Limited Liability Partnerships: Should There Be One in Your Future?

California adopted SB 513 on October 8, 1995 establishing Limited Liability Partnerships (LLPs) as an alternative method for lawyers to conduct the practice of law. SB, which was signed by the Governor on October 8, 1995 is now found in Article 10 of the California Corporations Code sections 16951-16962. Although the legislation makes limited liability partnerships available to accountants and lawyers only, this article will focus on issues applicable to lawyers.

Many lawyers are considering, or have already made, the conversion to an LLP. This article describes LLPs and raises some issues for consideration when making the decision to become one.

Limited Liability Partnerships

Limited Liability Partnerships are in effect limited partnerships with no general partner. While all partners in a general partnership are jointly and severally liable for all partnership debts and liabilities, partners in LLPs are not. [2 California Corporations Code, § 16306(a). ("Corp. Code")] Thus, a partner in an LLP practicing law is not liable by statute for the malpractice committed by other attorneys, whether partners or associates, unless the partner is directly liable.

Some states do not allow lawyers to limit their exposure to vicarious malpractice liability or to general debts of the partnership or a professional corporation and some attorneys believe that vicarious malpractice liability cannot be limited in California by the use of either professional corporation or limited liability partnerships.

Law partners remain liable for their own malpractice and for the malpractice committed by those that they supervise. They also remain liable for malpractice liability that they have contractually agree to assume.

Limiting personal liability for all of the LLP's debts is contingent upon obtaining a certificate of registration from the State Bar in addition to filing with the Secretary of State, Corporations Code §16306(f). Note that certain provisions of other laws, notably tax laws relating to employment taxes, override non-liability provisions and impose personal liability on persons responsible for implementation of the law.

Limiting liability for vicarious malpractice also requires maintaining security to cover malpractice claims. For law LLPs, that means:

  1. Maintaining professional liability insurance of $100,000 for each licensed person up to a maximum of $7,500,000 or
  2. Maintaining liquid assets such as cash or specified liquid securities in a trust or bank escrow in the same amount, or
  3. Maintaining the personal guaranty of each partner in the same amount, or
  4. Any combination of these three. Although the statute is not clear on this point, the security requirement probably commences with the first dollar of claim, so that a guarantee or cash deposit is required to secure the deductible amount under a professional liability policy.

LLPs are partnerships and, if properly formed, they operate and are taxed as a partnership, with the exception that LLPs are liable for an $800 annual tax to the Franchise Tax Board for the privilege of doing business in California. [See Corp. Code § 15902.01 and Revenue & Taxation Code § 17935.] However, care must be taken because characterization under local law as a partnership does not automatically classify an entity as a partnership for purposes of federal income taxation.

The potential problem is that the Internal Revenue Code classifies "associations" as corporations for tax purposes. [26 U.S.C. § 7701.] Thus, while general partnerships are almost always taxed as partnerships because of the partners' underlying unlimited liability, limited partnerships are classified as associations taxable as corporations if they have more corporate than non-corporate characteristics. Similarly, because LLPs provide limited liability, they must be carefully structured to be taxed as partnerships.

A partnership will generally be taxed as such unless it has more corporate than non-corporate characteristics from among the four that are identified by the Federal Income Tax Regulations. [Regulations 301.7701-2(a ) and 310.7701-2(a)(3).]

Although the regulations provide that in some cases other factors may be significant, the four specified in the regulations are usually the only characteristics considered. An LLP therefore must avoid at least two of the following corporate characteristics to be taxed as a partnership: continuity of life, centralization of management, limited liability and free transferability of interests.

Two of the factors are usually clear. Since LLPs are formed to limit liability, they will be presumed to have the corporate characteristic of limited liability. On the other hand, as partnerships they will generally lack the corporate characteristic of free transferability of interests. Assuring that an LLP will be taxed as a partnership therefore depends upon avoiding at least one of the two remaining corporate characteristics, continuity of life and centralization of management.

Continuity of life can be avoided by providing for the dissolution and reformation of the LLP upon the death or withdrawal of a partner. However, this approach can cause problems due to the procedural requirements of obtaining partner consents to the partnership's continuation and because of the possibility that the needed consents may not be obtained.

Centralization of management generally will be absent in smaller LLPs because all of the partners are likely to be active in the partnership's management. However, larger LLPs may need centralized management for partnership political reasons and because management will be unwieldy without a smaller management committee.

Although avoidance of at least two of the four corporate characteristics generally can be accomplished with appropriate planning, care must be given so that the LLP will run smoothly and because classification as a partnership for tax purposes cannot be made with absolute certainty.

Converting an Existing Law Practice

If the decision is made to practice as an LLP, issues involving the conversion should be considered. Those are likely to be dictated in large part by the form of the existing law practice. Converting a general law partnership will be a relatively transparent event because the LLP is the same entity as the partnership.

However, converting a professional corporation is likely to involve substantial costs because a liquidation will be required, thereby causing the corporation to realize gain on appreciated assets such as accounts receivable and goodwill, and re-negotiation of leases and bank loans. Although in-depth consideration of issues involving conversions is beyond the scope of this article, a careful analysis of the risks and costs to conversion must be made case by case.

Is the Conversion Worth It?

The prospect of obtaining a limitation on vicarious malpractice liability may justify converting a general partnership to an LLP, although that protection may be illusory given the security requirements and the unclear status of the law. However, the costs and risks of making the transition are small.

In contrast, converting a PC to an LLP entails the liquidation of the Professional Corporation and possibly substantial cost. Since the primary disadvantage of practicing in the corporate formalities and to juggle year-end distributions to avoid incurring corporate level tax, the costs of converting a PC to an LLP must be more carefully analyzed.