potential liability, tax consequences, and the relationships and roles of the various partners involved. Tackling the complexity and workload involved in selecting the right firm structure is no small task. The upshot is that today, more than ever, diligent lawyers can establish a law firm structure tailored specifically to their personal and professional needs.