TABLE OF CONTENTS

Introduction ................................................................................................i

1. Establishment of the Practice ................................................................1

2. The Form of Practice ............................................................................25

3. Hiring Staff ..........................................................................................106

4. Client and Case Management ............................................................135

5. Marketing of the Practice ...................................................................241

6. Billing and Collecting Fees ..................................................................269

7. Trust Account .......................................................................................294

8. Using Paralegals ..................................................................................308

9. Automation in the Small Law Office ....................................................320

10. Specialization of the Practice .............................................................337

11. Continuing Legal Education and Certification ..................................349

12. The Office: Vacation and Closure .....................................................360

Index ..........................................................................................................372

This book was designed to fill the gap between a new attorney's practical legal knowledge and the need for business and financial acumen in the operation of a law office. Most law schools are derelict in their practical instruction on how an attorney should actually run an office, how to do it well and how to make money at it. Law schools tend to devote themselves to the sterile aspects of the practice of law. Little guidance or instruction is devoted to how the law school graduate will ultimately go about establishing a legal practice.

Prior to the 1990's, most law schools did not consider it necessary to teach law office management courses. This belief was centered on an unfailing optimism by the legal profession that attorneys would always be in high demand and would always earn a good living. Unfortunately, those responsible for shaping the direction of the legal profession failed to envision the huge growth in the number of attorneys from the 1870's forward. In California, for instance, from 1974 through 1995, the number of practicing attorneys nearly tripled to more than 110,000 attorneys. While the number of attorneys nearly tripled during this period, the population did not even double in California. The effect of this explosion of attorneys in California is simply a reflection of the accepted rule of supply and demand. As the supply increases, the demand and cost for the item decreases.

It has become more important that ever for attorneys to adopt practical business procedures to market themselves and manage their practices to maximize their earning potential and their net income. The purpose of this course is to guide attorneys in that endeavor. It is designed to assist attorneys in recognizing and avoiding the pitfalls that practicing attorneys face early in their careers. If an attorney does not have a grasp of the basic management procedures necessary to operate an office efficiently when he becomes a sole practitioner, he begins a long and expensive learning process.

This course is designed to address the most common and pressing concerns of the sole practitioner with a small law office. It begins with the procedures for establishment of the office and its management, such as the delegation of authority and the assignment of supervisory and administration duties. Law office systems and controls, such as timekeeping, financial records, billing and docket control are discussed. In addition, this course covers the types of automated equipment a law office should have. Suggested forms used in practice, such as interview forms, docket control forms, case summaries and the like, are included for use.

It has been observed that very seldom does a law office have clients who come off the street. Today almost all potential clients telephone for an appointment, just like they would with any other professional. In fact, the more affluent, established and the better reputation the law firm has, the less likely they will have potential clients enter without an appointment. Most people call for an appointment. More often than not, these people will consult the phone book, or they will see some advertising and will call the attorney. Advertising for the new law office is discussed in the chapter "Marketing of the Practice."

One of the first decisions that an attorney entering private practice must make is what form the practice will take. If the attorney prefers to practice alone, he should decide whether or not he will form a professional corporation or be a sole practitioner. If he plans to form a law practice with one or more attorneys, they must decide together if they will form a partnership, corporation, or perhaps a professional limited liability company. These considerations are discussed in the chapter "The Form of Practice." The basic consideration behind choosing a form of practice is the limitation of personal liability for any actions by other attorneys or employees of the practice.

A new law firm or a small firm with one or two employees must establish good bookkeeping and accounting procedures for the office at the beginning of the practice. The "Trust Account" chapter covers establishment of the office's client trust account. In addition, accounts must be opened for personal use, payroll, operation and the like.

The new sole practitioner or the small firm of two or more attorneys might initially want to consider a computerized bookkeeping and payroll service. The firm probably will find it less expensive to use these services. The firm can thus avoid investing in computer equipment and programs and doing the work in house. As the firm grows, it may decide to do its own bookkeeping, but until that time it may be a good idea to have it done outside. In the small practice, valuable attorney time should be used to generate business and make money rather than spending time on bookkeeping tasks. It might be less expensive initially for the sole practitioner to do such work, but once he gets busy with clients, it is more cost effective for him to review a bookkeeper's monthly product than to keep the books and records up to date personally. A small law office should be able to contract such tasks through a computerized bookkeeping service for a relatively small amount.

Another advantage these computerized bookkeeping services provide is handling payroll matters. Their computer programs canprepare the checks for the attorney's signature, compute the necessary state and federal withholdings and prepare all state and federal employee withholding tax forms at a great saving of time for the small law office. The charge for such work is usually quite reasonable and is a legitimate tax deductible expense.

There is no set way for managing an office. Whatever really works for the law office to get the job done quickly and not expose anyone to malpractice should be considered. Different theories concerning law office management are discussed in great detail in Section IV.

In a sole proprietorship the management will be conducted by the attorney. In law offices with more than one attorney, the management is usually by a managing committee. This managing committee usually determines the practice's various administration duties. This committee also might appoint an administrative manager or a law office manager who will be responsible for personnel, accounting, file clerks, copying facilities, libraries, billing management and the nonlegal staff.

Frequently there are department heads in the larger firms for different types of law that the firm practices. There might be an estate department, a corporate department, a personal injury department, each with a manager, assistant manager and so forth handling the staff and the legal assistants. This is the general makeup of larger firms. For the smaller firms, one attorney tendsto be the managing partner and all firm members meet on a regular basis, perhaps daily since they work in the same office, to discuss general business. The managing partner will oversee the office manager who is responsible for the legal secretaries, writing checks and paying the bills.

All law firm checks should be signed by the sole practitioner, or in the case of a multi-attorney law firm by the managing attorney or partner. As an aside, the law firm should never have its checks prepared by a nonattorney.

The treatment of client trust accounts is detailed in the "Trust Account" chapter. All checks should be signed by only one attorney, and all bank statements should be received unopened by the managing partner. In addition, a monthly review of all accounts and ledgers should be done by the managing attorney or partner for the firm and not by a lay person. In this way, each check can be seen by the managing person as he signs it. These are common basic steps, and if they are taken, the chances of an embezzlement decrease.

Often, as the law firm increases in size, the day-to-day housekeeping chores of administration, such as paying regular bills and delegation of authority and duties to different secretaries, should be done by the office manager. That gives the attorney freedom to do what he is trained to do: practice law. Once the law office has more than three secretaries or paralegals, it is goingto require someone with authority for the day-to-day business affairs other than the practice of law. This person is usually designated the office manager.

Whenever a law office plans to have more than one employee, an office policy manual should be prepared. The implementation of the procedures in the manual, except for the firing of employees, should be the initial purview of the office manager. The policy manual should state how the office is to be run, the job descriptions of each person and what each person is expected to do. Specifically, it should include a written policy for the hours of employment, designation of normal office hours, lunch breaks and coffee breaks, management of the telephone and reception area, determination of work schedule for Saturdays, calculation of overtime, vacation time, and holidays. Additionally, every law office should have written policies concerning fringe benefits such as life and health insurance, payday, advances and most importantly, some form of employee evaluation. Criteria for job evaluations should be explained. Also the firm's policy on sick leave, wearing attire (how the employees should look in the office) and designation of smoking area should be included.

A law firm, as with any other employer, should adopt procedures for addressing employee complaints and grievances. Included in this section should be a policy covering termination and whether or not it can be for cause or without cause.

Many sole practitioners and small law offices do not have the need for a full-time secretary. With computer automation of the office, there are some types of law practices that do not require secretaries. In these practices, most of the drafting is done by the attorney directly on the computer, and there is little for a secretary to type. The secretary in this type of office becomes a receptionist and file clerk. When a secretary is needed, the attorney can call an employment service to have someone help on a temporary basis. Many attorneys are sole practitioners in this situation. They save a great deal of money by not having a full-time secretary.

A full-time secretary generally does not help the small law office a great deal unless the law firm is in the litigation area. Much of the need to have a secretary is generated by litigation. When a small law firm is in the litigation area, it is usually necessary to have a secretary because there is so much paperwork to do, such as complaints to draft, motions, interrogatories and the like to be prepared, copied, served and filed. The time required for these processes is enough for a litigation law office to need a full-time secretary to handle the time-consuming nonlaw acts. Many small law firms which are not primarily engaged in litigation can manage without a full-time secretary or with a temporary secretary as needed.

Many attorneys, especially beginning sole practitioners, will not have the need or enough work to keep a full-time secretarybusy. In most cities of moderate size, there are employment agencies who will help a law firm get a legal secretary on a part-time basis. In addition, many legal secretaries love to work part-time for extra salary. By using a legal secretary from a temporary service, the attorney does not have a full-time employee. Therefore, the law office does not have to worry about withholding, fringe benefits, getting an employee ID number and many other things that employers are required to do. A law office should not hire an employee (a secretary or anyone else) unless there is no other way to get the needed work done cheaper. If the person is not going to help your office, there is no point in having that person as an employee. If the firm does not need a secretary, the office should not have one.

Every law firm must adopt and implement a filing system to keep track of the cases handled by the firm. The actual procedure for setting up a filing system is discussed in the "Client and Case Management" chapter.

Most law offices have a filing system where each client is given a number, and each case handled for that client is identified by the client's number and an identifying letter relating to that particular case. There are some law firms that have their filing system segregated according to what type of law is being practiced by the attorneys. For instance, such firms could have all their probate files in one area of the file room and their bankruptcy,corporate, etc. each in a different area.

Probate cases can generate huge amounts of paperwork. The average probate fills an entire carton and files can be a foot thick with all that has to be done in terms of the accounting, property being sold, inventory and appraisals. Probate files can take up a large percentage of storage area, so many firms tend to segregate them. Segregation of the files requires a good filing system to be able to split client files up among various filing cabinets, to make sure that the files are always documented and that the individual cases can be found as they are needed.

The complexity of such an arrangement means that more can go wrong than in the basic filing system. Nevertheless, the convenience in being able to find a case quickly may override this concern. In point of fact, this is how most courts handle their pleading. Many courts color code their pleadings, family law, criminal, civil, injunctive, etc. Each file is then given a number and filed in the area of the file room allotted to that type of case. One particular plaintiff may have several cases in the court file room scattered among the segregated files.

An attorney entering into sole practice will need an office. There are three options for the sole practitioner regarding an office in addition to simply renting an office. The alternative options are opening a home office, office sharing and an executive suite. Each of these options has its own advantages and to someextent disadvantages as well.

The home office is least used by attorneys in moderate and large cities, but is often used in small communities. A home does not appear as professional as an office in an office building. The advantage of a home office is that it is less expensive to operate. In fact, except for the business telephone, it is virtually free. In small communities there is little prejudice against home offices because in such communities there are few business offices available for rental. In small towns, many professionals will have their offices in their homes. Another advantage of a home office is that the attorney can work on a case at any time without having to leave home. He is able to deal more efficiently with the case load because no time is lost in commuting to and from the office.

The executive suite is a relatively new concept since the 1970's. This is a situation where a developer builds an office building and provides the reception service to the tenants. In addition, the building has one or more general conference rooms available to be reserved by the tenants. The developer also may provide, upon request, copy, fax and secretarial service. The advantage of this arrangement is that the tenant does not have to pay for services until they are used. In addition, the attorney can have access to conference rooms without the necessity of paying rent for the space when it is not being used. Another advantage of an executive suite is that there are usually other attorneys in the building. This arrangement also increases the potential for theattorney to receive pour-over (referral) work from the other attorneys in the building simply because of their close proximity. The rent for an executive suite is more expensive than for an office elsewhere, but the other services available or included in the suite may make the arrangement cheaper than the stand-alone law office.

Another method of securing an office is office sharing with another attorney. This arrangement is not a partnership. Usually one attorney has rented the office space and is subletting it to one or more other attorneys. There are several advantages in office sharing. The rent for office sharing is often less than the attorney would pay if renting a similar office directly. Office sharing often permits the new attorney access to the other attorney's law library. In addition, the attorneys may share the cost of a secretary which neither one alone could afford. The most important advantage of an office sharing relationship is that the new attorney has someone who is legally trained with whom to discuss cases. One of the main drawbacks to sole practice is that the attorney is on his own and the risk of missing issues or adopting erroneous strategies increases if the attorney is unable to discuss such matters with other attorneys.

It is often stated that there are two competing theories for the effective management of a law office. In fact, there is no onecorrect manner in which to operate an office. While all offices share many similarities, such as the type of law practiced and the number of employees and the types of employees, each office is nonetheless unique. The human factor often makes adherence to a predetermined management scheme inefficient. An effective law office will adopt the management most closely associated with the management style and philosophy of its owner or partners and then adapt to the individual human nature of the office. The point for any manager to remember is that there is no one ultimately correct form of management. The organization should adopt and develop the form of management that works best under the particular circumstances of the organization. The first management theory is operation by system. The second theory is operation by management. The theories are not mutually exclusive and tend to overlap a great deal, but they are two different theories.

Operation by system involves management by established procedures. Everything is supposed to be done "by the book" (a procedures manual). Whenever an issue arises, its solution will be found in the book, and the proscribed response implemented. When another question arises, it is resolved in the same way. The effective operation system will have procedures for virtually every type of reasonable expectancy.

With operation by management, the manager at every level will have previously formatted answers and responses for most problems as they arise that relate to the manager's delegated field ofauthority. The quintessential example of operation by management is the United States military. Nearly all conduct by military personnel is governed by well- defined rules and regulations. The average military officer is given very little actual discretion to act independently from the group. Nearly all military operation sans management is directed through the inter-connected operations systems governing every particular action of its personnel.

The operation-by-management theory stresses the independence and problem solving abilities of the individuals in whom management authority is vested. Under this theory, it is the managers, through the exercise of their individual judgment based upon their training and expertise, who handle the problems as they arise and conduct the decision making for the organization. The manager is delegated specific authority to manage and administer certain organizational affairs. Within the scope of this delegated authority, the manager may make decisions without the need of obtaining permission from superiors. The organization will be bound by the decisions made by the manager that were within the scope of the delegated authority or which the organization may subsequently ratify under the ordinary rules of agency. An example of such management is the scheduling supervisor of a business who sets the delivery schedule for goods to be both shipped and received. While there are general guidelines on how to conduct such operations, the supervisor is vested with great discretion to change operations to address new circumstances as they arise and therefore work more efficiently.

Most law offices, depending on their size and complexity of operation, will use both systems to some extent. As the office grows, it will become more and more systematic in how it is operated simply because there are more people involved with the operations that must be administered.

In the small office of the sole practitioner, the operational procedure is more of management than procedure. The reason is that the attorney-owner or managing partner is more familiar with all of the aspects of the office and what is occurring throughout the office. It is easy for the person to handle problems as they arise. If the small law office has a secretary, it is easy for the manager to direct how any particular matter should be handled and later to refer to that particular previous procedure.

Regardless of which management theory a law office uses, there should be a well-defined job description for every person employed or who is a part of the organization. Both agency law and the theory of respondeat superior make it very important that every person associated with an organization understand what his duties are and the limit of his authority to act for the law office. There must be discussion about what the particular duties of each person are going to be, and there should be a clear chain of command set forth to govern the office's management. The manager, assistant manager and person who runs the office must be clearly identified to all. While the above sounds rather simplistic, suchcommunication is necessary so everyone knows their responsibilities and to whom they should direct any questions.

One managerial practice often overlooked is development of an office manual which specifically states the job description for each person. An office procedures manual will prevent duplication of work and assure that someone is assigned to do each task that arises. One of the worst things that can happen for a law office is for a statute of limitations to be missed and a case lost because someone failed to handle the matter because they assumed it was someone else's responsibility.

As the number of employees and the number of attorneys increases, the office must be managed more on a systems basis simply because there is so much activity. This is especially true in a full-service law firm. As the number and types of cases that a firm handles grows, so does the need to implement actual management and operational practices. It is no longer feasible, practical or possible for the attorney in charge to look at everything on a case-by-case basis. Cases should be segregated according to type of problem, and procedures for handling them must be readily, instantaneously available.

In addition, as the staff of an office increases it becomes more important and practical to have specialization among the staff. It might be efficient to have an office manager to handle the administration aspect, a receptionist to answer the phone and greet clients, a legal secretary to handle some types of legalaffairs, and secretaries assigned to attorneys based upon their particular expertise. The attorney or a managing partner will supervise the person doing bookkeeping.

Once the law firm reaches a certain size, which will depend on many variables, such as type of organization and type of legal work, it will have a staff of lawyers, legal assistants and administrators. The administrative staff will usually consist of an office manager who supervises the bookkeeper, the file clerks, copy management and the law office library. A large law firm, with 10, 20, 30, perhaps as many as 200 attorneys, will reach a point where it adopts a more sophisticated form of management simply because it has actually become a group of mini-law offices.

In larger law firms, there will be attorneys who specialize in particular areas of the law. The legal work of some attorneys may be totally different from that practiced by attorneys in another area. Probate law practice, for instance, is extremely different from corporate law, which is different from bankruptcy law. Administrative law could be different from everything else, although there may be some overlapping. The specialization of the attorneys in a firm will often result in the specification of the staffs that are assigned to the individual attorneys. This requires the adoption of greater and more effective support staff procedures.

In every law office, systems and controls must be adopted anddeveloped to keep track of records, client files, client billing, etc. If an attorney is retained on an hourly basis rather than a flat rate or contingency rate, he will need to keep track of his billable hours. Many law firms, especially larger ones, require a minimum number of billable hours per year by every attorney (associate) who works for them. An attorney in this type firm, must complete those billable hours, even if it means working 60 or 70 hours a week. Every attorney must keep a good record of the time spent on each case, both for billing purposes and for good case management. From this information he is able to determine if too much or too little time is being spent on a case. With experience, an attorney will be able to estimate with relative accuracy the amount of time required to prepare to represent a client in a particular matter.

The easiest way to keep track of the time spent on a case is to have a notebook and record the time as it is accrued. In keeping track of work on a case, the attorney should put down the time spent and also a notation of what was done, the case number, the client, and whether or not people were met. At the end of the month, the attorney can compile his billing report from the notes in his book. For the computer literate, there are many computer-assisted devices on the market specifically geared to attorneys. There are appointment logs which permit the attorney to type in the time spent, what was done, and other notes. At the end of the month a computer disc with the information can be delivered to thesecretary for processing.

Another way to account for time spent is to record on a cassette recorder the case information as the work is being done and deliver it for compilation. Regradless of the method employed, the attorney must keep track of billable work, because without these records the attorney will be unable to charge accurately and collect for such work.

The specter of malpractice should haunt every attorney. In the back of every attorney's mind should be the thought that he could be sued and probably would be sued for malpractice in the event of a mistake made by him or anyone working for him. In the last few years, solely because of the huge increase in competition among attorneys, there has developed a new area of law: legal malpractice.

There has always been malpractice liability imposed on attorneys for their actions. What is new, however, is that there are now attorneys who specialize only in suing other attorneys for alleged malpractice. In nearly every legal publication, there are advertisements by attorneys whose practice is suing other attorneys. As a result of this specialization, the number of malpractice lawsuits filed against attorneys has increased at progressively higher rates each year since 1990.

One of the reasons for the large increases in attorneymalpractice suits is that many attorneys carry malpractice insurance. As with any other insurer, a malpractice insurer is more likely to settle a marginal case than risk a higher judgment at trial. The insurer is more willing to settle the case and thereafter either raise the insurance premium of the attorney or cancel the insurance altogether.

An attorney who has no malpractice insurance will suffer a double whammy in a malpractice suit. Without an insurance policy, the attorney will have to either hire another attorney to defend the action or he must defend the action himself. In either event, defense of the action will cost the attorney dearly, win or lose. If the attorney hires a defense attorney, he will have to pay the defense attorney. If he conducts his own defense, he loses income by working on his own case for free instead of earning a living.

If the attorney wins a malpractice case, he does not have to pay a judgment. Unless, however, he can prove that the suit was a malicious prosecution or an abuse of process, he cannot sue the losing plaintiff and former client for the damages, loss of reputation and business as a result of the suit.

If the attorney's fee agreement with the client has a clause awarding attorney fees to the prevailing party in the event of a lawsuit, and if the attorney wins, he will recover his attorney fees if a defense attorney had been retained.

Many courts will not award attorney fees to an attorney who defends himself in a malpractice action. The attorney mustactually hire a defense attorney to get attorney fees. Of course, if the retained attorney loses the malpractice case, the attorney must pay the client's attorney fees as well as the judgment. In most states, if any money is awarded, even as part of a settlement, to a plaintiff in a malpractice action, that person is the prevailing party and is entitled to attorney fees unless the settlement agreement states otherwise. Bearing all of the above in mind, it is important that attorneys design their practice and their case management procedures to minimize the potential for malpractice claims.

The most common cause of malpractice arises from missing filing dates or missing important information that prejudices the client's case. The biggest concern of an attorney regarding malpractice is that he will miss something that cannot be cured. Attention to detail will greatly reduce this fear, but it will not alleviate it altogether. The potential always exists.

One way to limit the potential of malpractice is in the choice of area in which the attorney practices. There are some areas of law, such as bankruptcy or probate work, where it is difficult to commit malpractice. The simple reason for the reduced potential of malpractice in these areas is that nothing is final in such areas until the court says so. The court supervises virtually everything being done in the case. The court's reviews of the attorney's actions make it more likely that mistakes will bediscovered and cured before they can injure the client, and in some instances an attorney can reopen a matter (such as an estate in bankruptcy) and correct mistakes. In like manner, an attorney in probate will usually have the court's supervision on every major step. If the court grants permission for an attorney to do an act after notice to all of the heirs of the proposed action, unless the notice deceived the heirs, their failure to object to the action will normally relieve the attorney of any malpractice claim. In both probate and bankruptcy, it is difficult for an attorney to commit malpractice negligently.

In litigation, however, it is a whole different ballgame. An attorney can misstate positions, lose evidence, fail to "follow up" on particular clues as another attorney might have done, and other things that will give rise to malpractice liability. It is obvious there are many things that can happen in a litigation matter that can result in a malpractice complaint. To reduce the potential for a malpractice claim, the attorney must adopt good management and filing procedures so he can keep track of what is expected to be done in a case. An attorney must always be able to prove that the case was handled correctly. Case and client management are discussed in their own chapter. They are mentioned here to reinforce the fact that such proper techniques will lessen the potential of malpractice.

Documentation of all verbal and written communication with a client is an important tool in avoiding a malpractice claim. Oncea client loses a case, it is human nature to blame the attorney. Occasionally, the client takes the frustration of losing the case to the next step and sues the attorney. In many malpractice cases, the client claims that the attorney misled the client in some fashion. The client alleges that had there been no misrepresentation, the client would not have lost the case or would have done something differently. The attorney in such a case is required to prove a negative act, that he did not tell the client what the client claims to have been told. The only way for an attorney to protect himself from such a situation is to document all client communications. For oral and telephone communications, the attorneys should immediately thereafter send confirming letters of the conversation's content simply to prove what was discussed and agreed.

It is quite popular today to sue attorneys for malpractice without good reason or just cause. If the attorney has not protected himself by keeping complete records, he can be sued for malpractice when he didn't commit it. There is no doubt that many attorneys have settled malpractice claims because they could not prove they did not give the advice the client claims.

One of the best defensive practices to malpractice actions is simplicity itself. It is wise for the attorney to screen a person carefully before agreeing to represent him as a client. There are some who will immediately sue an attorney if they lose their action. An attorney must attempt to recognize this type ofindividual and avoid him. Simply taking as a client everyone who enters an office exposes the attorney to such individuals.

For complete peace of mind and protection an attorney should consider purchasing malpractice insurance. As a result of the plethora of malpractice suits occurring in the last few years, malpractice insurance premiums have skyrocketed. In some states, malpractice insurance is offered by insurance companies formed by attorneys. In California, for instance, attorneys have formed the "Lawyers Mutual Insurance Company" to furnish malpractice insurance to attorneys. Many state bars also have established relationships with insurance carriers to provide insurance to their members.

There are different types of malpractice policies. The first type is the "occurrence" policy. This type will cover the attorney for any claims arising from actions during the period of time the policy was in effect even if the attorney is not insured by the company at the time the claim is made. This type of policy is not always available.

Many insurance companies now require that the attorney not only be a client at the time of the incident but also at the time of the claim. Under this situation the attorney is required to be a client for life. The insurance company does not want to insure a client for the potential liability of one big risk and not receive proceeds for the other years when the risks are low.

There is also "tail" insurance. This is a particular coveragethat persists after policy termination. Many insurance companies end tail coverage only by retirement. Some companies will offer tail coverage even though a client is moving to another carrier.

One type of policy not readily available is the "blanket" policy that covers the attorney for claims made while the policy is in effect; the attorney is not required to have been an insuree at the time the incident arose. The attorney is only required to be an insuree when the claim is filed. This type of policy was popular with new attorneys who did not have assets. A malpractice by an attorney early in his practice would collect little because the attorney had little to lose. As the practice grew and the attorney acquired assets, a blanket policy would thereafter protect the attorney for malpractice performed in the early years. Of course, there was a trade-off in premiums. The insurance company would charge the attorney more for the blanket policy because it was insuring for past work as well as work being conducted during the term of the policy.

Professional liability insurance is a legitimate business expense, and the premiums for the insurance are tax deductible. The amount an attorney pays for premiums is based upon the type of law the attorney practices. An attorney with a bankruptcy practice will pay less in premiums than an attorney in real estate litigation. Insurance companies base their premiums and coverage on the types of law an attorney practices. Some insurance companies offer attorneys the option of choosing coverage only for claimsarising in certain areas of law. In this situation, for example, the attorney can elect to be covered for any real estate malpractice claim but not any social security malpractice claims. When shopping for malpractice insurance, the old adage of "buyer beware" applies. Insurance policies by their very nature must be read closely with all riders so that one fully understands what is in them. Because of an attorney's knowledge of the law and legal training, an attorney would be less likely to win an action based on misunderstanding the policy than a lay person. The attorney must understand the exact coverage of the policy.

Obviously, one of the best ways to make money is to earn it. There are two legal ways for a person to earn money: working for others and working for himself. As an employee, a person has the stability of knowing that a fixed paycheck will be forthcoming each week. The drawback is that the employee does not share in the profits of the business and does not have the time to form his own business.

An attorney in sole practice shapes his own destiny. No money is earned unless he earns it. When no client comes into the office for advice or services, the attorney does not earn any money. However, a sole practitioner has the opportunity to make more money overall throughout a year than a salaried associate doing the same work. In addition, a sole practitioner can, because he owns the legal practice, set the hours, goals and objectives of the practice. An attorney who decides to go into business for himself or with others is to be congratulated.

An attorney entering private practice must decide how his legal practice will be organized. An attorney may, in some states, incorporate or form a limited liability company or may operate as a sole proprietor. An attorney practicing law with one or more other attorneys must decide whether the relationship will be in theform of a partnership, corporation or limited liability company. The scope of this chapter is to help attorneys understand the advantages and liabilities of each form of operation. Such information can yield an intelligent decision concerning the form of business of the legal practice.

The normal rules of agency apply in the practice of law. The torts committed by employees in the course of their employment are imputed to the employer. This is the legal concept of "respondeat superior." A law firm is governed by this principle like any other organization. Businesses incorporate or organize themselves as limited liability companies in order to limit the personal liability of the business owner, whether shareholders or members.

Most states permit their professionals, such as attorneys, to incorporate or practice their profession through a limited liability company. If a law firm has employees, the law firm should either carry a large amount of insurance or be incorporated or organized as a limited liability company. This allows each of the attorneys owning the law firm to protect himself as much as possible against any judgments obtained as a result of employees' or other attorneys' actions. The incorporation or formation of a limited liability company to practice law acts as a one-time insurance policy.

The most recent development in business law is the creation of the limited liability company. The first limited liability company was created in the 1970's. For many years limitedliability companies were not popular because the tax law during that period subjected them to more taxation that either a corporation or a limited partnership. In 1977, Wyoming created the first limited liability company for an oil company, and the company was granted a private tax ruling stating it would be treated as a partnership. In 1980 the Treasury Department issued proposed regulations stating that a limited liability company would be taxed as a corporation because its members did not have a partners' liability for the company's debts. It was not until 1988 that the Internal Revenue Service finally issued Revenue Ruling 88-76, 19882 CB 360, stating that a limited liability company could be taxed as a partnership. This revenue ruling calmed the concerns which people had regarding forming limited liability companies. As a result, there has been a dramatic boom in the number of states which permit limited liability companies to be created under their laws. As of January 1996, 48 states and the District of Columbia permit limited liability companies to be formed, only Hawaii and Vermont had yet to adopt a limited liability company act. However, just as some states do not permit attorneys to form professional corporations, not all of the states permit attorneys to form professional limited liability companies. An attorney wishing to form a professional limited liability company must verify that such professional legal practices are permitted under the attorney's state law.

Today, the most common way for two or more attorneys to practice law together is in the form of a professional corporation. A professional corporation is basically the same as a regular corporation with one major difference. Each of the shareholders of a professional corporation must have a license to practice the profession for which the corporation was formed. The purpose of this requirement is to keep an unlicensed person from exerting any control over the legal services rendered to the corporation's clients and to assure that client confidences are not shared with persons who are not under an ethical requirement to observe them. A professional corporation is essentially the same as any other corporation except for this difference.

A corporation is an artificial entity created in conformity with a particular state's law. As a distinct legal entity, a corporation is considered to be separate and apart from all of the people who own, control or operate it. A corporation holds most of the rights of a legal person. A corporation is able to execute contracts, incur debts, hold title to both real and personal property and paying taxes. The attractiveness of corporations lies in their ownership by shareholders that gives them unique advantages over both sole proprietorships and partnerships.

A corporation is said to have perpetual existence. A corporation will legally exist forever unless it is dissolved or terminated under state law. One of the main grounds for acorporation's existence being terminated is its nonpayment of taxes. As long as a corporation pays its taxes, it will remain in effect.

A corporation's perpetual existence is an important advantage over other forms of business. A partnership terminates upon the death of a partner, and a sole proprietorship also terminates upon the death of the owner. A corporation continues regardless of the death of a shareholder. The perpetual existence of a corporation is one of its compelling features. The fact that a corporation continues regardless of the death of its shareholders is what gives a corporation its stability. Most people are reluctant to invest in a business that is not a corporation and that may terminate upon the sudden death of any partner. The stability of a corporation derives from its continuity of existence beyond that of its shareholders.

The main advantage a corporation has over a sole proprietorship or a partnership is that the shareholders are not personally liable for the debts of the corporation or the actions of the employees. In a partnership or sole proprietorship, if a partner or employee does an act in the scope of his employment that injures another person, each of the partners or the owner (if a sole proprietorship) is personally liable to pay for the resulting damages. The most any shareholder can personally lose if a monetary judgment is taken against the corporation is the assets he contributed to the corporation in payment for his stock.

This limited liability for corporate shareholders is different from a partnership or sole proprietorship. There, the owners are totally liable for all debts of the business. The creditors of the business can seek and attach every dollar and piece of property that a partner or sole proprietor owns to settle a judgment against the partnership or sole proprietorship. There will be no attachment of personal assets to satisfy corporate debts. This limited liability for the debts of the business is the reason most people incorporate. Few people would ever invest in a business if by doing so they risked losing everything they have earned or will earn in the future.

There is a limitation on the limited liability of an attorney who does business in the form of a limited liability company. An attorney is responsible for reviewing and overseeing the acts of all employees regarding legal work that they may be doing in the office. State law may dictate that an attorney is personally liable separate from his stock ownership for negligence of an employee when the attorney should have noticed the negligence. Example: Two attorneys engage in business as a professional corporation. Their employee is involved in a car accident while serving papers for the firm. Neither attorney will be personally liable for a judgment arising as a result of the accident. Assume instead that a secretary missed filing a pleading that resulted in a loss of one of the law firm's cases. The law firm can be sued and will be liable for malpractice. The attorney who supervisedthe secretary would also be subject to liability, but the liability would derive under malpractice law and not by virtue of the attorney owning the law firm. In fact, if the attorney was just an associate of the law firm instead of a shareholder, there would be liability against the attorney for failure to oversee the secretary.

In addition to limited liability, special tax treatment of Subchapter S small corporations makes them as attractive as partnerships. The federal government taxes Subchapter C corporate income twice. Corporate income is taxed when the corporation first earns it and again when distributed to the shareholder. The federal corporate tax rate is:

1. 15% of the first $50,000 of taxable income, plus

2. 25% of the next $25,000 of taxable income, plus

3. 34% of the remainder of taxable income over $75,000.

Corporations having income between $100,000 and $335,000 are taxed at a 39% rate to recover the taxes saved on the lower graduated rates.

When the after-tax income is distributed to the shareholders as dividends, the shareholders must include it on their tax returns and pay additional tax on it. One alternative to this double taxation is for a small corporation to pay most of the income as legitimate salaries to the shareholders for work they have done. The salary is deductible by the corporation whereas a dividend payment is not deductible. Thus, if the income can be paid assalaries, corporate taxes are reduced.

The federal tax code calls a regular corporation a C corporation and subjects it to a different taxing structure than a partnership or a sole proprietorship. A special corporation called an S corporation is taxed quite differently from a regular C corporation. The income tax of a C corporation is subject to double taxation. It is taxed first when the corporation files its corporate tax return for the net earnings for the corporation. The C corporation income is subject to tax again after the corporation pays dividends to its shareholders. The dividends that a shareholder of a C corporation receives must be included in the income of the shareholder on Schedule B of Form 1040. Example: A C corporation has $1,000,000 net profit. It will pay approximately $360,000 in taxes. After the corporation distributes the remaining $640,000 to the shareholders, they will pay taxes on it again. Assuming the shareholders' tax rate is 28%, the shareholders will pay an additional $179,200 in taxes. The total taxes on the corporate income of $519,200, paid by both the corporation and then its shareholders, could exceed 51%.

Partnerships provide more flexibility than S corporations in a few areas:

1.Partnerships may admit anyone as a partner and have any number of partners, whereas S corporations are limited to 35 members of special status, and

2.Partnerships can divide profits and losses in a manner not related to the partners' ownership interest. Incontrast, S corporations must divide profits and losses among its shareholders in accordance with their percentage of stock ownership.

Generally, these differences are not significant because the S corporation usually does not want additional shareholders and does want profit and losses allocated according to stock ownership.

An individual who incorporates a business is given the opportunity to use the tax advantages of fringe benefits. A corporation is allowed to deduct from its pretax income the costs of certain fringe benefits that are not deductible by persons in a partnership or sole proprietorship. One of the main areas of tax advantage is a retirement plan. A corporate employer may contribute, tax free, significantly more to the employee's retirement plan than a self-employed person's Keogh plan. In addition, employees of corporate plans may borrow to $50,000 of the funds contributed to a plan without penalty. Such is not the case with Keogh plans. Other fringe benefits that are deductible by a corporation but not by a partnership or sole proprietorship are health, life and disability insurance and a $5,000 death benefit. These benefits are deductible by the corporation and usually are tax free to the corporate employee.

The costs for incorporating a business vary somewhat from state to state. In California, the cost for filing the Articles of Incorporation and the minimum franchise tax fee is about $915. In addition, the corporate books (including the minute books, stockbook and the corporate seal) cost between $75 and $125. Attorney fees are normally $800 to $1,000 in California, if needed. Most states are not as expensive as California and charge between $300 and $500 for an incorporation. Attorney fees in these states vary from $300 to $1,000. The cost of incorporation should be viewed as a one-time insurance premium. Once the business is incorporated, the shareholders are protected from individual liability caused by the actions of the corporation or its employees. After incorporation, shareholders no longer have everything they own at risk. Peace of mind is an important consideration when deciding to incorporate.

After a corporation is formed, the yearly requirements for meetings and record keeping are not much more than those of any noncorporate business.

There is no mystery or difficulty in forming a corporation. In its simplest sense, a corporation is merely a license to do business in a particular manner. In that sense, the Articles of Incorporation is the application for the license and when accepted for filing by the secretary of state becomes the license. In fact, in legal parlance a corporation is said to have been "licensed to do business" once it is filed.

The act of incorporating a business is simple. All it entails is filing of the Articles of Incorporation and the subsequentissuance of stock. The actual act of incorporating is no more than standing in line before a clerk in the secretary of state's office and having the articles file-stamped (it can also be accomplished by mail). There are many companies that provide corporate kits that include basic articles, minutes and bylaws specifically designed for use in just one state at a cost of $50 to $100. The corporate kit does not address the many issues or provide the information contained in this book. This book goes beyond the mere corporate kit and provides guidance and advice on the considerations that arise in forming any corporation. Before filing any articles the incorporator should decide what additional provisions, if any, may be needed in the articles. In addition, the attorney should read the provisions of the state's corporation code to assure that state law has not recently been changed, affecting the new incorporation.

There are many choices that an incorporator must face in forming a corporation. Many of those choices can be difficult considering the many options available and the particular concerns of each business. An example is whether or not to become a close corporation, which requires the shareholders to agree to operate the business pursuant to a shareholders' agreement rather than under the formalized procedures of the state's corporate law. Another example is whether or not the corporation should elect to seek Subchapter S tax treatment and when, since such an election can be made at the first directors' meeting or in any yearsubsequent. Nothing can replace the cold practical consideration of the person forming the corporation. That person knows the business purposes and how it will be operated. The most any book can do is steer the incorporator to those provisions and issues of concern and most practical use.

There is no set definition of a small corporation. The definition varies among the states and is different under federal law. Generally, it means a corporation with a limited number of shareholders. When a business qualifies as a small corporation, it has the opportunity of availing itself of special advantages. Under federal tax law, a small business (less than 35 shareholders) may elect subchapter S tax treatment which allows the corporation to be treated as a partnership for tax purposes. Many states have similar subchapter S laws for small corporations. Several states also permit small corporations with varying numbers of shareholders (in Delaware it is 30; in Ohio it is unlimited, provided there has never been a public offering) to elect to become close corporations as discussed above.

The steps for incorporating a business are simple: file the Articles of Incorporation and issue the stock.

All corporations must have a name that denotes "corporation" and not "partnership" or "sole proprietorship." The name usually must contain the word "Incorporated," "Corporation" or "Limited." The name must not mislead the public into believing it is an agent of the federal or state government. The name of the corporation usually must be followed by the words "a corporation" or the initials "P.C." for corporation.

In practice the main concern is whether the proposed name is so similar to an existing corporation's name as to mislead the public. No state will permit two corporations to have the same name or names so similar that they are confusing. To avoid the possibility of having the articles rejected because of similarity to the name of an existing corporation, the incorporator should conduct a name search with the secretary of state's office. If the name is not in use, it can be reserved for 60 days or longer. The search can be accomplished by mailing a request with the proposed name and a check in payment for the search to the secretary of state. The amount of the check and where to send it can be obtained by calling the secretary of state's office. A search through the secretary of state's file may take 30 days. There are attorney service firms listed in the phone book for the state capitol that will do the name search and reservation within two days for about $30.

After the corporate name is reserved, the incorporator then prepares and files the Articles of Incorporation. Each state has its own requirements for the contents of the articles. In every state, corporate kits may be purchased which contain the basicarticles, shares of stock and filing materials needed to become a corporation under that state's law. These kits cost $50 to $100. Most attorneys charge to $1,000 to tailor-make a set of articles (seldom necessary).

After the articles are prepared, they must be filed with the secretary of state's office. Most states require the articles to be filed in triplicate, and each copy must be signed by the incorporator. Therefore, four or more copies should be filed to insure that the corporation will receive a conformed, file-stamped copy. The filing can be done by mail, and it will take 30 to 60 days for return. The alternative is to use an attorney service firm to file the articles. Such a firm usually takes only a week to get the articles returned and charge about $50 for the service. The advantage of the attorney service firm is that any problem can be corrected faster. Most attorney service firms also sell corporate kits in the event the incorporator wishes to purchase one. This CLE progarm also has a course of corporations which also contains the basic corporate kit for all states.

When the articles are filed, the incorporator must pay the filing fee and the yearly franchise fee for the corporation. The fees vary from state to state. In California the total fee is $917 ($117 filing fee and $800 franchise tax). The correct amount of the fees can be obtained by calling the secretary of state. If an attorney service firm is used, they will know the fees.

After the articles are filed, the corporation exists in a de facto mode. That means the corporation exists on paper, but until stock is issued it does not exist at law ("de jure"). The fact that it has outstanding shares in the hands of shareholders is the defining characteristic of a corporation.

Once the articles are filed, the incorporator calls a special meeting of directors. In most states the initial directors are named in the articles. In other states, the incorporator appoints the first directors at the meeting.

At this first meeting, the bylaws are adopted by the corporation. This is an important step because it is the adoption of the bylaws that creates the officer positions of the corporation and governs its daily operations. The officers of the corporation are then appointed. The most important matter of business at the first meeting of directors is the issuance of the stock. Here the corporation sells its stock in exchange for money, property or labor furnished or to be furnished to the corporation. When the stock is issued the incorporation is complete.

A regular corporation is described in Subchapter C in the federal tax code as a "C" or "regular" corporation and is subject to a different taxing structure than either a partnership or a sole proprietorship. A special corporation called an S corporation is described in Subchapter S of the code and is taxed quitedifferently from a regular corporation. Normally, the federal government taxes corporate income twice for a regular or C corporation. Corporate income is taxed when the C corporation first earns it, and the corporate income is taxed a second time when distributed to the shareholder.

The federal corporate tax rate is:

1. 15% of the first $50,000 of taxable income, plus

2. 25% of the next $25,000 of taxable income, plus

3. 34% of the remainder of taxable income over $75,000.

Corporations having income between $100,000 and $335,000 are taxed at a 39% rate to recover the taxes saved on the lower graduated rates. When the after-tax income is distributed to the shareholders as dividends, the shareholders must include it on their tax returns and pay additional tax on it. One alternative to this double taxation is for a small corporation to pay most of the income as legitimate salaries to the shareholders for work they have done. The salary is deductible by the corporation; whereas a dividend payment is not deductible. Thus if the income can be paid as salaries, corporate taxes are reduced. A second alternative is for the C corporation to retain a reasonable amount of income in its treasury called "accumulated earnings." A corporation is permitted to accumulate reasonable amounts of earnings for future use of the corporation. Since the earnings are not distributed as dividends, they are not taxed to the shareholders. Retained earnings also are not available for use by the shareholders.

The income tax of a C corporation is subject to double taxation. It is taxed first when the corporation files its corporate tax return on the net earnings of the corporation. The C corporation income is taxed again after the corporation pays dividends to its shareholders. The dividends that a shareholder of a C corporation receives must be included in the income of the shareholder on Schedule B of Form 1040. For example, assume that a C corporation has $1,000,000 net profit. It will pay approximately $360,000 in taxes. After the corporation distributes the remaining $640,000 to the shareholders, they will have to pay taxes on it again. Assuming the shareholders' tax rate is 28%, the shareholders will pay an additional $179,200 in taxes. The total federal and state taxes paid by a C corporation and its shareholders, on the corporate income of $519,200, as a result of this double tax can exceed 51%.

Subchapter S of Chapter 1 of the Internal Revenue Code (IRC) (hence the name S corporation) permits qualifying C corporations to receive special tax treatment. Under the IRC, qualifying corporations may elect to become an S corporation and be taxed in a manner similar to that of a partnership for federal income tax purposes. An S corporation becomes a pass-through entity whereby all of its income and deductions are passed to the shareholders. The shareholders claim their share of the corporation's income and deductions on their individual tax returns.

The S corporation is not subject to corporate income tax, accumulated earnings tax or the personal holding company tax at the federal level. However, it may be subjected to a special tax on its passive net income. Such tax arises when the S corporation has (1) earnings and profits and (2) gross receipts composed of passive investment income.

When an existing C corporation elects subchapter S status, there is a gains tax on any gain attributable to the appreciation in value of any asset from S corporation conversion date to asset sales date. The requirements to become an S corporation are statutorily set. The moment that the requirements are no longer met, the S status of the corporation terminates. Only a small business corporation can elect S status. To be a small business corporation, the corporation must meet the following requirements:

a.It must not have more than 35 shareholders (married couples are treated as one shareholder),

b. It must be a U.S. corporation,

c. No shareholder can be a nonresident alien,

d. The corporation can have only one class of stock,

e. All shareholders must be individuals, estates or trusts,

f.The corporation cannot be part of an affiliated group of corporations.

g. The corporation can not be a bank or insurance company, and

h. The corporation has elected to be treated as a Subchapter S corporation.

A corporation electing S corporation treatment will have its profits and losses passed to the shareholders. Passing the profitsand losses results in the shareholders, not the corporation, being taxed on them. The S corporation income is taxed as though it was derived from a partnership or sole proprietorship.

An S corporation must use a calendar year as its taxable year unless a legitimate business purpose is proved to the satisfaction of the IRS.

An S Corporation is a corporation given special tax treatment under federal law. The effect of the S corporation election is to have the corporation treated for general tax purposes as if it were a partnership. In an S corporation, the income is attributed to shareholders in accordance with their stock ownership. The S corporation itself pays no income tax on the federal level.

Once a valid S election is made, the S corporation will no longer be subject to corporate income tax, accumulated earnings tax or the personal holding company tax at the federal level. An S corporation may be subjected to a special tax on its passive net income. Such tax arises where the S corporation has (1) earnings and profits and (2) gross receipts composed of passive investment income. Example: An S corporation earns $1,000,000. It will pay no taxes. The shareholders of the S corporation will have to include the $1,000,000 on their tax returns. Assuming a 28% federal individual tax rate, the shareholders will pay $280,000, not the total $519,200 that a C corporation and its shareholdersmust pay in combined taxes.

Because of its tax advantages, every highly successful small corporation should consider electing to become an S Corporation.

A federal S corporation election does not mean that the corporation will be treated as a partnership for state taxes. Not all states permit S corporation treatment for small corporations doing business in their states. For most states, despite a federal tax election, the corporation will continue to be taxed as though the federal election had never been made. The reason for nonpartnership treatment is obvious. By denying S status to the corporations, the states retain the double taxation on the corporate income.

Unless a corporation does business in a state that has no income tax on corporations (not all do), it will have to file a return and pay taxes. Only a few states, such as California, permit S corporation tax treatment. In these states, the profit and loss of the corporation is passed through to the shareholders. In California, an election to be treated as a federal S corporation automatically operates as a state election as well. A federal S corporation not wishing to be an S corporation in California must specifically inform the state that it elects not to be an S corporation for state tax purposes. Unlike federal law, California continues to impose a corporate tax on S corporations at a reduced tax rate of 2.5% but not less than the state's minimum tax on netincome. California, however, does not impose a tax on excessive passive income like the federal government does.

Most of the states that permit S corporations require an affirmative election by the corporation for that tax treatment.

A corporation wishing to become an S corporation must have the written consent of its shareholders for the S status. Where the stock is owned jointly by a married couple, both spouses must consent to the S status. Where the stock is owned jointly, all joint owners must consent to the S treatment.

The consent must be signed by each shareholder of record when the election is made. In the situation that an existing corporation is electing to receive S status for the year of election, any shareholder who owns corporate stock at any time during that year before the election is made is also required to consent to the election even though the shareholder may no longer be a shareholder.

The corporation is required to file Form 2553 with the IRS together with all shareholders' consent to S status for the corporation. The S election must be made on or before the 15th day of the third month of a corporation's tax year for the S corporation election to become effective for that tax year. A late filing of the S election would be ineffective for the current tax year but would be effective for subsequent tax years. For new corporations, this means the election must be filed within 2«months of the incorporation to be effective for the first tax year.

Once the election is made, it is valid and in force for as long as the corporation meets the qualification requirements for S corporation status. The shareholders can revoke their S election. Once an S election is revoked or terminated, the corporation must wait five years before it can apply again for S corporate status.

Each state has its own laws as to whether or not the corporation can be treated as an S corporation. In states that have no corporate or individual tax, this is not a problem because there is nothing to tax. In states that have a corporate tax, the state must have adopted tax laws permitting S treatment or else for the state side, the corporation and shareholders will still be taxed as a C corporation as before. California automatically grants S treatment to any California corporation that receives federal S status. California requires the S corporation to file Form 3560 to notify the state of the S election.

Regardless of whether or not a state permits S corporation treatment under its laws, the greater tax savings will come from the federal election. Therefore, if the corporation wishes to be an S corporation, it can be so recognized and taxed federally even if the state will not allow it. A tax consultant for the corporation can advise whether under applicable state law it is possible to make a state S election.

An S status election can be revoked by the corporation byfiling a revocation statement with the IRS Service Center handling the return. The revocation statement must state that the corporation is revoking its S election. The revocation statement must also state the number of shares that are issued and any outstanding stock (both voting and non-voting). In addition, the statement must be accompanied by a shareholders' consent to the revocation signed by shareholders owning more than half of the outstanding stock (both voting and nonvoting) at the time the revocation election was made. Because the requirements to be an S corporation are statutorily set, the status is automatically terminated prospectively when any of the following events occur:

a. The corporation's shareholders exceed 35 (married couples count as one shareholder).

b. The corporation issues more than one class of stock.

c. The corporation becomes part of an affiliated group.

d. The corporation begins to operate as a bank or insurance company.

e. Ineligible shareholders acquire stock (foreign aliens, corpo-rations, etc.).

f.The passive investment income (a) exceeds 25% of the corporation's gross receipts for three consecutive years, and (b) the corporation has earnings and profits at the close of the three consecutive years.

Once the S status is terminated, the corporation must wait five tax years before it can reapply for S status unless the IRS gives special consent to an earlier application.

Because an S corporation is treated differently than a regularC corporation, it must file different tax returns. Profits and losses of an S corporation are passed to the shareholders, and the corporation is not taxed by the federal government.

The income, losses and other K-1 items are allocated to the shareholders on a per share per day basis. Each shareholder is allocated a percentage portion (based on the shareholder's ownership interest) of the pass-through items of each day in the taxable year. Example: An S corporation has $750,000 in income. George and Harry each own 25 shares for a full year. Mark owned 50 shares for half a year and then sold them to Marcie for the other half of the year. The allocation is made as follows:

a.The $750,000 is divided by the number of shares divided by the number of days (366) of the taxable year ($750,000 7ö 100 ÷ 366) for a total of $20.49 per day.

b. Each shareholder's allocation equals the number of days times shares owned times the daily allocation per share.

George 25 shares X 366 days X $20.49 = $187,500

Harry 25 shares X 366 days X $20.49 = $187,500

Mark 50 shares X 183 days X $20.49 = $187,500

Marcie 50 shares X 183 days X $20.49 = $187,500

$750,000

Even though the S corporation is not taxed directly on its income, an annual tax return, the U.S. Small Business Corporation Income Tax Return (Form 1120-S) must be filed within two months and15 days of the end of the corporation's tax year. Form 1120-S is an information return. The IRS uses the corporate return to cross-check the shareholders' returns to ensure they are actually reporting their share of the S corporation income.

An S corporation is a pass-through vehicle for the income and deductions of its shareholders. The shareholder's tax effect on the state level depends on whether the corporation is an S or C corporation and if the shareholder is a resident or nonresident of the corporation's state of domicile. The United States Supreme Court in its 1920 decision Shaffer vs. Carter F 252 U.S. 37 made clear that a state is permitted to tax all the income of a resident from whatever source. Income from stock (dividends) is generally taxed at the residence of the stock's owner.

States tax a C corporation on its income from all activities in the state. Dividends of C corporations are usually taxed to the individual shareholders according to their state of residence and not the state where the corporation does business. If a state exempts S corporations from state corporate income tax, the state derives no income unless it can tax the shareholders on their portions of the corporate income. This is no problem when the shareholder is a state resident because the state can tax all income of its residents, whatever the source. Therefore, for residents of the state where the S corporation is located, thecorporate income will be passed to the shareholder and taxed routinely.

The United States Supreme Court in its 1920 decision Shaffer vs. Carter 252 U.S. 37 made clear that a state is permitted to tax all the income of a nonresident to the extent it arises from property or activity located in the state. If a state exempts S corporations from state corporate income tax, the state derives no income unless it can tax the shareholders on their share of the corporate income. This is no problem when the shareholder is a state resident because the state can tax all income of its residents, whatever its source. The problems arise when the shareholder of an S corporation is a nonresident.

Each state addresses the issue of corporate income distributed to nonresident S corporation shareholders in its own fashion. Some states like Delaware and Vermont require the S corporation to pay the tax attributable to its out-of-state shareholders. Some states such as Indiana and Maryland require the S corporation to withhold taxes for its out-of-state shareholders. California and a number of other states require non-residents to file written consent to the state's personal income tax on the pass-through income. Several states (Mississippi, Nebraska, Oklahoma, and Rhode Island) require the corporation to pay the taxes on nonresident shareholders if the shareholders do not file their consents to betaxed.

A distinct disadvantage can arise if the nonresident shareholder lives in a state that does not have an individual income tax. The following states do not have an individual income tax: Florida, Washington, Texas, Nevada, Alaska, South Dakota and Wyoming.

If the stockholder is a resident of a state that (a) has no individual income tax or (b) does not include S corporation income from out-of-state sources (Connecticut, New Hampshire, Tennessee, Michigan and Oklahoma) by electing S treatment, the person will owe income tax to the state where the corporation was formed.

A nonresident shareholder in the above states owes no taxes to his home state but is volunteering to pay taxes to the corporation's home state on his S corporation income. If the election was not made, the tax would have been paid in the corporation's state at the corporate level with no additional tax at the shareholder level in either state. Still, whether the shareholder is taxed in his home state or the S corporation's state, the income of the S corporation is still taxed only once at state level, whereas C corporation income would be taxed twice.

All states have jurisdiction to tax the income of their residents, plus income from all sources for nonresidents. Therefore, all income tax that has a source in another state hasthe potential of double taxation. To avoid having the income from an S corporation taxed to the shareholder both in the corporation's state and the shareholder's state, most states allow their residents to claim a credit for taxes paid to another state, as long as the other state does not allow a credit. This credit allowed by the shareholder's state generally cannot exceed the taxes that would be paid in the shareholder's state. For example, California permits its residents to claim as a credit taxes paid in the following states:

Alabama, Arkansas, Colorado, Delaware, Georgia, Hawaii, Idaho, Illinois, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Mississippi, Montana, Nebraska, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Vermont, Virginia, West Virginia, and Wisconsin.

To be eligible for credit for income tax paid to another state, the state giving the credit usually requires that the income have its source in the taxing state. Intangible income, such as dividends, that is taxed by a state because the state considers the individual to be a resident usually will not qualify for a credit. Moreover, most states will not give a credit for a dividend distribution that is treated as an S corporation distribution by one state but a C corporation distribution by the other.

How fringe benefits in an S corporation are treated depends on the amount of stock the recipient of the fringe benefit owns. An employee who owns more than 2% of the corporate stock in an Scorporation is required to include the receipt of all fringe benefits, such as medical reimbursement payments, in gross income. The shareholder is entitled to deduct fringe benefits only to the extent that a partner in a partnership could do so.

The basis of the stock in an S corporation is treated very much as the basis in a partnership interest. Generally, both taxable and non-taxable income and deductible and nondeductible expenses will serve either to increase or decrease the shareholders' bases in their stock. Income and loss will apply to adjust the basis before application of the rules relating to distributions for any particular year. To the extent that property distributions are treated as a return of basis, the stock basis will be reduced by the fair market value of the property. Income passed to a shareholder will first increase the shareholder's basis in loans to the corporation to the extent it was previously reduced by the pass-through of losses.

There are innumerable tax consequences that might result if a shareholder is a nonresident of the state where the corporation is formed. Before an S election is made, the shareholders should consult with a tax professional to determine the tax effect the nonresident shareholders.

Generally, for a resident shareholder an S election is advantageous. Without the election, the resident shareholder istaxed on the dividends. When the election is made, the resident shareholder is still taxed on the distribution that would have been a dividend under a C corporation. The only difference is that the C corporation would have to pay taxes on any earnings retained by the corporation. Therefore, it is usually better for a resident shareholder to elect S treatment if available under state law. A tax professional should be consulted if the corporation has any sophisticated tax situations or if the shareholders have any questions.

The traditional form for two or more attorneys to practice law together has been the legal partnership. The main reason for this is that many states do not permit professionals to form professional corporations or limited liability companies. Another reason that partnerships are used is because they are simple. A partnership is not required to be in writing to be legal, although it makes a great deal of sense to have it in writing. It is not uncommon for legal partnerships to have one or more partners who are themselves professional corporations.

While general partnerships are simple to form and operate, that does not mean that they are unregulated. On the contrary, a complete body of partnership law has been developed both by case law and statutory law. The rights and obligations of partners and those persons dealing with partnerships are covered by a state'sgeneral partnership law in the absence of written agreement of the partners to the contrary.

This section will educate the reader about the differences between partnerships and corporations, and more to the point, it is intended to raise an awareness of the legalities expected of those doing business in the form of a partnership. It is important that lawyers considering the possibility of forming a partnership possess a good understanding of the rights and obligations that arise from a partnership arrangement.

The National Conference of Commissioners on Uniform State Laws wrote the Uniform Partnership Act (UPA). The UPA has been adopted by every state except Louisiana. The UPA provides the rules on how a partnership is to operate when the partnership agreement is not explicit. In short, the UPA fills the blanks in a partnership agreement. The partners can agree not to use the UPA provisions, and they can write their own replacement provisions if they elect to do so.

A partnership is two or more persons or entities working together as co-owners to run a business for profit. The Internal Revenue Code defines a partnership in Section 761(a) as:

"a syndicate, pool, joint venture or other unincorporated organization through which. . .and business is carried on. . . and is not a corporation trust, or an estate (meaning sole proprietorship)."

A partnership may be formed by a written agreement or it may be formed by an oral agreement of the parties. The determining factors as to whether or not a partnership exists are:

1. Whether the parties intended to form a partnership, and

2. Whether they intended to make a profit from the activities.

Once the foundational elements of a partnership are met, the partnership is formed and governed either by the terms of the written agreement, the UPA or in the case of Louisiana, its own state partnership law.

A joint venture is a partnership that was created to accomplish a very narrow purpose. Most partnerships exist to make a profit while engaging in a particular type of business. A joint venture seeks to make a profit usually on a one-time basis. When the purpose of the partnership is accomplished, the joint venture automatically terminates. Example of a regular partnership: Two persons form a cement paving company. Example of a joint venture: Two persons agree to work together to pave just one job. Joint ventures, as with regular partnerships, are governed by the partnership law of the state where they are formed. Like any partnership, the agreement should be in writing or otherwise have its provisions set by its state's Uniform Partnership Act. Except for the limited purpose of the joint venture, it has the same issues, problems and elements of a regular partnership.

Partnerships are treated for federal tax purposes as pass-through vehicles. All profits and losses of the partnership pass through the partnership and are attributed to the partners. The effect of this pass-through of profits and losses is that the partnership itself is not taxed. Partnership income is not subject to double taxation as is the income of a regular C corporation. To achieve this same tax benefit for small corporations, Congress created the S corporation.

A partnership does not pay any taxes on the income from the partnership. All partnership profits and losses are passed to the partners. The partnership files a Form 1165 informational partnership return and a K-1 to inform the IRS how the profits and losses are being allocated to each partner. Each partner is treated for tax purposes as a self-employed individual. Each partner is required to estimate his share of the partnership income and make estimated quarterly payments to the IRS.

Under the 1986 Tax Reform Act, profits and losses passing through to partners retain the same character they had in the partnership. A passive profit or loss to the partnership remains a passive profit or loss. All of an active partner's attributed profits and losses will be taxed as active if he materially participates in the partnership business. A partner who does not actively participate in the partnership business will have all of his share of profits and losses taxed as passive.

Generally a joint venture is treated the same as a partnershipfor tax purposes. There are, however, certain differences or elections that pertain only to joint ventures, such as:

1.A joint venture must, like a partnership, file an informational return except for certain real estate joint ventures.

2. The joint venture makes tax elections for computation of its taxable income.

3. The joint venture can adopt its own tax year, but it must have IRS permission to use a tax year different from any principal partner.

4. Under the IRC, a joint venturer (one of the partners in the joint venture) may enter into a business transaction with the joint venture and be treated as an outsider for tax purposes.

5. If the joint venture is basically a passive investment, the members of the joint venture may elect to be excluded from some or all of subchapter K of the IRC that defines how partnerships are taxed.

The above tax aspect of joint venturers gives them an advantage of flexibility over regular general purpose partnerships.

The main drawback to any general partnership is that the partners are personally liable for the debts of the partnership. In short, the partners have agreed by forming a partnership to guarantee payment of any debts or judgments taken against the partnership. Partners are not liable for the personal nonpartnership related debts of the other partners.

Under the UPA, the partnership (and thus the partners) are liable for "any wrongful act or omission of any partner in theordinary course of the business of the partnership." Where loss or injury is caused to any person by the partnership, the partners are individually liable for payment of the damages. In addition, the partners are liable for their share of any damages that arise from the actions of any partnership employee or the other partners during the course of their work for the partnership. Example: If a partner is involved in a car accident and kills two people while engaging in partnership work, all of the other partners will be liable to pay the damage award that the heirs of victims receive in wrongful death action against the partnership. If the award is $1,000,000 and the partnership has assets of only $200,000, a personal judgment will be taken against each partner for $800,000.

This is one of the main drawbacks of the partnership. The general rule of thumb is that if a partnership is formed and it has employees, the partners should either carry a great deal of insurance or incorporate as a limited liability company to limit their individual personal liability for the partnership's debts.

By law, each partner is the agent of the partnership. Each partner owes fiduciary duty to the partnership and to the other partners to act in their best interests. Some of the most important things that partners cannot do are:

1.A partner may not usurp a partnership benefit. This means that a partner must give the partnership the right of first refusal on any business opportunity that thepartner comes across that may be of benefit to the partnership. Example: If the partnership is in the paving business and a partner finds out that a school is intending to repave its parking lot, the partner cannot bid on the job for himself without first informing the partnership of the job and giving the partnership the chance to bid on the job.

2. A partner may not divert partnership assets for his own personal use. Such conduct is a breach of trust and may even expose the partner to criminal liability.

3. The partner must fully disclose all material facts affecting the partnership and its affairs to the other partners.

A partner who breaches any of these duties may be sued by the other partners for lost profits or other damages suffered as a result of the partner's misconduct. If the partner usurped a partnership benefit, he may be ordered to pay all of the profits realized from the transaction to the partnership on the theory that the partnership should have received it.

In a general partnership, each partner has full authority to act on the partnership's behalf in the normal course of its business. Each partner can bind both the partnership and the other partners to contracts even if the other partners did not authorize or approve the contracts. This unlimited power on the part of one partner to bind the partnership and the other partners is the biggest concern of most investors. The partners may agree to limit their authority to bind the partnership or act on its behalf.

People dealing with a partnership are entitled to assume, unless informed otherwise, that any partner has the right and power to act for the partnership in the normal course of its business. Even though a partner may only have actual limited authority to act for the partnership, the apparent authority of the partner may nevertheless bind the partnership to contracts with third parties. Contracts entered with people who did not actually know that the partner lacked the authority to bind the partnership are binding on the partnership.

There are some acts that a partner can never do unless the authority is specifically granted in a partnership agreement. Anyone dealing with a partner is presumed to know that unless the partnership agreement gives the partner specific authority to act in certain special areas, a valid contract in those areas cannot be executed.

The UPS requires that, unless the partnership agreement expressly states that a partner can do the following acts, the acts are invalid and not binding on the partnership:

1. The transfer of a partner's interest to another.

2. The conveyance of partnership property.

3. The mortgaging of partnership property.

4. Confession of a judgement against the partnership.

5. Submission of a partnership claim to arbitration.

6. Any act that would make it impossible to carry on the business of the partnership.

Anyone dealing with a partnership should always ask to reviewthe partnership agreement to assure himself that the partner executing the contract does indeed have the authority to do so.

Before forming a partnership, the parties should consider the following issues and decide for themselves how they should be addressed:

1. The name of the partnership.

2. The term of the partnership.

3. The purpose of the partnership.

4. Whether or not a joint venture is being created.

5. How the partnership will be funded.

6. How profits and losses will be determined and distributed.

7. Admission of new partners.

8. Expulsion of old partners.

9. Withdrawals of contributed assets.

10. Expense accounts.

11. Salaries and draws of income by partners.

12. Responsibilities of the partners.

13. Dissolution of the partnership.

14. Staffing and management.

15. Comparison with the alternative of incorporating.

16. Extent of possible personal liability for partnership debts.

These are important considerations but not the only ones. Each partnership is different because each is composed of different people with different viewpoints. Remember, anything not detailed by the partnership agreement will be determined by the state's Uniform Partnership Act. If the partners do not want the UPA toapply on a particular point, they must expressly create their alternative provision.

All partners have certain basic rights in a general partnership. These rights are:

1. The right to insist on a partnership accounting, including the right to have the books examined by an outside accountant.

2. The right to dissolve the partnership in accordance with the terms of their partnership agreement or, if none, the Uniform Partnership Act of the state.

3. The right to restrain the partnership from performing acts prohibited under the partnership agreement.

4. The right to bring a legal action for breach of the partnership agreement.

These are implied rights in any partnership agreement. Provisions in partnership agreements that waive such rights are usually invalid and against public policy.

One concern that has recently developed is whether or not a law practice is governed by the federal employment laws regarding the promotion of associates to partners. In California, a federal court held that law firms doing business as partnerships are governed by such laws. Therefore, in at least one case in California, a law firm doing business in a partnership form and advancing associates to partners in the past could not deny partnership participation to an equally qualified associate in thefuture. This issue has not yet been addressed by the Supreme Court or other jurisdictions. The California holding was based on a case in which a woman sued for discrimination because she was denied partnership. The law firm defended by claiming they had a basic right of association that gave them the authority to determine with whom the partners wanted to engage in a partnership. The partnership lost.

The issue addressed in this instance is that of equal opportunity in employment. It is one of which attorneys must be aware when doing business in the partnership form. The attorneys should carefully review the law on this subject before offering partnership to any associate to ascertain if a right or expectation of partnership is being created among current or future associates.

One of the most important issues in any partnership is how the profits and losses are divided. After all, the partners formed the partnership in order to conduct a business and make money. Therefore, it is important to know how the accounting of the partnership's profits and losses will take place.

Under the UPA, all profits and losses of a partnership are divided equally among the partners. The equal division of profits and losses occurs even if they contributed unequal amounts of work or property to it.

The partners can agree to an unequal division of profits and losses, such as based on partnership ownership interest orcontributions. Any agreement to an unequal division of profits and losses must be detailed to ensure that the UPA does not apply.

Under the U PA, property titled in the partnership name is owned by the partnership. A partner who contributes property to a partnership gives up ownership in the property. Likewise, property purchased with partnership funds is owned by the partnership.

The property held in a partnership can be legally sold, transferred or conveyed only by the partnership. Since partnership property is owned by the partnership, it cannot be directly attached to satisfy any court judgment taken against a partner. A partner's ownership interest in a partnership can be attached and sold by a creditor, but the creditor cannot attach the underlying property in the partnership.

The UPA requires unanimous consent of all partners before the admission of new partners. Unless the partnership agreement has a clause to the contrary, the UPA requirement controls, and the admission of new partners requires unanimous consent. Requiring unanimous consent only makes sense. If unanimous consent is not required, new partners could be added over the objections of partners who might not have entered the partnership had they known who would be their future partners.

Under the UPA, a new partner is only liable for the partnership debts incurred before becoming a partner and only tothe amount of his contribution to the partnership. The partner is liable, as any partner, for all of the partnership debts incurred after becoming a partner. Example: George joins an existing partnership that owes $200,000 in debts. George contributes $50,000. After joining, the partnership acquires another $100,000 in debt. Of the total partnership debt, George is liable for $150,000 ($50,000 pre-existing debt and $100,000 debt after joining) and the other partners are liable for the whole $300,000.

A tax consideration that all persons forming a partnership should bear in mind is the tax consequence of contributing services for an equity interest in the partnership. Under federal tax laws, when a person purchases a partnership interest for either services rendered or to be rendered, that partner has to recognize as income the value of the partnership interest received. A person cannot acquire a partnership tax free by bartering services. Example: George agrees to become a partner by working for it, and the partnership interest acquired is worth $10,000. George would have to report the $10,000 as income on his tax return.

The tax consequence of acquiring a partnership interest for services may result in the transaction not becoming commercially viable. It simply may not be worthwhile to work for an interest. In addition, there is often an undercurrent of resentment from the partner who contributed services against the partner who just contributed money. In a successful partnership it is not uncommonfor the partner who contributes most of the work to feel slighted when a partner who does less but who contributed the start-up capital receives a bigger share of the partnership because he contributed the capital.

Generally, a partner may freely sell or convey his interest in the partnership unless the partnership agreement says otherwise. As a normal point of fact, if the other partners do not approve of the transfer, they can usually dissolve the partnership. In a professional legal partnership, a partnership interest can only be assigned to another attorney. The canons of professional responsibility do not permit a nonattorney to own an interest in a partnership engaged in the practice of law. It is permitted, however, for the surviving spouse or family to receive payments from the partnership to compensate for work previously done by the deceased partner.

Under the Uniform Partnership Act, the remaining partners do not have to dissolve the partnership if they object to the transfer of an interest to another attorney. The remaining partners may continue partnership operations as before but not accord the new partner all of the rights of full partner. The new partner has the right to receive the selling partner's share of profits but is prohibited from demanding an accounting or inspecting corporate books.

Partnerships that have a large number of partners sometimes have a provision in the partnership agreement permitting the expulsion of a partner without dissolution of the partnership. Expulsion clauses in partnership agreements are valid if they exist to protect the partnership from harm caused by an expelled partner's breach of the partnership agreement or his fiduciary duties owed under it.

The procedure for the expulsion must be in the partnership agreement. An expulsion is obviously against the wishes of the expelled partner. Therefore, the courts will narrowly construe an expulsion clause to ensure it does not violate state law and is not against public policy.

Termination means that business is no longer being conducted by the partnership except to the extent necessary to complete its affairs. A partnership will end one day. It is not like a corporation that has perpetual existence. The partnership agreement usually lists the conditions under which a partnership will terminate. The partnership agreement may have a clause stating that the partnership will terminate:

1.When the partnership purpose is accomplished (in a joint venture).

2. On a certain date stated in the partnership agreement.

3. If a partner becomes insolvent or bankrupt. Under the UPA, when a partner files for personal bankruptcy, the partnership is automatically terminated even though thebusiness may itself be solvent. When a partner goes bankrupt the relationship with the partnership and the other partners greatly changes. By filing for bankruptcy protection, the filing partner is no longer liable for the partnership debts. The liability for payment of partnership debts remains with the partners who did not file bankruptcy. It is this general release of liability for the partner filing bankruptcy that gives rise to the termination of the partnership. The partners can agree not to have the partnership dissolved automatically upon the bankruptcy of a partner by a provision in the partnership agreement. Unless the partnership agreement states otherwise, the UPA will apply, and the partnership will be terminated upon the filing of bankruptcy by a partner.

4. If a partner dies or becomes disabled.

5. If any partner withdraws from the partnership.

6. If a partner dies or resigns without a clause in the partnership agreement stating otherwise, the law is that a partnership terminates on the death of a partner or his resignation.

7. If any of the following events occur, under the UPA a court may order dissolution of a partnership for the following reasons regardless of specific clauses in the partnership agreement stating otherwise:

a. A partner has been found insane by a court.

b. A partner is incapable of performing his duties under the partnership agreement.

c.A partner's conduct has prejudicially affected the ability of the partnership to carry on its business.

d.A partner has repeatedly breached the partnership agreement.

e. The partnership can only do business at a loss.

f. Equitable reasons support the dissolution.

A lawsuit seeking termination on any of these grounds will be difficult and costly to prove. An alternative is for the partnership agreement to have a specific provision permitting expulsion of a partner for any of the above reasons.

Termination of a partnership is accomplished in three steps:

1. The decision to terminate is made either by the partners or by law through the application of the provisions of the UPA.

2. The existing business of the partnership is completed. Under the UPA, each partner remains liable for the debts of the partnership incurred during the dissolution of partnership affairs.

3. The final cessation of business, the payment of creditors, taxes and final division and distribution of the remaining assets to the partners takes place.

After a partnership has been dissolved and its assets liquidated, the distribution is made as follows to the extent of partnership assets:

1. All federal and state taxes are paid.

2. All employee wages and benefits are paid.

3. All secured liabilities are paid.

4. All unsecured liabilities are paid.

5. The remaining funds, if any, are divided among the partners in accordance with their percentage of ownership interest in the partnership.

The proceeds received by a partner in the dissolution of a partnership is a return of his investment. Any gain or loss in thedissolution is treated as a capital gain or loss. Example: A partner paid $4,000 for stock and received $3,000. He had a $1,000 capital loss. If the partner received $6,000, he would have a $2,000 capital gain.

Depending on the complexity of the partnership business, termination may be quick, or it may be a long and involved process. Until the partnership is fully terminated, the individual liability of the partners continues. If the partnership does not have enough assets to pay all its debts and liabilities at time of termination, the partners must pay the remaining balance. If the partnership and some of the partners are insolvent, the UPA requires the remaining solvent partners to pay all the outstanding debts and liabilities of the partnership. Example: The partnership owes $2,000,000; it has assets of $1,000,000 and three of the four partners are insolvent. The remaining partner, who may own only 10% of the partnership, must nevertheless pay the entire $1,000,000 outstanding debt of the partnership. It is to avoid this result that the UPA states that a partnership dissolves when a partner files for bankruptcy protection.

Under the Uniform Partnership Act, a partnership does not pay interest on a partner's share of proceeds after dissolution except for the time "after the date when repayment should have been made." If the partnership is late in making a distribution after the dissolution, it must pay interest for the time of the delay. As with most provisions of the UPA, the partners can make an agreementnot to have this provision apply. Partners may agree to have the partnership pay interest on a partners' distributed share from the date the dissolution plan is adopted rather than the date the distribution could be made.

A partner who contributes property to a partnership does not recognize gain or loss on the transfer to the partnership. Example: A partner contributes real estate to the partnership with a basis (cost) of $200,000. The property has a fair market value of $1,000,000. If the partner had sold the property, he would have had to pay capital gain on the $800,000 profit. By contributing the property instead, the partner does not realize any capital gain. The partnership has the contributing partner's basis in the property, not its fair market value at the time of transfer. If the partnership sells the property for $1,000,000 the partnership has a capital gain of $800,000 that will be passed to the partners.

A partnership is subject to its own peculiar tax treatment under federal tax law. Most unincorporated associations and trusts that conduct business are taxed as though they were corporations. Partnerships, however, are treated differently. The income is attributed to the partners in accordance with their percentage of partnership interest. The partnership itself pays no income tax at the federal level. Example: A partnership earns $1,000,000. It pays no taxes. The partners must include the $1,000,000 on theirtax returns. Assuming a 28% federal tax rate, the partners will pay $280,000, not the total $519,200 that a C corporation and its shareholders must pay.

An S corporation is a corporation that, like a partnership, permits the pass-through of income to the shareholders. The major differences between a partnership and an S Corporation are as follows:

1. Partnerships may admit anyone as a partner and may have any number of partners, whereas S corporations are limited to 35 members of special status.

2. Partnerships can divide profits and losses in a manner not related to the partners' ownership interest. By contrast, S corporations must divide profits and losses among the shareholders in accordance to their percentage of stock ownership. In most cases, these differences are not important because the S corporation usually does not want additional shareholders and does want profit and losses allocated according to shareholder investment.

3. There is no personal liability on the part of the shareholders for the S corporation's debts. In comparison, the general partners, but not limited partners, have personal liability for the partnership debts.

Persons considering doing business as a partnership should weigh the relative merits of both a partnership and an S corporation and elect the one that best suits their type of business.

Most states require a partnership to file a fictitious business name if they are doing business with the public. Allstates require a partnership doing business under a name other than its own to file a fictitious business name statement. The purpose of a fictitious name statement is to give the world notice of the entity or person actually running the business. Usually the filing is in the county clerk's office of the county where business is conducted under the fictitious name. If the partnership does business under a fictitious name in several counties, the filing must be done in every county where it does business.

When a new partnership is formed, all of the partnership's employees are required to fill out new W-4 forms (Employee's Withholding Exemption Certificate). Everyone, except the partners, who receives compensation for work is an employee and is required to complete the W-4 form. Since the partners are owners of the partnership and have to make estimated payments every quarter on their earnings, they are not required to complete W-4 forms.

As an employer, the partnership must withhold federal income tax and social security tax together with all mandated "state withholding" from the salaries of the employees. These taxes are withheld and reported on a calendar year basis regardless of the tax year of the partnership. The returns for the tax withholding and the deposits are submitted to the IRS on a quarterly or more frequent basis.

The amount withheld from an employee's paycheck by the partnership is based upon the employee's wage level, marital statusand the number of allowances claimed on the W-4. The IRS will provide the partnership with information and assistance in calculating the proper amounts to be withheld.

Partners are not considered employees. Partners are denied many of the tax advantages available to normal employees. The deductions allowed employees for fringe benefits are not available for partners. There is no withholding from the partners for Social Security and other taxes.

A partnership and a regular C corporation treated differently. Profits and losses of a partnership are passed to the partners and are not taxed by the federal government. Even though income from a partnership is not taxed at the federal level, an annual tax return, U.S. Partnership Tax Return (Form 1165) must be filed. Form 1165 must be filed within three months and 15 days of the end of the partnership's tax year. Form 1165 is an information return that the IRS requires to assure that the partners are actually reporting their shares of the partnership income. The IRS publishes a pamphlet, Publication 541 (Tax Information on Partnerships) to assist partnerships in their tax filing.

A tax year is the year period for that a partnership calculates its tax liability. The Internal Revenue Code requires the partnership to use the tax year adopted by the principal partners. Principal partners are defined under the IRC as anyone owning over 5% of the partnership. A partnership is required tofile and pay its federal withholding return (Form 941) quarterly. The return is required to show the income and Social Security taxes withheld from the employees' wages as well as the matching social security contributions by the partnership. The partnership is required to deposit the federal income and Social Security taxes on a monthly basis in an approved commercial or federal reserve bank.

The partnership is required to furnish an annual Wage and Tax Statement (Form W-2) to every employee prior to January 31 of each year for the previous calendar year. The W-2 must show the total wages paid and the amounts deducted for income and social security taxes. The partnership must submit the original of each employee's previous W-2 and the annual Transmittal of Income and Tax Statement (Form W-3) to the Social Security Administration no later than the last day of February for the previous calendar year. For example, for tax year 1994, it must be filed by the end of February 1995.

Unless a partnership does business in a state that has no income tax (there are very few), it will have to comply with state tax laws. Partnerships are treated by the state tax codes in a manner similar to their treatment by the IRC. Partnerships, under state tax laws, are viewed the same as under federal law: pass-through vehicles. All profits and losses of the partnership pass through, meaning they are attributed to the individual partners according to their ownership interests in the partnership.

The effect of this pass-through of profits and losses is thatthe partnership is not taxed and there is no double taxation of the partnership income as with a regular corporation's income. Individual state laws can vary from the federal tax law on specific items, but overall they are quite similar in concept.

The most important change in partnership law since the creation of the limited partnership is occurring now. A few form of partnership has been enacted by some states called the REGISTERED LIMITED LIABILITY PARTNERSHIP or just the LIMITED LIABILITY PARTNERSHIP (LLP). The limited liability partnership is a cross between the two existing types of partnerships: the general partnership and the limited partnership. On the whole, a LLP is the treated the same as a general partnership except for the fact that the LLP provides a degree of protection to the partners for the liabilities of the partnership. A LLP must, the same as any other type of partnership, be composed of two or more persons, trusts, or companies who have joined together to engage in a business for profit.

The driving force behind the enactment of LLP Acts is that professionals are permitted to practice their profession through the use of the LLP. As discussed in the chapter, LIMITED LIABILITY COMPANIES some states, most notably California, does not permit professionals to do business through the use of a limited liability company, LLC. In such states, professionals are limited to doingbusiness in a corporate form, as either a regular corporation or subchapter S to limit their liability for the debts of the business. In order to provide professionals to get together and conduct their profession with some degree of limited liability for professionals working together, some states have enacted limited liability partnership acts. California is a state that does not permit professionals to operate through a LLC and instead adopted in October 1995, one year after the enactment of its LLC Act, a LLP Act. Other states which permit LLP's are Delaware, Minnesota, New York, New Mexico, Texas along with the District of Columbia. More states may be adopt such acts in the future. As of April 1997, all 50 states along with the District of Columbia have enactment limited liability company acts. A LIMITED LIABILITY COMPANY OFFERS THE OWNERS (MEMBERS) SAME DEGREE OF FREEDOM AND OPERATION AS AN LLP ALONG WITH EVEN GREATER PROTECTION FOR LIABILITY FOR THE BUSINESS'S DEBTS. Usually, if a person can do business in either the LLC or the LLP form, the LLC form is better. As stated above, however, not all states permit their professionals to do business in the LLC business form. Therefore, in such states, the LLP is the only alternative to a forming a corporation if it is available in the person's state

The LLP is for most purposes the same as a general partnership. All of the discussions previously,in this books,regarding a general partnership except for the personal liability of the partners applies to the LLP. A partner of a LLP is a general partner not a limited partner. One of the major differences between the LLP and a general partnership is that the LLP is governed and managed by a written partnership agreement whereas the general partnership is not required to have a written partnership agreement. THE GENERAL PARTNERSHIP AGREEMENT IN THIS BOOK CAN BE USED FOR A LLP IN THOSE STATES THAT PERMIT LLP'S.

As with a general partnership or limited partnership, the partners are the owners of the partnership in accordance to the terms and conditions set forth in the partnership agreement. As with any partnership, the partners are responsible for the management of the partnership either directly or through management which they elect or appoint. The partnership agreement will govern, when stated, those disputes that normally arise during the normal course of business. When the partnership agreement does not cover such instances, the normal business disputes or matters are handled by the majority vote of partn