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.

Weighing Options

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.