To PC or Not to PC

Some partners in multi-state partnerships have recently rediscovered the benefits of becoming a professional corporation (PC) partner in their law firms, primarily to obtain state income tax savings. Where the advantages outweigh the disadvantages, some firms have accommodated (and in some cases, encouraged) some of their partners to consider this alternative. A by-product of the influx of PC partners is that a number of multi-state law firms will consist of both incorporated and unincorporated partners, and partnership agreements must be reviewed (and in some cases amended) to accommodate this arrangement and deal with ancillary consequences.

Lawyers have used PCs to act as members of law firms for over 30 years. When first popularized, PC partners obtained significant pension and income tax benefits.

When PCs are formed and operated properly, the IRS and the courts have approved the effectiveness of the PC strategy. Some firms' structures might include among its partners individuals, S corporations and C corporations (each owned by an individual shareholder-employee).

The pension and tax advantages provided to the owner-employees of PCs were substantially reduced or eliminated by tax legislation in the early 1980s. As a result, the incentive for forming PCs was largely curtailed. Although the personal liability shield of PCs remained attractive in comparison to operation in general partnership form, at least with respect to certain (non-guaranteed) contractual obligations of the law firm, lawyers ultimately remain potentially liable for their own wrongdoings (ie, the limited liability shield does not protect one from one's own torts, including malpractice), regardless of the form of entity employed.

Many lawyers who had formed PCs found that extricating themselves from the corporate form could generate adverse tax consequences. For example, if one wished to liquidate one's PC and operate as an individual partner in the law firm, the liquidation event might accelerate income and/or trigger gain (including the value of any goodwill deemed owned by the corporation and transferred to the individual shareholder).

After the rise and post-1980s fall of incorporated partners, anecdotal evidence indicates a recent rebirth in the use of PCs for partners of profitable multi-state law partnerships, to provide aggregate (multi-state) income tax savings for some or many of the firms' highly-paid partners. As described below, the PC structure is particularly useful for highly profitable law firm partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs) ' taxable as partnerships that have a substantial amount of their income attributable to offices in states having high income tax rates applicable to individual partners.

In a typical favorable scenario, the firm will have at least one office located in a low or zero individual income tax rate state (eg, Florida, Texas or Illinois) and at least one other office in a relatively high tax bracket state (eg, California or New York). Due to long-established rules on apportionment of a partnership's income for state tax purposes, those partners who physically reside and practice primarily in the zero or low tax rate state nonetheless are subject to a substantial out-of-state tax liability. If a substantial portion of the firm's income is allocable to high-rate states, the problem is magnified.

The individual partners in the low tax rate states are penalized by having to pay income taxes on a substantial amount of out-of-state income taxed at high rates, and receiving only a zero or low out-of-state tax credit against their resident state's income tax liability. For example, Illinois only provides a 3% (maximum) tax credit for an individual's out-of-state taxes, even if Illinois partners pay taxes at rates exceeding 8% elsewhere on their out-of-state apportioned income. Texas and Florida resident partners (who pay no home-state income taxes) face the highest tax differential on partnership income allocated to high tax rate states.

Unfortunately, the multi-state tax rules provide no offsetting income tax benefit for the law firm's other partners working or residing in high tax rate states. In our example, a partner residing in a high tax rate state (paying say 8% on all of allocable income) must pay taxes on his or her out-of-state income, which may be taxed at a much lower rate. Thus, a California partner in a firm with a substantial amount of Illinois income will pay 3% income taxes on his or her Illinois-apportioned income. However, California will still require the partner to pay 8% on the total partnership income, and at most give a 3% credit for the Illinois tax paid. As a result, the California partner still pays 8% on the Illinois apportioned income ' 3% being payable to Illinois, and 5% to California, by difference. (This over simplifies the out-of-state tax credit analysis, but shows that law partners in high tax rate states usually are relatively indifferent to the apportionment of income, while their partners residing in low or zero tax rate states are potentially materially worse off on their income apportioned to the high tax rate states.)

The PC structure may mitigate this multi-state tax problem for those partners residing and practicing in low or zero tax rate states. If the low tax rate state individual partner transfers his or her partnership interest to a wholly owned PC, and the corporation annually pays W-2 salary, payroll taxes and other expenses equal to the PC's net income (before compensation), then his or her compensation presumably would be deemed to be earned and received in the state in which the partner provides services (ie, the low tax rate state). As a result, the PC (which itself would remain subject to multi-state income allocation on its net income, if any) would largely protect the attorney-shareholder from being subject to taxation in the high tax rate states.

The author is unaware of any state tax cases or rulings as to the viability of this solution. However, anecdotal evidence indicates that numerous individual partners residing in low tax rate states and facing this multi-state tax problem have chosen to go this route in the past few years, and some firms have chosen to accommodate this result.

Doing the Math

A cost/benefit analysis is appropriate for individual partners considering incorporation. Stated simply, is the state income tax savings generated by use of the PC-partner format worth the effort? Calculation of the potential state tax savings is not easy and requires annual, intricate computations as to the individual's federal, state and local tax liability, prognosticating the firm's ever-changing allocation or apportionment of its income among the various jurisdictions in which it conducts business, and several other factors.

Assume for purposes of argument that a law firm partner practicing in a low tax rate state making $500,000 (or more) per year might save $5000-$15,000 a year in state taxes by using the PC format. Is the savings worth the effort?

First, consider the tax treatment of the incorporation of the partner's law firm interest. If, at the moment of incorporation, the individual's partnership interest has a negative capital account for tax purposes, the transfer may generate gain (taxable in whole or substantial part as ordinary income).

Second, consider whether the state tax savings will by itself result in a somewhat larger federal income tax liability for the partner, thereby reducing the perceived PC advantage. Specifically, if the individual partner is not subject to the federal alternative minimum tax, the amounts paid for state income taxes are deductible for federal income tax purposes as itemized deductions and generally provide substantial tax savings to the individual on his or her Form 1040. Thus, a computed savings (by going the incorporated partner route) of (say) $10,000 per year for state taxes ultimately may be worth only $6500 to the individual, who (had he or she not 'incorporated' his or her partnership interest) would have deducted the $10,000 additional state taxes on Form 1040, Schedule A, and thereby reduced federal income taxes by (say) $3500.

Not an Easy Choice

The choice of form of entity for lawyers is deceptively complex. If the lawyer chooses to incorporate his or her partnership interest, the selection of C or S corporation status must be considered. Matters such as annual cash flow differences arising from the different timing between FICA tax withholding (required in the early months of the calendar year for W-2 employees, until they reach the FICA ceiling) and self-employment tax (which effectively is payable by the unincorporated partner on earnings from the firm in four payments spread out during the year is just one difference that flows from operation as a PC partner. Getting almost all of the PC's annual net income paid out by each December 31 can be a major challenge.

The administrative, planning and ongoing strategic and operative questions (and hassles) that arise from a partner's operating in PC form should not be understated. Many partners that have operated in PC form for a number of years can attest to the problems of doing it right.

The politically charged question of who pays for the costs of administration, tax return preparation, tax planning, organization, licensing, filing, operation, maintenance and ultimate liquidation, dissolution and unlicensing of the corporation must be explored. If the firm provides this service, will only those partners that benefit from corporate status be charged for the cost? Would this substantially reduce or eliminate the tax savings benefit? If, instead, the firm subsidizes those incorporated partners, will that cause friction among the other partners that obtain no benefit from corporate status themselves? Will those law firm partners that spend substantial (non-billable) time in overseeing their firm's PC partners be adequately compensated for undertaking the care and nurturing of the PCs? If not, the PCs may not get proper attention. If, instead, outside service providers are employed, will those costs be managed, and who (on behalf of the firm and/or its PCs) will supervise the outsiders?

The firm faces a Hobson's choice with respect to its PC partners. If the firm conscientiously oversees all formation, operation and liquidation aspects of the PCs, including payroll payments, payroll and income tax return filings and year-end planning (to minimize the PC's net taxable income), the costs may substantially reduce the computed tax savings. If the firm does not provide those functions, there's the risk that an outside payroll service company may prove unsatisfactory, or that certain of the incorporated partners are (overly?) aggressive on their individual PC's tax return positions. Might the audit of one aggressive PC partner (with adjustments resulting in taxes and interest) lead to audits of the firm's other PCs (including those taking more conservative tax reporting positions)? Still worse, might the audit of an aggressive PC lead to an audit of the law firm partnership itself? Even if no tax adjustments arise from such audits, is the cost and hassle arising from responding to IRS and state tax agencies' information requests (and possibly mounting an audit defense) worth the aggravation?

The tax costs of liquidation of the PC may be formidable; adopting PC status has been described as a lobster trap. See, Banoff, 'Shop Talk, Are Personal Service Corporations Back in Style?' Journal of Taxation, Vol. 105, pg. 62 (July 2006). Assuming the analysis otherwise marginally favors forming PCs, the (potentially) material adverse tax consequences of ultimately trying to unwind the corporation on a tax-neutral basis may weigh against going the PC route at this time. Nonetheless, when the savings for individual, highly paid (and important) partners may substantially exceed $10,000 per year, it is easier for them to downplay the potential negatives described above.

Also to be weighed in the equation: Will the high-tax states ultimately recognize the validity of the PCs, which (this time around) are providing primarily state tax (rather than pension law) benefits or a personal limited liability shield? If not, then the upside of the planning will not be achieved, but the downsides may continue to exist (particularly if, the PC's creation, existence and liquidation are all given effect for federal income tax purposes!). Only time will tell.

Some partners in multi-state partnerships have recently rediscovered the benefits of becoming a professional corporation (PC) partner in their law firms, primarily to obtain state income tax savings. Where the advantages outweigh the disadvantages, some firms have accommodated (and in some cases, encouraged) some of their partners to consider this alternative. A by-product of the influx of PC partners is that a number of multi-state law firms will consist of both incorporated and unincorporated partners, and partnership agreements must be reviewed (and in some cases amended) to accommodate this arrangement and deal with ancillary consequences.

Lawyers have used PCs to act as members of law firms for over 30 years. When first popularized, PC partners obtained significant pension and income tax benefits.

When PCs are formed and operated properly, the IRS and the courts have approved the effectiveness of the PC strategy. Some firms' structures might include among its partners individuals, S corporations and C corporations (each owned by an individual shareholder-employee).

The pension and tax advantages provided to the owner-employees of PCs were substantially reduced or eliminated by tax legislation in the early 1980s. As a result, the incentive for forming PCs was largely curtailed. Although the personal liability shield of PCs remained attractive in comparison to operation in general partnership form, at least with respect to certain (non-guaranteed) contractual obligations of the law firm, lawyers ultimately remain potentially liable for their own wrongdoings (ie, the limited liability shield does not protect one from one's own torts, including malpractice), regardless of the form of entity employed.

Many lawyers who had formed PCs found that extricating themselves from the corporate form could generate adverse tax consequences. For example, if one wished to liquidate one's PC and operate as an individual partner in the law firm, the liquidation event might accelerate income and/or trigger gain (including the value of any goodwill deemed owned by the corporation and transferred to the individual shareholder).

After the rise and post-1980s fall of incorporated partners, anecdotal evidence indicates a recent rebirth in the use of PCs for partners of profitable multi-state law partnerships, to provide aggregate (multi-state) income tax savings for some or many of the firms' highly-paid partners. As described below, the PC structure is particularly useful for highly profitable law firm partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs) ' taxable as partnerships that have a substantial amount of their income attributable to offices in states having high income tax rates applicable to individual partners.

In a typical favorable scenario, the firm will have at least one office located in a low or zero individual income tax rate state (eg, Florida, Texas or Illinois) and at least one other office in a relatively high tax bracket state (eg, California or New York). Due to long-established rules on apportionment of a partnership's income for state tax purposes, those partners who physically reside and practice primarily in the zero or low tax rate state nonetheless are subject to a substantial out-of-state tax liability. If a substantial portion of the firm's income is allocable to high-rate states, the problem is magnified.

The individual partners in the low tax rate states are penalized by having to pay income taxes on a substantial amount of out-of-state income taxed at high rates, and receiving only a zero or low out-of-state tax credit against their resident state's income tax liability. For example, Illinois only provides a 3% (maximum) tax credit for an individual's out-of-state taxes, even if Illinois partners pay taxes at rates exceeding 8% elsewhere on their out-of-state apportioned income. Texas and Florida resident partners (who pay no home-state income taxes) face the highest tax differential on partnership income allocated to high tax rate states.

Unfortunately, the multi-state tax rules provide no offsetting income tax benefit for the law firm's other partners working or residing in high tax rate states. In our example, a partner residing in a high tax rate state (paying say 8% on all of allocable income) must pay taxes on his or her out-of-state income, which may be taxed at a much lower rate. Thus, a California partner in a firm with a substantial amount of Illinois income will pay 3% income taxes on his or her Illinois-apportioned income. However, California will still require the partner to pay 8% on the total partnership income, and at most give a 3% credit for the Illinois tax paid. As a result, the California partner still pays 8% on the Illinois apportioned income ' 3% being payable to Illinois, and 5% to California, by difference. (This over simplifies the out-of-state tax credit analysis, but shows that law partners in high tax rate states usually are relatively indifferent to the apportionment of income, while their partners residing in low or zero tax rate states are potentially materially worse off on their income apportioned to the high tax rate states.)

The PC structure may mitigate this multi-state tax problem for those partners residing and practicing in low or zero tax rate states. If the low tax rate state individual partner transfers his or her partnership interest to a wholly owned PC, and the corporation annually pays W-2 salary, payroll taxes and other expenses equal to the PC's net income (before compensation), then his or her compensation presumably would be deemed to be earned and received in the state in which the partner provides services (ie, the low tax rate state). As a result, the PC (which itself would remain subject to multi-state income allocation on its net income, if any) would largely protect the attorney-shareholder from being subject to taxation in the high tax rate states.

The author is unaware of any state tax cases or rulings as to the viability of this solution. However, anecdotal evidence indicates that numerous individual partners residing in low tax rate states and facing this multi-state tax problem have chosen to go this route in the past few years, and some firms have chosen to accommodate this result.

Doing the Math

A cost/benefit analysis is appropriate for individual partners considering incorporation. Stated simply, is the state income tax savings generated by use of the PC-partner format worth the effort? Calculation of the potential state tax savings is not easy and requires annual, intricate computations as to the individual's federal, state and local tax liability, prognosticating the firm's ever-changing allocation or apportionment of its income among the various jurisdictions in which it conducts business, and several other factors.

Assume for purposes of argument that a law firm partner practicing in a low tax rate state making $500,000 (or more) per year might save $5000-$15,000 a year in state taxes by using the PC format. Is the savings worth the effort?

First, consider the tax treatment of the incorporation of the partner's law firm interest. If, at the moment of incorporation, the individual's partnership interest has a negative capital account for tax purposes, the transfer may generate gain (taxable in whole or substantial part as ordinary income).

Second, consider whether the state tax savings will by itself result in a somewhat larger federal income tax liability for the partner, thereby reducing the perceived PC advantage. Specifically, if the individual partner is not subject to the federal alternative minimum tax, the amounts paid for state income taxes are deductible for federal income tax purposes as itemized deductions and generally provide substantial tax savings to the individual on his or her Form 1040. Thus, a computed savings (by going the incorporated partner route) of (say) $10,000 per year for state taxes ultimately may be worth only $6500 to the individual, who (had he or she not 'incorporated' his or her partnership interest) would have deducted the $10,000 additional state taxes on Form 1040, Schedule A, and thereby reduced federal income taxes by (say) $3500.

Not an Easy Choice

The choice of form of entity for lawyers is deceptively complex. If the lawyer chooses to incorporate his or her partnership interest, the selection of C or S corporation status must be considered. Matters such as annual cash flow differences arising from the different timing between FICA tax withholding (required in the early months of the calendar year for W-2 employees, until they reach the FICA ceiling) and self-employment tax (which effectively is payable by the unincorporated partner on earnings from the firm in four payments spread out during the year is just one difference that flows from operation as a PC partner. Getting almost all of the PC's annual net income paid out by each December 31 can be a major challenge.

The administrative, planning and ongoing strategic and operative questions (and hassles) that arise from a partner's operating in PC form should not be understated. Many partners that have operated in PC form for a number of years can attest to the problems of doing it right.

The politically charged question of who pays for the costs of administration, tax return preparation, tax planning, organization, licensing, filing, operation, maintenance and ultimate liquidation, dissolution and unlicensing of the corporation must be explored. If the firm provides this service, will only those partners that benefit from corporate status be charged for the cost? Would this substantially reduce or eliminate the tax savings benefit? If, instead, the firm subsidizes those incorporated partners, will that cause friction among the other partners that obtain no benefit from corporate status themselves? Will those law firm partners that spend substantial (non-billable) time in overseeing their firm's PC partners be adequately compensated for undertaking the care and nurturing of the PCs? If not, the PCs may not get proper attention. If, instead, outside service providers are employed, will those costs be managed, and who (on behalf of the firm and/or its PCs) will supervise the outsiders?

The firm faces a Hobson's choice with respect to its PC partners. If the firm conscientiously oversees all formation, operation and liquidation aspects of the PCs, including payroll payments, payroll and income tax return filings and year-end planning (to minimize the PC's net taxable income), the costs may substantially reduce the computed tax savings. If the firm does not provide those functions, there's the risk that an outside payroll service company may prove unsatisfactory, or that certain of the incorporated partners are (overly?) aggressive on their individual PC's tax return positions. Might the audit of one aggressive PC partner (with adjustments resulting in taxes and interest) lead to audits of the firm's other PCs (including those taking more conservative tax reporting positions)? Still worse, might the audit of an aggressive PC lead to an audit of the law firm partnership itself? Even if no tax adjustments arise from such audits, is the cost and hassle arising from responding to IRS and state tax agencies' information requests (and possibly mounting an audit defense) worth the aggravation?

The tax costs of liquidation of the PC may be formidable; adopting PC status has been described as a lobster trap. See, Banoff, 'Shop Talk, Are Personal Service Corporations Back in Style?' Journal of Taxation, Vol. 105, pg. 62 (July 2006). Assuming the analysis otherwise marginally favors forming PCs, the (potentially) material adverse tax consequences of ultimately trying to unwind the corporation on a tax-neutral basis may weigh against going the PC route at this time. Nonetheless, when the savings for individual, highly paid (and important) partners may substantially exceed $10,000 per year, it is easier for them to downplay the potential negatives described above.

Also to be weighed in the equation: Will the high-tax states ultimately recognize the validity of the PCs, which (this time around) are providing primarily state tax (rather than pension law) benefits or a personal limited liability shield? If not, then the upside of the planning will not be achieved, but the downsides may continue to exist (particularly if, the PC's creation, existence and liquidation are all given effect for federal income tax purposes!). Only time will tell.