Should Accounting Firms Incorporate?

Introduction

Large accounting firms today, e.g., the "Big Five," are Limited Liability Partnership (LLPs). They are LLPs because LLP registration limits all partners' malpractice liability to their own. Originally, they became partnerships because historically, corporate tax rates were high (up to 48% compared to 35% today) and they wanted to avoid "double taxation," there were fewer retirement plan options, and there was a wide difference between corporate and non-corporate plans.

It may be time to revisit the choice of business form for accounting firms. Incorporating has become a more serious option, due to many factors, including the demand for technology-related stock; new approaches to compensation packages; near entity-neutral retirement plans and employment taxes; availability of Limited Liability Companies (LLCs) and S Corporations, including Qualified Subchapter S Subsidiaries (QSubs); and the increasing percentage of non- CPA professional employees. When small practitioners formed "PAs" or Professional Associations in the 1960s and 1970s, it was primarily to qualify for corporate deferred compensation plan limits. Today, even SIMPLE Plans (Savings Incentive Matching Plans for Employees) are available to small employers-incorporated or not.

Employee Vs. Partner

A corporation only has employees, while partners are independent contractors. Here are some factors to consider when comparing the two:

* Limited Liability: Partners are liable for the debts of the partnership, even with LLP registrations, and for each other's malpractice consequences; unless LLP registrations are in effect. Employees have no liability exposure.

* Self-Employment Taxes: For years, partners and employees have all been subject to employment taxes at the same 15.3 percent rate--half of which is deductible. Employees pay one half directly and one half indirectly--since the employer pays the second half on the employee's behalf--while a partner pays both halves.

* Job Title: It is entirely possible that corporate titles like "vice president" and "senior vice president," will have as much or more credibility and recognition in the business community as "partner," "principal" and "manager."

* Compensation Packages: A frequently touted advantage of a partnership is the flexibility resulting from the ability to amend the partnership agreement; e.g., adjust profit and loss sharing ratios. However, a corporation can design and adjust compensation packages to classes of employees or to individual employees. Thus, salaries, bonuses, options and deferred compensation plans (qualified or nonqualified) may be used to reward work, results and performance. Corporate and non-corporate pension and profit-sharing plans have been substantially identical since the mid-1980s. Compensation is deductible without limit, (reducing or eliminating "double taxation") except that compensation in excess of $1 million for the five highest paid employees must be "performance based" to be so under Code Section 162(m).

* Already Employees: Most people who work for accounting firms are employees, even if the employer is a partnership. In fact, the larger the firm, the smaller a minority do the accountants become!

A small firm may consist of three accountants and a secretary/receptionist. However, large firms employ an increasing number of highly paid professionals; e.g., actuaries, lawyers, economists, computer engineers, MBA-consultants, etc. Even all non-partner CPAs are employees! Why not make everyone an employee? It may actually simplify matters!

Corporate Advantages over Limited Liability Partnerships (LLPs)

LLPs have become popular the last few years, since an annual registration in each state with an LLP statute insulates a partner from the other partners' malpractice consequences. Thus, all the "Big Five" companies are LLPs! However, the following factors are on the side of a corporate solution:

* A corporation has limited liability--audit employees have none--for contractual debts; LLPs and their partners do not.

* An employee, even a "senior vice president," has no liability for the malpractice of other employees. No annual registrations are needed. Partners are jointly liable for each other's malpractice claims, unless LLP registrations are made.

* LLP registration varies from state to state and is not even available in some jurisdictions.

* An LLP has to post bonds and/or maintain escrow deposits, acquire and post letters of credit and/or purchase malpractice insurance. Corporations are not required to obtain malpractice insurance. Decisions in this area should be based on the individual situation; e.g., degree of being judgement proof.

Reorganizations

The tax-free reorganization provision in Code Section 368 makes it possible for corporations to engage in merge[acute{r}]s, acquisitions, consolidations, spin-offs and recapitalizations without gain recognition. The following are examples of the application of these rules:

* The issuance of common stock, preferred stock, voting and non-voting stock, convertibles to current and future shareholders and exchanges of such stocks;

* The tax-free conversion of convertible bonds and convertible preferred stock into common stock;

* The tax-free acquisition of other accounting firms or their separately incorporated divisions; e.g., audit divisions or consulting divisions;

* The tax-free spin-off of a subsidiary; e.g., the E-commerce division to the parent corporation's shareholders;

* The tax-free creation of a subsidiary; e.g., a consulting firm, (a "drop down") or the opposite, the tax-free liquidation of a subsidiary into the parent.

The "S" Election

Making the S Corporation election eliminates most corporate level taxes. Since an S Corporation now is permitted 75 shareholders, most of the largest local accounting firms would be eligible. An S Corporation, just like a C Corporation, may form any number of LLCs as subsidiaries; e.g., audit, consulting, E-commerce, etc. As an alternative, an S Corporation may form any desired number of wholly armed S Corporation subsidiaries (QSubs). Like LLCs, these are disregarded for tax purposes, but afford limited liability under local law.

Going Public -- The IPO 

A corporation may go public through an IPO (Initial Public Offering). If successful, an IPO may raise significant capital and make many shareholder-employees wealthy in the process. In some cases, only a division of the business may go public; e.g., a separately incorporated consulting practice. Many accounting firms are well positioned to literally "capitalize" on the electronic or Internet aspects of their activities, such as information systems, information technology or any web-based or E-commerce activities. Thus, instead of contributing capital for a non-transferable partnership interest, the equivalent "vice president" or "senior vice president" may wind up with a significant amount of marketable stock.

Miscellaneous Consideration

The following facts should be reviewed before deciding to incorporate:

* Retirement Age: Employees cannot be forced to retire, due merely to attained age, while a partner's retirement age is governed by the partnership agreement.

* Stock Sales and Redemption: An employee with marketable stock may sell it during or after employment. Upon retirement or death, the employer may redeem the stock--pursuant to a buy/sell agreement.

* Incorporations and Liquidations: Since a business may incorporate tax-free, but corporate liquidations (necessary to convert to a partnership) are taxable, the decision to incorporate should not be taken lightly.

Conclusion

The corporation is an underutilized vehicle for accounting firms. Although partnerships certainly will remain with us, the corporate form deserves a second look. Among the reasons to consider incorporating are: going public, making the S election, the attractiveness of shareholder-employee status, the corporate reorganization provisions, and the disappearing line between corporate and non-corporate businesses for deferred compensation and employment tax purposes.

Rolf Auster, Ph.D., LLM, CPA is a professor of taxation in the School of Accounting at Florida International University in Miami.