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Making it your business: possible new structures for law firms

Feature Articles

Cite as: (2005) 79(7) LIJ, p. 62

While the Legal Profession Act 2004 (Vic) paves the way for new business structures, law firms need to carefully consider the financial and taxation attributes of each when deciding which model to adopt.

By Keith Harvey and Anna Tang

The Legal Profession Act 2004 (Vic) (the new Act) will allow Victorian lawyers to incorporate and provide legal services either alone or alongside other service providers who may or may not be legal practitioners. Essentially, the new Act, which will begin by 1 October, permits:

  • the formation of an incorporated legal practice (ILP) provided the ILP has at least one “legal practitioner director” and complies with the requirements of the new Act; and
  • the formation of multi-disciplinary practices, both incorporated and partnerships.

The new Act removes the restrictions on the type of activities a law firm can conduct and certain liabilities previously imposed on shareholders of an incorporated practitioner. It also allows non-lawyers to become shareholders, directors or partners in a legal practice.

Some of the arguments that have been made in support of the new Act include the following:

  • improved taxation and succession planning options;
  • the creation of a company board with a wider range of skills, experience and contacts than those available within the firm;
  • the ability to raise equity capital outside the firm;
  • the ability to secure debt funds by providing a mortgage debenture charge;
  • the ability to sell shares, and options over shares, to staff below the level of principal;
  • improved access to asset protection strategies;
  • allowing stakeholders to continue their equity investment in retirement, therefore eliminating the conflict caused by older practitioners managing the business with short-term financial objectives; and
  • the adoption of a more modern business structure which unbundles the roles of partners into the discrete roles of shareholders, employees, directors and managers.

Undoubtedly the financial and taxation issues will be the key drivers of change for most law firms. A certain amount of resistance to change is to be expected because some partners will not want to be relegated to shareholder, employee and/or manager without access to the privileges usually associated with partnership.

Incorporated practitioners under the current Act

Traditionally, Victorian solicitors have traded as sole practitioners or in partnership with other lawyers. While sole practitioners and partnerships remain the most prevalent form of legal practice in Victoria, s289 of the Legal Practice Act 1996 (the current Act) allows a company to apply to the Legal Practice Board (the LPB) for registration as an “incorporated practitioner”. However, the restrictions placed on share ownership and the onerous liabilities on directors and shareholders have rendered incorporated practitioners an unattractive choice for many law firms.

Incorporated legal practices

Any corporation that has at least one “legal practitioner director” can engage in legal practice in Victoria under the new Act, provided that the Legal Services Board (the Board) has been given prior written notification of the company’s intention to engage in legal practice. To be eligible to be a legal practitioner director, that person must hold a current practising certificate as a principal of a law practice. The ILP cannot be without a legal practitioner director for more than seven days.

These companies do not become registered as a “legal practitioner”; they are simply allowed to trade as an ILP.[1] The transitional provisions in the new Act provide that an incorporated practitioner under the current Act becomes an ILP under the new Act.[2]

Section 2.7.5 of the new Act allows an ILP to conduct any other business that it may lawfully provide or conduct (subject to certain exclusions prescribed by the new Act and its Regulations).[3] This paves the way for law firms that have adopted a corporate business model to conduct a multi-disciplinary practice (see below).

The legal practitioner director is responsible for the management of the legal services provided by the ILP. In addition to the obligations and liabilities of a director under the Corporations Act, the legal practitioner director must also take reasonable steps to prevent breaches of the professional obligations imposed on Australian legal practitioners.[4]

While an ILP may provide other services in addition to legal services, the legal practitioner director must exercise care in who it allows to be directors or employees of the ILP. This is because s2.7.11 provides that a legal practitioner director may be guilty of unsatisfactory professional conduct or misconduct in the situations where:

  • an Australian legal practitioner employed by the ILP is found guilty of unsatisfactory professional conduct or misconduct;[5] or
  • the conduct of any other director of the ILP adversely affects the practice’s provision of legal services; or
  • any other director of the ILP is found to be unsuitable as a director of a corporation that provides legal services.

Thus, while the liability of shareholders for actions of the company and its employees under the current Act has been removed, the liabilities of legal practitioner directors are made more onerous by the new Act. However, as there is no longer any restriction on shareholding, an ILP opens up the possibility of key stakeholders (other than principals) buying equity in a law practice. These might include junior lawyers, external financiers, and members of a lawyer’s family or their family trusts. The ILP can also invite onto its board of directors persons with skills other than simply legal (e.g. financial, marketing, management), or persons with wider experience and contacts than the firm itself may have.

Multi-disciplinary practices

Division 3 of Part 2.7 of the new Act provides for legal practitioners to supply legal services in partnership with persons who are not legal practitioners if the partnership is in the form of a “multi-disciplinary partnership”. Section 2.7.36 defines a partnership to be a multi-disciplinary partnership if it includes the provision of legal services as well as other services. See more on this below.

The new Act allows a multi-disciplinary partnership to engage in legal practice in Victoria provided that the Board has been provided with prior written notification of the partnership’s intention to engage in legal practice. Section 2.7.39 of the new Act provides that each legal practitioner partner in a multi-disciplinary partnership is responsible for the management of the legal services provided by the partnership. The legal practitioner partner must ensure that appropriate management systems are implemented and maintained to ensure that the legal services provided by the partnership comply with the professional obligations imposed on legal practitioners, and that these professional obligations are not affected by other partners and employees of the partnership.[6] It should be noted that similar obligations are imposed on a legal practitioner director of an ILP.

Like ILPs, each legal practitioner partner must exercise care in who he or she allows to be partners or employees of the partnership. This is because s2.7.40 provides that a legal practitioner partner may be guilty of unsatisfactory professional conduct or misconduct in similar situations to those discussed for an ILP.

Multi-disciplinary partnerships differ from ILPs in one significant respect. As discussed above, an ILP can share income from legal services with non-legal practitioners. This is irrespective of whether or not the firm provides other services in addition to legal services. However, the income of a partnership which solely provides legal services can only be shared by legal practitioners. Section 2.7.37 provides that “a legal practitioner may be in partnership with a person who is not a legal practitioner where the business of the partnership includes the provision of legal services”. [emphasis added] The use of the word “includes” implies that a non-legal practitioner person can only be a partner where services other than legal services are provided by the partnership. On this construction of the section, only partnerships which engage in a multi-disciplinary practice are able to share income with non-lawyers.

While the definition makes it clear that there must be some service provided that is not a legal service, it remains silent on what the nature of such a service might be. The Explanatory Memorandum to the new Act does not give any guidance on this point. However, the Victorian Attorney-General, in his second reading speech, states that the adoption of this non-traditional mode of legal practice by the new Act stems in part from a desire to enable legal practitioners to better compete with other service providers by permitting them to create a “one stop shop”.

Case law that discusses the scope of legal practice makes a distinction between someone who provides a legal service and someone whose occupation or profession is something other than the law, but by virtue of their expertise provides an opinion about the law in the area of their knowledge.[7] Examples may include accountants, tax agents, financial planners, architects, town planners, building surveyors, customs agents, migration agents, forensic scientists and private investigators.

Should your firm take advantage of the new Act?

Legal practices are also businesses, and as such these businesses now have access to the full range of business models available to other businesses. The table below summarises the financial and taxation attributes that we consider to be of most importance when choosing one business model over another.

Structure

Business attributes

Sole practitioner

Privacy (no returns lodged with ASIC); simplicity; no income streaming (other than via a service trust – see below); personal tax rates; access to most CGT concessions; no asset protection; use if professional rules prohibit incorporation; business can be rolled over into a company at a later date.

Company

Use where several families are involved; stakeholders have a fixed interest in the assets and income of the business; profits can be retained in the business to finance growth at a favourable tax rate (30 per cent); limited liability; can grant a charge over chattels and choses in action to secure external debt; perpetual succession; useful if business is part of a wider group and there is a need to move assets and income around the group (i.e. by entering the tax consolidation regime); maximum tax deductions available for contributions to superannuation; flexibility in regard to managing succession; most CGT concessions and rollovers denied unless entity enters the tax consolidation regime; franking credits can become trapped.

Fixed trust

Privacy; can be simpler than a company (no returns lodged with ASIC); ownership and income distribution flexibility (may require a family trust election); use where several families involved in the business; limited liability (by use of a corporate trustee); access to CGT 50 per cent discount and small business CGT relief (need controlling individual); tax concessions flow through to beneficiaries; entity can enter the tax consolidation regime; losses can be trapped in the trust; business can be rolled over into a company at a later date.

Discretionary trust

Privacy; simplicity; significant ownership and income distribution flexibility (may require a family trust election); best when business owned and operated by one family; some limited liability; access to CGT 50 per cent discount and small business CGT relief; tax concessions flow through to beneficiaries; losses can be trapped in the trust; business can be rolled over into a company at a later date.

Partnership of individuals

Privacy; simplicity; some flexibility in regard to distribution of income; marginal tax rates; if business will be trading at a loss (perhaps during start-up) these losses can be set off against other income; access to CGT 50 per cent discount and small business CGT relief; business can be rolled over into a company at a later date; no limited liability.

Partnership of trusts

Privacy; simplicity; use where two or three principals from different families; maximum ownership and income distribution flexibility; some limited liability; losses can be set off against other trust income; unused losses will be trapped in the trusts; access to CGT 50 per cent discount and small business CGT relief; business can be rolled over into a company at a later date; a very technical argument exists that the structure is not possible because of the inherent conflict between the fiduciary obligations owed by each partner to the others and the separate fiduciary obligation that each trustee owes to its beneficiaries.

Service entities
Many law firms use a service entity. While service entities come in many shapes and forms they are usually trusts, and their essential character is that the legal practice incurs a deduction for the acquisition of clerical and administrative support services, premises and plant and/or equipment from the service trust. Common features of a service trust include:

  • the taxpayer is a member of a professional organisation which traditionally had rules prohibiting the use of companies and/or trusts as the trading entity (e.g. lawyers, doctors, dentists, accountants, pharmacists), therefore the taxpayer typically carries on their professional practice as a sole practitioner or partnership;
  • there is a trust that is controlled by the professional practice;
  • the practice enters into an agreement to pay certain fees and charges to the service trust in return for the supply of a range of goods and services;
  • the practice claims a deduction for the service fees and charges as expenditure incurred in the conduct of its business (this has the effect of transferring income to the service trust); and
  • the profits derived by the service trust are distributed, directly or indirectly, to the practitioner and/or to associates of the practitioner.

These arrangements are sometimes called Phillips trust arrangements after the Full Federal Court decision in Federal Commissioner of Taxation v Phillips.[8] The commercial reasons for a Phillips trust are said to be:

  • to place tangible assets in an entity separate to the professional practice to protect those assets from creditors of the practice; and
  • to allow professionals to share the income from professional practice with associates, in exchange for an investment in the tangible assets used in the practice, where those associates are otherwise prohibited from sharing income because of ethical/legal rules that restrict membership of the profession.

The Commissioner has always distrusted these arrangements (as being no more than income splitting). However, since 1978 the Commissioner’s position has been that service fees paid to a related entity for use of assets and employees are deductible as long as the services being provided are connected with the taxpayer’s income earning activities and the service fees charged are not grossly excessive.[9] Most official Australian Tax Office comments over the years have concentrated on the level of mark-up (i.e. the difference between the cost to the service entity and the fees charged) and whether it is reasonable. However, the Commissioner has recently issued draft taxation ruling TR 2005/D5. This focuses more attention on the need to establish commerciality of the arrangement, both in relation to the reason for the arrangement and the level of the service fees charged. And while the draft ruling does not purport to say that Phillips trusts do not work, the explanation and the examples provided in the draft ruling adopt a much tougher stance as to what the Commissioner will find acceptable.

While taxpayers are awaiting further guidance from the Commissioner as to what will be acceptable, it appears fair to say that many professional practices must seriously consider collapsing their service trust arrangements. We say this because the draft ruling:

  • suggests that use of service trusts as part of an asset protection strategy is not sufficient reason to allow the tax deductions associated with the arrangement;
  • places a significant compliance burden on taxpayers because of the need to continually check to ensure that the terms of the arrangement remain commercially justifiable; and
  • appears to require the parties to the arrangement to be at arm’s length when by the very nature of the arrangement the parties are related.

Fortunately, the advent of the new Act means that law firms no longer need to have a service trust. Instead, the new Act allows law firms to restructure in such a way that they obtain limited liability, access to external funds and the sharing of income with non-lawyers.

Conclusion

There is no one best business model. Each practice will have to weigh up the features, advantages and benefits of each basic model (sole trader, partnership, trust or company) and the many hybrid models (partnership of trusts etc., licensing another entity to conduct the practice) before deciding how to structure their business for the future. The following are two possible models.

Incorporated legal practice

figure1

The model described in Figure 1 might be appropriate in the following circumstances:

W is a new partner who acquires equity in the practice company via a family trust. W may or may not be a lawyer.

X and Y were the original partners of the firm. They intend that they will always vote their shares as a block and they require sufficient shares to ensure they decide who will be appointed to the board.

Alternatively, a shareholders’ agreement could provide that W and Z can appoint one director if they are, for example, unanimous as to who that person will be.

X and Y become the legal practitioner directors.

The consent of either W or Z will be required before X and Y can pass a special resolution.

Z might be a company limited by guarantee. The company’s constitution may provide, among other things, that any employee of the firm with at least five years service can apply for membership.

W and Z will only obtain statutory accounts. X and Y, as directors, will continue to receive full management accounts.

Multi-disciplinary partnership

Figure2

The partnership agreement between the entities described in Figure 2 could provide that the income is attributable to the partners in the following manner:

The company that holds the Australian Financial Services Licence is paid 50 per cent of all fees earned by that part of the practice. The company will receive the income on trust for the unit trust and it will be distributed to unit holders.

The migration agent and the lawyer are entitled to drawings of $100,000 each. The migration agent will receive the income on trust for his family trust and that income can be distributed widely and in different proportions each year.

Fifty per cent of the net profit before tax but after drawings and licence fees (or a fixed amount) is payable to the company that provides the capital used in the business.[10]

The remaining income is shared equally between the partners.[11]

At a later date one or more of the businesses conducted by the partnership can be sold, perhaps to an ILP controlled by the partners, and the partners can defeat capital gains tax by using either:

  • the 50 per cent CGT discount[12] and the small business capital gains tax concessions[13] (if certain conditions are met); or
  • if the business is sold to a company that they control (and certain other conditions are met), rollover of the capital gain into the shares that they acquire in the new ILP.[14]

KEITH HARVEY is the principal of Ambry Legal, a fellow of CPA Australia, the Australian Institute of Banking and Finance and the Taxation Institute of Australia. He is also a member of the LIV Commercial Law Section Executive Committee. ANNA TANG is an associate with Ambry Legal, practising in taxation and commercial law. She is also a fellow of the Taxation Institute of Australia.


[1] Refer to s2.7.4.

[2] Schedule 2, cl 2.4.

[3] An ILP is not permitted to conduct a managed investment scheme or a business that is prohibited by the Regulations (refer to ss2.7.5(2) and (3)).

[4] A legal practitioner director who fails to take such steps may be guilty of unsatisfactory professional conduct or misconduct under the new Act.

[5] This is compared to the current Act where both directors and shareholders will be liable in this instance

[6] A legal practitioner director who fails to take such steps may be guilty of unsatisfactory professional conduct or misconduct under the new Act: refer to s2.7.39.

[7] See Felman v Law Institute of Victoria [1998] 4 VR 324 at 350.

[8] 78 ATC 4261.

[9] Refer to taxation ruling IT 276.

[10] This income will be taxed at 30 per cent, leaving 70 cents in the dollar to fund growth in the partnership’s balance sheet. In this event, franking credits will accrue for use at a later date. The company can give a mortgage debenture charge over these assets to secure external funding.

[11] Employment on-costs such as payroll tax will not be payable on the income paid to partners whereas these on-costs will be payable on a shareholder’s salary.

[12] Div 115 Income Tax Assessment Act 1997

[13] Div 152 Income Tax Assessment Act 1997.

[14] Div 122B Income Tax Assessment Act 1997.

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