Most law firms start out as sole proprietorships, partnerships, or professional corporations. Now firms can chose to change partnerships to “limited liability partnerships,” or the entity, which has recently arrived on the scene: the “limited liability company.” Is it a corporation? No, not exactly. Is it a partnership? Sort of. Is it a sole proprietorship ? No, not quite. LLC’s resemble (and are usually taxed as) partnerships, and offer the advantages of limited liability, like corporations. While it has long been possible for partnerships to offer limited liability to their LIMITED partners, a limited partnership always had to have at least one GENERAL partner, who was fully liable for the debts of the business. Limited liability companies have, in effect, done away with the need to have unlimited liability for ANY of the owners of what is, in essence, a partnership form of business organization. Now, all states but Wyoming have adopted the limited liability partnership (LLP) or registered limited liability partnership (RLLP). The LLP (or an RLLP) is simply a garden variety partnership that registers with the state and pays a specified fee, in order to become an LLP or RLLP to have limited liability conferred upon the partnership which is generally quite similar to an LLC, except that it may be operated like a regular partnership, for the most part.  In many states, an LLP offers only very limited protection, insulating only against the liability arising from malpractice committed by another partner in the firm, and does not confer general protection against trade creditors or against other liabilities of the LLP, as a rule.

The upshot of the major law changes relating to LLC’s, will probably make S corporations, sole proprietorships, and general partnerships “endangered species,” as almost every small business will not be able to gain some measure of limited liability by adopting either LLC or LLP formats without need of incorporating or paying corporate-level income taxes. Pursuant to Rev. Rul. 95-37 the IRS has ruled favorably that an existing partnership may generally be converted, tax-free, to an LLC (if the LLC qualifies for partnership tax treatment). Such a conversion can be done without terminating the partnership’s taxable year (the LLC is simply treated as a continuation partnership) and without need to obtain a new Federal Employer Identification Number. 

Note that if an LLC is treated as a partnership, the members may be subject to self-employment tax on their earnings from the partnership. However, newly proposed IRS tax regulations, if adopted, would generally treat members of an LLC like limited partners in a limited partnership, so that certain members of an LLC would not be subject to self-employment tax on their distributive share of earnings from the LLC. However, a member of an LLC that elects to be taxed as a partnership (or a partner in a limited partnership) would be treated as earning self-employment income if (a) he/she has personal liability as a partner of the partnership for debts or claims against it; (b) the member has authority to contract on the LLC or partnership’s behalf; or (c) the member participates in the entity’s trade or business for more than 500 hours during the year. Even if a member of an LLC participates more than 500 hours a year in the LLC’s business, his/her distributive share of the profits may not be subject to self-employment tax, although any “guaranteed payments” received from the LLC for services will be. So, part of a member’s income from any LLC could be subject to self-employment tax while part is not, under the Proposed Regulations. In law partnerships, anyone who provides more than a minimal amount of services would not qualify for treatment as a “limited partner” for purposes of the above exemption from self-employment tax on his/her income from a limited partnership or LLC.

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