Law firms, incorporated

Richard Hill By Richard Hill
from Stepien Lake and chair, ILFM

This blog post was also featured as a column in the May 2014 issue of Legal Practice Management magazine. To read the issue in full, download LPM magazine (14MB file).

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It has long been the perception that the legal industry generally is not the most forward-thinking of industries (as much a truism as accountants being boring), but there are more reasons now than ever before for legal practices to review their business structures. 

There has been a steady increase of legal firms incorporating into limited companies. Many firms have already recognised what they envisage as the key advantage of incorporation – limitation of liability. While PII protects client interest, the limited company status also gives protection for the owners from creditors. However, banks or landlords will still seek high security over debts, so may still ask for personal guarantees, although there is the option where banks could also seek a debenture over the assets of the company.

This leads us onto another driving factor behind incorporation – finance. Self-finance is becoming more pertinent when firms are apparently finding banks less willing to lend. A company vehicle is ideal for external investment (ABS) and a more tax-efficient vehicle than an LLP for retaining profits for reinvestment in the firm. Despite being liable for corporation tax, the company will not be taxed further until the profits are extracted. In effect, the conversion can be a shift to a capital model away from the traditional partnership income model.

That brings us onto another consideration when incorporating – tax. In the past, firms have incorporated with a potential tax incentive in mind regarding the creation of goodwill. Goodwill is an intangible asset of any profitable business and is the additional value (eg, reputation, brand recognition and repeat business) in excess of the net assets (or book value). In short, the new limited company purchases the goodwill from the partners. The new limited company then has an asset (the goodwill) and a liability being the amount transferred into the new company’s directors’ loan account (the directors being the same partners that sold the goodwill). The formation of goodwill for the incorporation will trigger a one-off capital gains tax charge (lower than income tax at 18% or 28%) and it is also feasible that entrepreneurs’ relief might apply, which could reduce the tax charge still further. The directors can then draw their share of the goodwill payment from the loan accounts without any further tax payments.

This sounds very simple, but the reality is that any structure solely created for tax purposes is likely to be vulnerable to investigation by the HMRC and their interpretation of the valuation of goodwill upon notification.

Considering the tax implications is imperative, as directors of a limited company suffer a double whammy with tax, as they are no longer self-employed. The company pays corporation tax on profits and then the profit (and so cash) is distributed in the form of dividends, which is taxable income for the recipients. The directors (former partners) would be paid a salary and the change from self-employed status would also affect any fixed-share equity partners in the existing partnership (or LLP) as well as increase the employer’s NI contributions.

The payments of tax can be easier to plan for in a smaller limited company, avoiding the spikes of 31 January and 31 July. Corporation tax is payable nine months after the company’s year-end, allowing more time to ensure the cash is there to cover the liability.

Limited companies can offer better succession planning by attracting younger partners that may be comforted by the limited liability – the risks of ownership are higher than 10-20 years ago. Limited companies can allow staged buy-in of shares and, on retirement, a partner could conceivably sell their ‘shares’ to realise a gain.

Incorporating can provide some firms with the ideal structure for business investment and attracting new talent, but careful planning and advice should be sought. You never know – it could even highlight those firms that strategically plan and understand their business models, eradicating the “old-fashioned” tag that the legal industry is tarnished with. 

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