Choosing the Legal Form of a Service or Professional Business — an Urban Legend

Jonathan Davis Jonathan Davis

There are good reasons to organize a professional practice or other service business as a limited liability company (LLC) or a limited liability partnership (LLP), and there may also be good reasons not to.  But, the matter is complicated and sometimes what is thought to be a good reason turns out to be no reason.

In very general terms, major reasons to organize a professional practice or other service business as an LLC or an LLP include (a) that the business owners are often substantially protected from personal liability for the business’ own debts;  (b) it’s easier to have different percentages of tax characteristics (i.e., taxable income, losses, credits) and different proportions of cash distributions awarded to different owners –  that is, the owners don’t all have to march in lockstep the way stockholders of a corporation are usually required to;  and (c) only the owners are taxed on the business profits (unlike a corporation where profits are first taxed to the business entity and then, a second time, to the owners).

There is often thought to be another attraction to using a non-corporate form.   This attraction is that if one of the owners  retires or otherwise leaves the business and transfers his/her ownership interest back to the business, the Internal Revenue Code gives the owners an opportunity to decide among themselves whether (a) to have some of the payments to the departing owner for his/her interest in partnership property  treated as capital gain (favorable to the departing owner) but with the remaining owners reporting the same amount as income on their own tax returns (not  favorable to the remaining owners) – or, (b) to have some of the payments to the departing owner for his/her interest in partnership property treated as ordinary income (usually not favorable to the departing owner) but allowing the remaining owners to reduce their income from the business by the same amount (favorable to the business and the remaining owners).  It may be especially beneficial to the business to shift ordinary income and income tax to the departing owner because payments to the departing owner will, by themselves, take money out of the business, and if some of the income tax burden is not shifted from the business to the departing owner the cash flow drain on the remaining owners will be greater.

How the matter is resolved – with payments reducing the business’ income (and the departing partner reporting more of the payments as ordinary income rather than capital gain), or with payments not reducing the business’ income (and the remaining owners taking part of the payments onto their own income tax returns while the departing owner takes the payments as more favorable capital gain) may depend upon the relative bargaining powers of the remaining owners and the departing owner, or it may depend upon whether the partners take a short term or longer term view of their true best interests.  But, the point is that a noncorporate form of business may present this opportunity to shift taxable income between the remaining owners and the departing owner.  This idea is often a factor in organizing professional practices like medical groups, dental practices, law firms, architecture firms, engineering firms, and other service businesses.

However, it turns out that this opportunity to negotiate a shift of a service business’ taxable income and tax liability onto the departing owner and away from the remaining owners may not always apply – and, in the future, may apply less and less as new service businesses are formed.  The reason is a provision of the US Internal Revenue Code – sec. 736(b)(3)(B) – that requires that in order to cause part of the payment to a departing owner to reduce the business’ income and shift income tax from the remaining owners to the departing owner, the departing owner must have been a “general partner”.

In 1993, Congress specifically targeted service businesses for this special tax relief partly by requiring that a business be a service business (Code sec. 736(b)(3)(A)), but also by requiring that the departing owner be“general partners”.   (Code sec. 736(b)(3)(B)).

That was then, in 1993 – but this is now.  Nowadays, service businesses – and professional practices in particular – have a greater menu of business formats to choose from (like LLCs, LLPs).   These have the non-tax advantage of, to a greater or lesser extent, insulating owners from the business’ own debts and other obligations.  Yet, an  important aspect of being a “general partner” is that the general partner is liable for the business’ debts and other obligations.  Therefore, it would seem that the advent of LLCs and LLPs, and their increasing use by new professional and other service businesses, is moving professional practices and other service businesses away from the tax break that Congress had intended for them.

Without the tax break, the general rule would seem to apply that payments to a departing owner for his/her interest in the business’ assets do not shift ordinary income and tax from the remaining owners to the departing owner, and the departing owner reports capital gain rather than ordinary income.

Conclusion – When professionals or other service providers are organizing a service business, there may be many advantages to using one of the newer non-corporate business formats like an LLC or  LLP, but the attraction of being able to trade off ordinary income tax treatment between a retiring owner, on the one hand, and the remaining owners, on the other hand, is more likely to be an urban legend than a reality.   Deciding what business format to use is usually not straightforward, and there are many issues to consider.

Afterthoughts –

Surprisingly, there appears to be little in the tax law that defines the term “general partner” for purposes of the Internal Revenue Code.   See, for example, the case of Garnett v. Commissioner, 132 TC 368, 377 (2009), where the Tax Court lamented the lack of a tax law definition of “general partner”, but then decided to interpret the term “general partner” in connection with a different part of the income tax law, the “passive activity loss” rules, and held that, for that specific purpose, an LLC member is a general partner.

Perhaps, in the future, the IRS or a court will similarly interpret the term “general partner” in Code sec. 736(b)(3)(B) to reach LLC members or LLP partners – but, so far, that has not happened.

Another approach is outlined in both the House Ways and Means Committee report describing Code sec. 736(b)(3) and, also, in the case Wallis v. Commissioner, TC Memo 2009-243 (2009), affd. 391 Fed Appx. 826 (2010).   Both the Report and the Wallis case, provide that a non-corporate business may create an unfunded non-qualified deferred compensation plan for its owners, and when an owner departs payments by the business to the departing owner can reduce the business’ income and shift ordinary income to the departing owner.  However, this would seem to imply additional payments by the business, beyond what the business might otherwise pay the departing owner for his/her interest in the business assets.

Interestingly, Wallis involved payments to a partner who was retiring from an LLP and who, therefore, was not personally liable for the business’ debts and other obligations the way a true general partner would have been.  The Tax Court acknowledged that Code sec. 736(b)(3)(B) expressly refers to general partners, but the Court did not consider whether an LLP partner is or is not a “general partner” for purposes of Code sec. 736(b)(3)(B).  Instead, the Court focused on the payments in question being payments under a long-standing unfunded non-qualified deferred compensation plan that the LLP had maintained for its partners.

Dated:  4/13/11

This Update is intended only to provide generalized information.  It is not intended to provide information or advice with respect to specific situations.  To address real life, specific situations you should obtain appropriate professional assistance.