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To Incorporate, or...

29.11.2012

The growing trend towards incorporation, and away from the traditional partnership model, in the legal profession raises the question again of what benefits there are for partners from incorporating their business.

Figures released this week by the SRA show that the number of traditional partnerships in the country has fallen by 26%, to just under 3,000, in the past 3 years. The number of incorporated companies has almost doubled, also to nearly 3,000, and LLPs have increased in number by over 50%, to more than 1,500.

Most partners who decide to incorporate their firms, or indeed to set up from scratch as limited companies, do so for two main reasons. Firstly, limited company status offers greater asset protection and greatly reduces the liability for business owners as compared with a partnership structure. Secondly, there are significant tax benefits to be had, especially for profitable firms where the partners would be subject to the 50% rate of income tax.

However, there are more issues to consider in the context of running a firm, and the question of whether to convert to limited company – or indeed LLP – status merits careful consideration.

The LLP

Converting to an LLP from a partnership is simpler and less disruptive than incorporating, and maintains the ‘feel’ of a partnership – possibly keeping the collegial ethos and preserving the existing power structure. Moreover, compared with a traditional partnership, liability is limited.

However, an LLP is still essentially an ‘all or nothing’ equity membership, and potentially features all the inherent management difficulties of a partnership. Remuneration is a tricky issue, as profit is a combination of ‘salary’, ‘interest’ and ‘bonus’, and it is thus much harder to match remuneration to performance than it is in a limited company. Furthermore, the culture of profit extraction, which can lead to weak balance sheets and a lack of headroom in financial management (see our article), remains a significant problem.

To Incorporate, or...

Creating a limited company allows for the separation of ownership from management, which ultimately smooths the decision-making process. New owners can be brought in incrementally, and owners can also make phased exits – which neutralises many of the succession issues firms face. Shares can be used as a currency for incentives and options can be awarded, and it is easier to involve more people in the firm and consequently get more staff pulling in the same direction.

Attracting lateral hires to an incorporated firm with a degree of ownership but not a full equity stake is easier, and the focus on growing share value creates a culture of growth rather than the culture of extraction that pervades the legal profession. Selling an incorporated firm may also be easier.

Nonetheless, banks will still require personal guarantees from the incorporating partners, so the liability issues are not entirely avoided. Changing the ownership structure will require negotiation and possibly external advice, and the more that staff are involved (in the form of offering equity or options), the more time-consuming the process itself becomes. Finally, some ‘partner level owners’ may be less committed if they have earned their shares rather than subscribed their own cash.

The decision to convert the firm’s ownership structure is not one that should be taken lightly, and different firms will arrive at different conclusions. Ultimately, the choice should be based on a sober analysis of the costs and benefits – financial and managerial – of each structure.

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