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Organizing a Professional Practice: an After-Tax Choice-Of-Entity Calculus

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Organizing a Professional Practice: an After-Tax Choice-Of-Entity Calculus Electronic copy available at: http://ssrn.com/abstract=1361915 PARTNERSHIPS , S CORPORATIONS, & LLCs EDITED BY SAMUE L P STARR, CPA, LL . M. ORGANIZING A PROFESSIONAL PRACTICE: AN AFTER-TAX CHOICE-OF-ENTITY CALCULUS BY THOMAS E. RUTLEDGE, MARKS. FRANKLIN, AND STEPHEN M. LUKINOVICH A crucial decision made in any sional practices, we consider, on a pro for­ The tax tail should by no means wag the business venture is the choice ma basis, the after-tax benefit realized by choice-of-entity dog, but practitioners agree of entity, a complex calculus the professional owner of the venture un­ that weighs and balances competing in­ der various classification scenarios. While that the overall tax liability projected to terests and objectives against the "stan­ this analysis is of necessity limited to its result from any particular form chosen for a dard models" that are available under assumed facts, we conclude that assuming the various business organization professional practice is a serious considera­ such is otherwise defendable. It is from statutes. The standard model ultimately the tax perspective most efficient to use tion. The key to any comparison wi ll be the selected is then customized to the ven­ an S corporation in which 25% of earn­ assumptions made, including those re lating ture by private agreement. Or at least ings are distributed as salary with the bal­ that is what should happen. ance distributed in the form of dividends. to the client's income and the stabi lity of the In most organizations, the client, the The next most efficient approach is to or­ practice. accountant, or the attorney makes a ganize an LLC taxed as a partnership in quick decision, informed by the advisor's which 50% of the funds available to our prior practice and an up-to-date appreci­ owner are distributed as a guaranteed ation of recent changes in the law (both payment with the balance as a distribu­ organization and tax). There are many tion, where this member is not a manager. discussions that compare, on a character­ istic-by-characteristic basis, the various means of organizing a business struc­ ture. 1 Here, we attempt to quantify the STATE LAW ORGANIZATION OPTIONS impact of those various factors. Almost every state now allows a profes­ THOMAS E. RUTLEDGE is a member sional practice to be organized as a sole of, and MARKS. FRANKLIN is an asso­ ciate with, th e law firm of Stoll Keenan Basic facts. We assume our facts as fol­ proprietorship, as a general partnership, Ogden PLLC, both resident in the firm's lows: A veterinary practice owned as a professional service corporation Louisville, Kentucky, office. Mr. Rutledge equally by three licensed professionals, (PSC), as an LLC, or as a limited liability has previously written for The journal, and chairs th e Subcommittee on Limited with four additional employees. In the partnership (LLP) .2 Liability Companies of the Committee on practice, one owner has "all ocable" Traditionally, a professional practice LLCs, Partnerships and Uninco rp orated gross income of $500,000 and de­ Entities of the ABA Section of Business had to be organized either as a sole pro­ Law. Mr. Franklin is a member of th e ductible expenses (before determina­ prietorship or as a general partnership. Kentucky Society of CPAs. STEPHEN M. tion of owner contributions to retire­ Due to certain tax pressures, however, LUKINOVlCH, CPA, is a member of th e accou nting firm of Chilton & Medley ment savings accounts) of $150,000, efforts were made to develop forms of PLC in Louisville, and is a board mem­ resulting in $350,000 that is to be dis­ business organization that, while not ber of th e Kentucky Society of CPAs. tributed in some manner to this owner. "incorporated;' would have the tax ben­ Copyright © 2009, Thomas E. Rutledge, After reviewing our facts and the state efits of corporate tax classification un­ MarkS. Franklin, and Stephen M. Luki­ nm,ich. law governing the organization of profes- der the Code. JOURNAL OF TAXATION I MARCH 2009 • 135 Electronic copy available at: http://ssrn.com/abstract=1361915 PARTNERSHI PS, S CORPORATIONS, & LLCs This course of action culminated for purposes of the Code, be classi­ closest analog, S corporation status, in Kintner, 216 F.2d 418, 46 AFTR fied as a corporation. 4 As a general imposed significant limitations and, 995 (CA-9, 1954). In response to the rule, these various PSC acts imposed because of the maximum number of government's loss in that case, the structural limitations, such as who shareholders at times permissible, Kintner classification Regulations may serve as members of the board was not available to larger firms.s were adopted by Treasury with the of directors, who may qualify as purpose and effect of making it shareholders, requirements as to of­ more difficult for professional firms ficers other than the treasurer and Early in the 1990s, the LLC was to achieve the benefits of corporate the secretary, the voting of shares, identified by several professions classification even as state law incor­ and mandatory buyout require­ as a viable mechanism for the poration was denied them. Proving ments on death or disability.s organization of professional Ludwig Borne's adage that "nothing Early in the 1990s, as the "LLC ex­ is lasting but change;' professionals plosion" was taking place, this form firms. in the various states turned to their of business organization was identi­ respective state legislatures and lob­ fied by several professions (most no­ bied for the adoption of professional tably the accounting industry as rep­ service corporation statutes pur­ resented by the AI CPA) as a viable States have taken a variety of ap­ suant to which they could formally mechanism for the organization of proaches to structural limitations on professional LLCs. For example, in incorporate their practices.3 professional firms. This categoriza­ Kentucky the only requirements ap­ Eventually, every state adopted a tion of the LLC was based on the plicable to a professional LLC that PSC act, and with great reluctance availability of partnership taxation, differ from a nonprofessional LLC in­ the Service agreed that a PSC would, not usually an option in the PSC. The volve name identifiers and a recitation NOTES in the articles of organization as to 1 See, e.g., McNulty and Kwon. "Tax Con­ sional services to be rendered by LLC) and what profession or professions are be­ siderations in Choice of Entity Decision;· 8 275 100(1) (name requirements). ing practiced through the LLC.7 By Bus. Entities 28 (May/June 2006); Keatinge 8 See Tenn. Code sections 48-249-1106 (pro­ and Conaway, Keatinge and Conaway on fessional services to be rendered only by contrast, the Tennessee LLC Act im­ Choice of Business Entity (Thomson Reuters/ individuals so licensed by the state), 48-249- poses on professional LLCs structural West, 2007), Appendix A. 1108 (name requirements). 48-249- 11 09 (eli­ limitations roughly equivalent to those 2 The Ca lifornia LLC act precludes the use of gible members). 48-249-1100 (transfers only to eligible persons) and 48-249-1111 (manda­ the professional LLC in California by licensed imposed on PSCs organized in that tory redemption) . professionals. California Corp. Code section state. a The 2006 Revised Uniform Lim­ 17375. See also Calif. AG Opn. 04-103 9 68 U.L. A. 407 (2008). ited Liability Company Act (RULL­ (7/23/04) 10 See generally Rutledge and Hester, "Practical 3 See generally Rutledge, "The Place (If Any) Guide to Limited Liability Partnerships," 5 CA)9 contains no provisions specific to of the Professional Structure in Entity Ration­ State Limited Uability Company and Partner­ the regulation of professional firms, ship Laws (Jacobson. Ludwig, Miller. and alization;· 58 Bus. Law. 1413 (2003), pages leaving such matters exclusively to the 1415-16. Rutledge, eds.; Aspen, 2008) See RUPA section 306(c). See also Bishop, 4 See, e.g., Bittker and Eustice, Federal In­ 11 rules and regulations adopted by pro­ "The Limited Liability Partnership Amend­ come Taxation of Corporations and Share­ fessional regulatory boards. ments to the Uniform Partnership Act holders, Seventh Edition (Thomson Reuters/ (1994);' 53 Bus. Law. 101 (1997). But see Even as the availability of LLCs WG&L, 2006). ~ 2.06. See also Rev. Rul. 70- Ederer v. Gursky, 881 N.E.2d 204, 9 N Y3d 101 , 1970-1 CB 278. moved across the country, there rose 514 (N.Y., 2007). wherein the New York Court 5 See Model Professional Corporation Supple­ of Appeals held that section 26(b) of the New the effort, initially in Texas, to permit ment (1984), § 20 (permissible shareholders), York Partnership Act applies, inter alia, only to the formation of the LLP. A subspecies § 23 (mandatory redemption of shares of claims of third parties against the partnership deceased or unlicensed shareholder or transfer­ but does not apply to claims among the part­ of the general partnership, as con­ ee), § 30 (requirements as to directors and offi­ ners. In this instance, the court held that the trasted with a new form of business cers). § 31 (proxies and voting tnusts) partners in an LLP were personally liable on organization, the LLP modifies-to a 6 Starting in 1958, an S corporation was limited claims asserted by a former partner against to ten shareholders under Section 1371 the partnership. Based on Ederer. a similar greater or lesser degree, depending lall1 ). The threshold increased to 15 w ith con­ holding was rendered in Kuslansky v. Kus­ on the state statute at issue-the tra­ ditions in 1976 and 15 generally in 1978. In lansky, Robbins. Stechel and Cunning­ ham, LLP, 50 App Div.
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