Today we’re going to talk about the business structures that Lawyers use when they are starting out as well as the related accounting peculiarities in each structure. Partnership and their related accounting can be complicated, and the accounting treatments that you use in your partnership need to mirror the terms in your partnership agreement. Professional Corporations can be used to defer tax, but is it the right strategy for you?
Whether or not you choose to practice in partnership with another lawyer or you want to ‘go it alone’ you’ll need to decide whether a Professional Corporation is right for you. Some jurisdictions require lawyers to practice through a Law Corporation, which could also be called a Professional Corporation. In Alberta, lawyers are not required to practice through a Professional Corporation but may choose to do so or various tax planning and perception reasons.
A corporation can be used to create tax efficiencies that are not available to proprietors, and ultimately provide the ability to leave more after-tax dollars to reinvest in growing your law practice. Achen Henderson has prepared a great summary called Should I incorporate my small business?, most of which apply to Professional Corporations with a few notable exceptions.
- Unlike a regular corporation, a Professional Corporation generally provides no legal liability protection to the practitioner/owner. That is, practitioners’ liabilities are generally not limited to their investment in a professional corporation, the liability sees right through the professional corporations.
- Unlike a regular corporation, certain jurisdictions or professional associations/colleges limit who can own a professional corporation. For example, under rule 131(3) of the Law Society of Alberta certain non-practicing peoples can hold non-voting shares of a professional law corporation, including, spouses, children, and trusts of the practicing lawyer; however non-practicing and unrelated third parties cannot hold any shares of the professional law corporation.
Limited Liability Partnerships
Lawyers often go into business with other lawyers for a number of reasons, which typically result in the formation of a Limited Liability Partnership (“LLP”). Meriam-Webster defines a partnership as “a legal relation existing between two or more persons contractually associated as joint principals in a business”, I would replace the word “relation” with “agreement”. A corporation is considered to be a separate legal person in the eyes of the law, it pays its own taxes, it can be sued, etc… whereas a partnership is simply an agreement. Partnerships do not pay their own taxes, and the liabilities of the partnership flow to the partners. A LLP generally limits the liability of any particular claim or event to the partner that caused the claim.
Why use a LLP?
Quite simply, a LLP is a hybrid structure that allows for the separation of Liability while providing the ability to share operational resources, gain operational efficiencies, reduce costs, and create a common brand. It really is the ‘best of all worlds’. Here is a chart comparing lawyers practicing together using a single corporation, or via an LLP:
|No separation of legal liability
|Inherent separation of legal liability
|Income recorded and taxed in the corporation. Reduces tax planning opportunities for the individual partners
|Income flowed through to the partner; tax was subject to each partner’s individual ownership structure
|Difficult to add and remove partners
|Simple to add and remove partners
|Taxable salary and dividends subject to employment agreements, articles of incorporation and the USA. Can be difficult to change year to year
|Distributions and income allocations are subject to the terms of the partnership agreement. Can vary widely year to year
|Difficult to incorporate and dissolve
|Simple to form and dissolve
Common ownership structures
See the below organization chart of Him, Her and They LLP (“HHTLLP”). The structure introduces a variety of ownership models and highlights one of the important features of using an LLP – each of the partners can have an ownership structure that suits their individual needs without impacting the ownership structure of another partner.
Partner A chose to hold his 33% partnership interest through a professional corporation. Income allocated to Partner A, according to HHTLLP’s limited partnership agreement, will be taxed at Professional Corporation #1’s corporate tax rate which in Alberta will range from 11-23% depending on the company’s access to the small business limit. Partner A receives his salary from Professional Corporation #1, as does Spouse #1 who is also active in the company at least 20 hours/week.
Partner A included his spouse, Spouse A, in the ownership so that they could split dividends paid from Professional Corporation #1. This was a common practice called “Income Splitting” and was widely used before the updated Tax on Split Income (“TOSI”) regime kicked in in 2018. Fortunately for the family, Spouse A is exempt from the TOSI regime given her long history of working more than 20 hours/week in Partner A’s law business under Professional Corporation #1.
Partner B has a similar corporate structure to Partner A, however, she is single and so has not had the opportunity to include a spouse in the ownership of Professional Corporation B. Partner A pays herself via dividends instead of salaries because she read Achen Henderson’s article Paying Yourself as a Business Owner: Salaries or Dividends? and decided that paying herself salaries best suited her particular situation.
Partner C owns their partnership units directly, and individually. After reading Achen Henderson’s article Should I incorporate my small business? they decided that they would spend most of the money they made personally, including a healthy contribution to their RRSP annually, and so there was no need for them to incorporate a professional corporation. Partner C reports their income as ‘business income on their personal tax return, and takes many of the same deductions that are available to Professional Corporations #1 and #2 against that income such as partner-level meals and entertainment, work automobile for visiting clients, and their home office which they mostly operate from and meet clients in.
The income allocated from the LLP to Partner C is subject to tax at their personal tax rates, which in most cases is much higher than the tax rates in a professional corporation. The advantage, of course, is reduced compliance complexity, and the fact that the income earned is available for Partner C to use on personal expenses, whereas Partners A and B have to take an extra step to get the income they need personally out of their Professional Corporations either as a dividend or salary. This income is subject to the same personal tax rates that Partner C’s LLP income allocations are subject to.
Shared LLP expenses, GST, Payroll
All of the staff and office resources, aside from the partner’s pay, are handled in the LLP. The LLP registers for and remits GST and collects related ITCs on the LLP’s revenues, and shared expenses. Administrative and other professional staff are set up on the LLP’s payroll, which is separate from the payroll in Professional Corporations #1 and #2, and the LLP administers the firm’s benefits and HR functions.
The office rental and office furniture are all paid for using the LLP’s funds, which are either contributed by the partners or retained through the LLP’s earnings (I.e. not distributed to the partners). Bookkeeping, marketing, IT, phone lines, and subscriptions to legal software, and research databases, are generally paid at the LLP agreement and such expenses can be allocated to each partner in their annual income allocation according to the LLP agreement
T5013 information returns and Allocation of income and expenses
The partnership will be required to file a T5013 information return, in this case by March 31 of the year following the fiscal year. If the LLP had only corporate partners, and not individual partners, that deadline may be extended to May 31 of the following year.
The T5013 is an information form that is prepared by the LLP’s accountant that allocates the income earned by the partnership, losses, capital gains and losses and the like to each of the partners. The calculation of this allocation is made in accordance with the terms of the LLP agreement. We’ve seen a good number of incomplete partnership agreements that do not address income allocations, which can turn into a huge problem down the road. We recommend reading our “Important features of a partnership agreement” to learn the minimum requirements that should be contained in your partnership agreement.
Individual partner’s expenses
The partners may all have certain expenses that they pay for individually that their partners may not agree to or may be outside of the terms of the partnership agreement. These could include certain expenses that the other partners would not agree to pay such as attendance at specialized conferences, certain meals and entertainment items such as hockey tickets, or the legal, accounting and other professional fees that are specifically related to that partner’s corporate structure and tax filings.
The income tax act (Canada) requires that all professional corporations, and professional partnerships, maintain a December 31 yearend.
As you can see, an LLP allows each partner the flexibility to choose their own ownership structure independent of their partners. They can even include family members in non-voting ownership without confusing the partnership agreement, and the income earned from the LLP is taxed at the prevailing tax rates in each Partner’s preferred structure. An LLP also allows the flexibility they join forces in a branded law firm and take advantage of shared resources and economies of scale that are gained through cost sharing.
Interested in setting up or restructuring your LLP?