lished, the decision management aspect of the firm needs to be established.
Who makes decisions and how decisions are made can make the difference in whether a firm survives or fails. The decision-making and management process need not be complicated, but principals must strive for clarity and fairness or an exodus of the best people will soon begin. This chapter reviews several models, noting their strengths and weaknesses.
Ways to Organize: An Overview
There are many ways to structure the professional services firm. But before a structure is chosen, some strategic issues have to be considered:
1. The scope of the business (local, national, or international)
2. The nature of the business (type of practice/industry)
3. Risk and personal liability considerations
4. Tax treatment
5. Capital needs and availability
6. Succession
7. Attracting and retaining talent
While there are a wide variety of ways to structure a business, the most popular are: subchapter C corporations, subchapter S corporations, and
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Managing and Governing the Professional Services Firm
limited liability company (LLC) models. Some smaller firms are sole proprietorships, and some firms, particularly in the legal arena, are still partnerships but the unlimited liability issue and the potential challenges of equitable distribution work against these models. Moreover, professional licensing or industry codes prohibit ownership in a firm by professionals from other disciplines; sole proprietorships and partnerships are not f lexible enough to accommodate growth with such restrictions. Exhibit 3.1 (pp.
63– 64) summarizes the advantages and disadvantages of each form.
Sole Proprietorship
Sole proprietorships are generally unattractive for a professional services firm of any size. While easy and cheap to start, usually requiring only the filing of a local business license, sole proprietorships provide little or no f lexibility for growth.
Advantages
1. Start-up costs are inexpensive.
2. Income and expenses of the business f low through directly to the owner.
3. As an extension of the individual, there are no business income tax issues.
4. This form works best for smaller, low-risk personal service and some retail businesses.
Disadvantages
1. Personal liability is unlimited for all claims and judgments against the business.
2. It is difficult to bring in others to accommodate growth.
3. Loan capacity is limited to personal loans and personal net worth, plus the value of accumulated assets.
4. Income sheltering and favorable tax treatment options are not generally available.
5. Exit strategies are limited.
Partnerships
Partnerships, whether limited or general, are legal entities in their own right. Partnerships can be formed by individuals, companies, or individuals and companies. A partnership can sign contracts, hold property, and file suit in its own name. Partnerships are dissolved on the death or insolvency
Partnership and Governance Structures
57
of one of the partners, and all partners have unlimited liability for partnership actions irrespective of initiating partner. Most states have minimal requirements for the creation of general partnerships, while limited partnerships typically require only the filing of a one-page certificate of limited partnership.
Advantages
1. Start-up costs are inexpensive.
2. It is easy to establish with two or more entities.
3. Limited registration is required.
4. Partnerships are their own legal entities.
5. Tax treatment is favorable because income and expense f low through to partners.
6. Limited partners’ liability is normally restricted to their investment (they can become liable if actively involved in the business).
7. Limited partner income is not subject to self-employment tax.
Disadvantages
1. General partners have unlimited liability.
2. Creditors of a general partner can pursue the partnership and force its liquidation.
3. The partnership normally ends when one partner dies or becomes
bankrupt (other partners elect to continue under some circumstances).
4. Adding new partners generally requires consent of all existing partners.
5. Limited partnerships have been attractive to passive investors but pose problems for investors (angel investors, venture capitalists, equity funds) who wish to assume an active role in the company.
6. Valuing partnership interests can be complicated.
Limitations of a Partnership
A good example of organizational structure impeding growth is the case of a construction management firm. The firm, a partnership, employed 7
principals (senior and junior partners) plus about 15 others and was managing about $35 million in construction contracts.
Due to the nature of partnerships (unlimited liability of all named
partners for any and all partnership liabilities) and bonding requirements (the need for hard assets to secure bonds), taking on larger projects was problematic. Many bonds required personal guarantees from
the principals and were often secured by their homes. This led to variations in opinion among the partnership about acceptable levels of risk and pursuit parameters for new projects.
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Managing and Governing the Professional Services Firm
Within nine months, the firm, with the help of an outside adviser, became a corporation. Bank financing for projects was secured. A valuation formula for the company was established, and one partner was bought
out. The remaining principals grew the firm to more than $100 million in sales, eventually selling it to a larger company.
Limited Liability Companies
The LLC is a relatively new organizational structure developed to overcome some of the shortcomings of the limited partnership. All members of an LLC
are essentially treated as limited partners in relation to liability issues, but with a difference. Creditors of individual LLC members cannot pursue the entity; bankruptcy (bankruptcy and assignments for the benefits of creditors terminates membership) or the death of a member does not necessarily force its dissolution. A well-thought-out operating agreement explaining all rights and remedies is critical to the LLC’s success.
Advantages
1. LLCs can be created by one or two members (individuals, corpora-
tions, other LLCs) depending on state law.
2. Most states require the filing of a single-page certificate of formation.
3. Members enjoy limited liability status but may be involved in the business.
4. Members have protection from creditors of individual members.
5. Members have interests, rather than shares, which are more scalable in accommodating internal growth.
6. LLCs may not offer options.
7. Flexible handling of ownership interests, distribution rights, voting rights, income distributions, losses, credits, and deductions can be allocated to members.
8. LLCs can be easily converted to the corporate form.
Disadvantages
1. Adding new members requires the agreement and consent of all existing members (unless provided for in the operating agreement).
2. LLCs are not true corporations and lack case law to support a full range of activities.
3. Interests do not provide for awarding of employee options or stock.
4. LLCs may restrict investment options if outside capital is sought, except in cases of foreign investment where the LLC is a familiar structure.
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Subchapter S Corporation
A popular structure for many professional services firms is the subchapter S
corporation (S-Corp). The S-Corp has been in existence for many years, and its corporate structure provides well-defined case law in support of the rights of officers, directors, and shareholders. In addition, it allows income and losses to pass through to the individual shareholders. The S-Corp follows the corporate form of the subchapter C corporation (C-Corp) in many ways but without the imposition of a second level of taxation. It has, however, some restrictions such as limitations on the number of shareholders and restrictions on who can own shares. Some of these restrictions have been eased by recent legislation.
For example, S-Corps are no longer limited to 35 shareholders. Under the new regulations, that number has been increased to 75. Stock ownership has also been relaxed. Currently, other corporations can own shares, as can pension plans, stock bonus plans, and profit sharing plans. The new regulations also allow S-Corps to provide stock incentives to employees.
Some restrictions still remain, including restrictions on employee benefits allowable to large shareholders. The S-Corp may still have only one class of stock. Foreign investors are not permitted. Only small business corporations are allowed to elect S-Corp status. While conversion to a C-Corp is possible, conversion to an LLC requires that the corporation be dissolved, leading to potentially adverse tax implications.
Advantages
1. S-Corps have a proven corporate structure.
2. S-Corps have a favorable tax treatment similar to partnerships.
3. Liability protection and regulations as in the corporate form apply.
4. Regulations were recently liberalized.
a. S-Corps can now have up to 75 shareholders.
b. Ownership is now open to other corporations and nonprofits.
c. S-Corps can own subsidiaries.
d. S-Corps can provide stock incentives to employees.
Disadvantages
1. Only one class of stock is allowed.
2. S-Corps are available only to qualified small business corporations.
3. Foreign investors are not permitted.
4. The form restricts investment options.
5. Employee benefits are limited for large shareholders.
6. Conversion options to LLC may trigger unwanted tax implications.
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Managing and Governing the Professional Services Firm
Scalability Is an Issue in S-Corp Succession Plans
The founding principal in an architectural firm had, over the years, sold a small percentage of ownership to his second-in-command, a person
several years his junior, with the understanding that he might eventually purchase more shares. In time, the firm identified another potential owner. He was hired with the express understanding that he would be