There are many options available now for structuring legal practices. These include:
- Sole practitioners
- Partnership of individuals
- Partnership of discretionary trusts
- Service entities
There are advantages and disadvantages for each structure, and the relevant choice, as always, is dependent on each principals’ and practice’s personal situation.
Since 2007, legal practices in Queensland have been able to incorporate. Provided there is compliance with the Legal Practitioners Act 2007, legal firms can now enjoy the same structuring advantages as most other businesses in Australia.
There are many advantages of incorporation, with the main ones being:
- Asset Protection
- Cash flow management
Whilst any eligible legal practitioner can incorporate, the taxation benefits commonly considered to apply to all companies, may not apply to all practitioners. It has long been understood that a company can retain business profits and be taxed at 30%, the company tax rate. However, where the income is regarded as personal exertion income, this generally cannot be retained in the company and must be paid out to the principal. A simple distinction between business profits and personal exertion income can be made by looking to who has earned the income. Where there are at least the same number of principal and non-principal fee earners, on a full time equivalent basis, the profits are more likely to be regarded as business profits. Whether a paralegal is considered to be a non-principal fee earner is a point for discussion. My view is that they would not be considered a fee earner because they cannot provide legal advice as a legal practitioner. So an incorporated legal practice where the principal is the sole fee earner with one or more paralegals and administration people will generally not be able to retain profits. These profits would need to be paid out to the principal as wages and taxed at their marginal rates.
These rules are different to the personal services rules, and should not be confused with them.
One other issue that some firms don’t consider when they incorporate is the shift for cash to accrual in terms of the timing of when income is assessable. For firms that were previously on a cash basis for bringing to account their income, when they incorporate they usually move to an accruals basis. This means that the company (or principal if the company cannot retain profits) will pay tax on the income that has been invoiced, not received. If when you sell your practice to a company, you do not sell the WIP and debtors, and you were on a cash basis, then during the next year the WIP and debtors will be collected on a cash basis in your name, but the company will be taxed on all invoices issued. This can cause some cash flow issues if it is not adequately planned for.
If you’re considering setting up and Incorporated Legal Practice, make sure you seek advice to address all the issues that will impact on your decision. Also be mindful of the significant advantages that incorporation provides and take a balanced view.