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Why conduct a legal practice as a limited company?

1 March 01

The founder of the first incorporated practice in Scotland explains why he has taken this option

by Walter Semple

Limited liability

Entering into partnership ultimately involves mutual responsibility for all partners’ personal credit. This goes far beyond what we wished to undertake. It is one thing to risk your investment in the success or failure of your business. To put at risk all personal assets outside the business is quite another matter. This is emphasised if the control of the business can at some stage pass into the hands of a management committee who may wish to develop commercial initiatives of various kinds.  In a partnership structure these will be based partly on the personal credit and even pension funds of partners who may have little effective control over decisions made or management of the business.

Limited liability offers protection from creditors in the event of insolvency. For solicitors, the Master Policy professional indemnity scheme and the Guarantee Fund arrangements reduce its effect and provide protection for clients.  Although freedom from the worry of an uninsured claim is a comfort, protection from creditors was not an important motivation for us. We felt that the kind of business relationship we wanted would be more easily achieved in the framework of a limited company. There were a number of reasons.

Structuring the relationship amongst lawyers in the practice

Our plan involved a business model, which bears some resemblance to English barristers’ chambers. We wanted to create a structure where lawyers in the firm would clearly maintain responsibility for their own earnings and their independence. The structure involves sharing the costs of administration finance, marketing and training. The lawyer meets this cost by sharing his fees with the company. In this way his financial and professional independence is expressly recognised.

This structure gives the lawyers a strong motivation for the best use of information technology. Best use can be made of the administrative centre by lawyers using computers to work with the minimum support staff. An increase in time working away from the office is possible if that is what is wanted. Modern communications through computers make this easier to do than it used to be.

A company structure allows a distinction between ownership and operations. Although the business may be small there is a distinction between the rights and duties of the shareholders and the practising lawyers.  This offers the opportunity to distinguish between the administrative and support arrangements and the professional client activity. The vagueness of partnership structure makes this more difficult. In this structure client services are in principle a matter for the fee earners or in large firms, teams of fee earners, and can be left under their control.

The objectives of the business include the need for lawyers in the office to work in a way which is mutually supportive and also that the quality of the service provided is as it should be. At first sight this may seem more difficult under the “fee sharing” structure within a limited company than it is in a partnership. On the contrary we think that it better recognises the realities of legal practice and has a better chance of achieving these goals than the traditional partnership arrangements. One key feature is that it has a much better chance of avoiding the difficulties which can arise in a partnership over profit sharing.

The share of fees paid to the company by the lawyers must be sufficient for the company to trade profitably in its own right and by that means to reward the shareholders, both in terms of profits and the increasing value of their shares. The potential in the fee sharing structure for saving in overheads seems to offer a realistic possibility to achieve this.

How do you go about it?

The rules are contained in the Solicitors (Scotland) (Incorporated Practices) Practice Rules 1997. The main requirements are the following:

  • Financial soundness must be demonstrated
  • Only solicitors and incorporated practices can be directors
  • Only solicitors and incorporated practices can be members and when a member is no longer a solicitor or incorporated practice he or she must cease membership.
  • The articles must make provision to anticipate and deal with a situation where there is no longer a solicitor or incorporated practice exercising day to day management and control of the incorporated practice.
  • Each member must give a joint and several undertaking in writing to the Law Society of Scotland to reimburse any grant paid from the Guarantee Fund by reason of the dishonesty of the incorporated practice or any of its directors or employees.

As a result of the commencement of our incorporated practice, a form of Articles which has passed Law Society scrutiny can now be found on the Register of Companies.

Tax effects

When the taxation of partnership profits was changed to a current year basis, it was changed to the same basis as company profits. However, the treatment of work in progress leaves an important difference for solicitors. In a partnership work in progress, which represents partners’ time, is excluded from tax calculations. We do not expect this to apply in a limited company. This can be a disadvantage in respect that taxation of income is to a degree advanced in time.

Members of a limited company pay tax in two tiers. The company pays corporation tax at 20% up to profits [after salaries] of the current limit for the small companies rate. This allows cash saved for the business to bear tax at a lower rate than income tax rates. However, income tax at personal rates and national insurance contributions are paid in addition when cash is extracted from the company through salaries. Dividends and loan interest payable to shareholders suffer only income tax. However, the different tax status of companies can give opportunities for tax planning that the partnership cannot. We expect to be able to arrange for an overall reduction in the amount of tax payable on income generated as compared with a partnership.

Joining the practice

The introduction of new partners in to a law partnership is cumbersome because of the flexibility of partnership. It may involve intermediate stages of quasi partnership where the rights and obligations of the candidate for partnership have to be expressed in some form of associate or salaried partner contract where status and financial liability is not easy to define. Nor is the relationship with third parties always clear.

The transfer to equity shareholder in a company uses a system which is clearer amongst the parties, and where voting rights and the extent of liability to third parties are more easily identified. The system of financing the business through the build-up of capital accounts after payment of income tax disappears. It is replaced by a system where the shareholders can finance the business through retaining profits at favourable rates of tax.

Leaving the practice

Members who leave a company where there is consent and no dispute may find the valuation of their shares relatively easy to establish. A company does seem to offer the chance to build up value in shares in a way which is much more difficult in a partnership. In addition, the type of structure we have created may allow the possibility of developing value at two levels. One is in the value of shares owned. The second is in the individual goodwill of the lawyers conducting the practice which could have a separate value.

The problems in a disputed termination of partnership are well known. A company structure does not avoid disputes. However, a company has a continuing legal personality which should provide a more satisfactory framework for regulation of the change. At least the threat of Judicial Factory will not arise, and the voting power of the situation will be clear subject to enforcement of minority rights. Generally the situation should be more easily provided for in advance.

Whether departing lawyers take away clients with them or leave their clients with the practice, there are established principles of share valuation which may avoid some of the difficulties which the vagueness of partnership law often causes.

Conclusion

Professional lawyers working together need to share fundamental values and business objectives and to help each other in their professional work. They should get on with each other. Nothing in the legal structure of a limited company hinders this. We think that it should help. The alleged flexibility in a partnership can turn out to be vagueness and rigidity. Whether our hopes are realised will emerge in the years to come.

Walter Semple is a director of Semple and Kennedy Limited, Glasgow