Does it really matter whether a law firm is set up as a PC or an LLP?
I asked numerous lawyers this question and the usual response was “not really.” In fact, according to this article, most firms have very little idea why they selected a particular entity type at formation.
While it might not matter as much at the individual lawyer level, I believe it does matter at the firm level and should matter at the creditor level, i.e. to landlords signing leases with law firms.
Limited liability partnerships afford more flexibility in financial management and allow for easier flow of partners into and out of the partnership. And, as the name indicates, they also allow limited liability for partners.
Professional corporations allow certain tax benefits, primarily in the way of higher pension plan contributions. Like LLPs, they also allow limited liability on the part of the shareholders. On the downside, corporate formalities associated with this entity type can be burdensome. Further, PCs do not allow for a mandatory retirement age as they are subject to employment laws governing corporations.
Why is mandatory retirement age relevant?
Mandatory retirement age is a sticky issue so I am going to address it only by briefly identifying some of the benefits and liabilities. On the benefit side, a mandatory retirement age (especially when coupled with a generous step-down program) can encourage senior partners to transition their client relationships to junior partners. It can also ensure that a law firm does not become a country club to senior partners who are no longer billing significant hours but are still collecting partner pay and occupying partner offices.
On the liability side, it can force productive partners with extensive experience and knowledge into a premature retirement.
I have seen this problem best addressed by those firms that offer a generous step down and transition incentive and then allow partners beyond retirement age to continue practicing as non-equity shareholders.
Does/Should mandatory retirement age matter to lenders and landlords?
From a landlord or lender perspective, the existence of a mandatory retirement age is relevant if the number of partners is bloated because senior non-producing partners are not retiring and this occurrence is dragging down profitability. In such an instance, the lack of a mandatory retirement age may affect the long-term viability of the firm and therefore the security of the loan or lease.
Conversion from one entity to another
Another downside of PCs: converting from one entity to another is not always simple – especially a conversion from a PC to an LLP or LLC. “The conversion of a professional corporation to an alternative form requires liquidation, which can be a significant tax event. For many, the PC is a decision where there is no turning back. Any change that winds up the corporation, including conversion necessitated by regulatory considerations or the dissolution of the firm for other opportunities or merger, can be prohibitively expensive.”[i]
This means that in an age of consolidation, PCs may offer merger challenges that their LLP counterparts do not. As a landlord, this challenge could prevent a failing PC from being absorbed by a larger, more viable firm, resulting in more lease risk to the landlord.
Despite the challenges associated with PCs, they are the predominant form for law firms in the United States.
Does the amount of equity buy-in matter?
In addition to consideration of the entity type, a law firm and its lenders should regularly evaluate the equity buy in required for partnership in the firm. For instance, I have spoken with lawyers at firms with no equity buy-in for partnership. While those firms might consider themselves judgment-proof, as a landlord or lender, I would consider them high risk. Why? Most law firm failures result from illiquidity. One down year can sink a firm that has no capital to weather fluctuations in revenue and collections.
Equity as handcuffs
Another consideration with respect to equity buy-in is the buy-out provision in the partnership agreement. For instance, if a partner leaves a firm, how much capital do they have invested in the firm they are leaving and what is the buy-out timeline?
One firm I spoke with determines buy-in capital based on points – a fairly common approach. In this scenario, the more revenue a lawyer generates, the greater their equity buy-in and the greater their profit participation. This firm’s partnership agreement provides that if a partner leaves for a competitor firm (as opposed to a judgeship, in-house position, retirement or other non-competitive endeavor), the partner’s capital buy-out will occur over a five-year period.
I personally like this approach because it encourages loyalty to the firm and a long-term commitment to the business. It also ensures that every partner’s interests are aligned with firm success. Arguably, it also allows those lawyers not comfortable with this commitment to self-select from joining the firm.
Compare this to another firm I interviewed. Their buy-in is a flat $20,000 for every partner. Liquidation upon departure from the firm is immediate. In my opinion, this not only limits the capital available to this firm to invest in the business of the firm (requiring debt for any major investment), it also may leave the firm susceptible to lateral departures. This can create a volatile environment.
Back to my landlord or lender hat – when evaluating a long-term lease with a law firm that requires only de minimis equity buy-in and attaches few strings to departure, I will want more security for the obligation. That may take the form of a letter of credit or personal guarantees on behalf of all of the partners.
What do you think?
I know that the lack of discussion around this topic is not a reflection of the lack of opinions about it. To that end, I would love to hear yours. I want to learn more and will update this article as I do!
[i] “Law Firms’ Entity Choices Reflect Appeal of Newer Business Forms” by Allison Martin-Rhodes, Robert W. Hillman and Peter Tran. Law Firm Organizations. July/August 2014