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Tax: Structuring Law Firms: ILPs and related tax issues

Feature Articles

Cite as: (2008) 82(10) LIJ, p. 68

Any restructure of a law firm into an incorporated legal practice needs to take into account related tax issues.

The LIV has been liaising with the Australian Tax Office (ATO) on tax issues associated with the incorporation of legal practices.

In recent informal discussions with various bodies the ATO flagged that it could have concerns about tax issues associated with service trusts, incorporation of legal practices and partnerships of trusts, and would be gathering further information to come to a view on these issues.

Although service entities tax issues have been around for some time, the ATO has stated that it will carefully monitor changes in professional structures to determine (among other taxation issues) whether the underlying risk of income alienation has subsided.

In 2006 the ATO released its guidelines concerning the tax treatment of businesses using service entity arrangements. The Commissioner’s approach since then has been to manage the compliance activities of such entities in accordance with the guidelines.

As part of this monitoring process the Commissioner was to consult with various firms last month to discuss particular concerns he has flagged in relation to the incorporation and operation of legal practices.

The LIV has made submissions to the ATO on the tax issues associated with incorporation of legal practices.

A key issue is the treatment of goodwill. For example, if a law firm’s partnership agreement specified a particular formula or methodology for determining the buy-in or exit price for partners, and that formula or methodology was carried over into the constitution or shareholders agreement for an incorporated practice, would the ATO accept this formula or methodology as producing the market value for the shares in the incorporated practice?

The LIV has argued to the ATO that it should.

 Another matter of interest involves how the Commissioner will treat any roll-over capital gains issues arising from the incorporation of “no goodwill” partnerships into “no goodwill” companies.

Under a standard “no goodwill” partnership agreement, partners do not pay, nor are they entitled to, any amounts for goodwill when joining or leaving a partnership.

In such circumstances, the Commissioner does not apply the CGT market value substitution rules, on the presumption that the partners have carried out the transaction at arm’s length. However, where such a partnership is incorporated (or where a partner seeks to enter or leave an incorporated legal practice), it is unclear whether the Commissioner will deem a capital gain to arise by applying the market value substitution rules as described under the various employee share acquisition and CGT provisions.

The LIV and the Law Council of Australia have both raised this issue in submissions lodged with the ATO.

We are of the view that there should be no CGT consequences arising from where a shareholder (partner) is admitted or is leaving the incorporated “no goodwill” practice. This would be consistent with the ATO’s position in relation to the CGT treatment of partnerships which adopt “no goodwill” practices.

Despite these various submissions, the ATO has not announced its position on these issues.

It is understood that the ATO has also raised concerns that professional firms may be using their incorporated structures in order to shift profits to the service trust’s beneficiaries while artificially increasing deductions to the partnership.

In evaluating compliance, the ATO has indicated that it will focus on the relationship between the parties and will use various transfer pricing principles to ensure that dealings have been undertaken at arm’s length.

The incorporation of legal practices can be advantageous. However, every law firm operates its business differently, and therefore many varieties of incorporated structures are possible, each with its own tax implications.

The LIV does not endorse any particular form of structure for incorporation of legal practices.

In restructuring an existing partnership (and even in establishing a structure for a new practice) there are many tax issues to consider. In moving from an existing structure to a new structure, whether it be incorporation of a practice or adoption of a partnership of trusts or some other structure, the commercial rationale for adoption of the structure must predominate, otherwise the ATO may be able to use the general anti-avoidance provisions (Part IVA ITAA 1936) to strike down the tax benefits associated with the structure.

Given the uncertainty about the ATO’s position, it is important to be aware of the issues and seek tax advice before undertaking any restructuring activities or establishing a new practice.

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