Tag: partnership

Checklist for Transitioning Founder-Owned Law Firms

When transitioning from a founder-owned law firm, it’s essential to establish a clear plan to ensure the firm’s continued growth and stability. A successful transition depends on strategic priorities that enhance operational efficiency, improve client satisfaction, and secure long-term success.

Below, we outline the key areas to analyze and implement for a seamless shift in leadership and operations.

  1. Work-Life Timelines 

Work-life timelines act as a roadmap for planning the future of the firm. They provide a structured planning horizon that helps leadership forecast and prepare for critical milestones, such as retirements or leadership transitions. For instance, mapping out partner retirement dates allows the firm to identify when leadership gaps may occur and develop succession plans proactively.

  1. Marketing Effectiveness 

Effective marketing strategies are the backbone of a firm’s revenue growth. Assessing your marketing effectiveness involves analyzing the ability to meet revenue goals while considering the business risks associated with exiting partners. For example, if a founder has historically been a key rainmaker, your marketing plan must address how to replace their client development efforts with targeted campaigns and new initiatives, such as digital outreach or niche practice area marketing.

 

  1. Attorney Development 

Attorney development ensures that the firm maintains a continuous and adaptable skill set. As founders exit, having a pipeline of well-trained attorneys is critical to sustaining client relationships and maintaining institutional knowledge. Regular mentorship programs, skill-building workshops, and tailored career growth plans help prepare attorneys to take on leadership roles in the future.

 

  1. Recruiting Effectiveness 

Strong recruiting processes are essential for addressing capability and capacity gaps created by departing founders. Recruiting effectiveness goes beyond hiring; it involves attracting and retaining top legal talent who align with the firm’s culture and goals. Offering competitive benefits, a clear career trajectory, and a supportive environment can position the firm as a destination for top-tier candidates.

 

  1. Compensation and Incentives 

A well-designed compensation and incentive structure is vital to the firm’s profitability and transition success. Attracting high-profit lateral hires, ensuring partners are practicing profitably, and facilitating smooth transitions for senior partners require thoughtful compensation planning. For example, implementing performance-based bonuses tied to billable hours or collections can motivate both current attorneys and incoming talent.

 

  1. Policy Development 

Clear and consistent policies build trust and promote a culture of fairness among partners, associates, and staff. Whether it’s defining work-from-home expectations or delineating the decision-making process, policy development ensures that the firm operates smoothly during and after the leadership transition.

 

  1. Partnership or Operating Agreements 

A robust partnership or operating agreement ensures that decision-making processes are clear and actions carry appropriate weight. These agreements provide a framework for resolving disputes, allocating equity, and governing major decisions—such as onboarding new partners or adjusting compensation structures. This clarity helps reduce friction during transitional periods.

 

  1. Equity Transfer Processes 

Equity transfer is one of the most sensitive aspects of transitioning a founder-owned firm. Establishing clear processes for equity transfer ensures that the firm can perpetuate itself without unnecessary controversy. By structuring buyouts or equity redistribution in advance, the firm avoids disruptions that could harm operations or morale.

 

  1. Technology 

Investing in technology is critical for maintaining efficiency and gaining a competitive edge. Technology tools, such as practice management systems, client portals, and AI-driven analytics, streamline operations and strengthen client relationships. For instance, adopting cloud-based platforms allows for seamless collaboration among team members and improves data security during the transition.

 

  1. Supportive Platforms 

Creating a supportive platform that elevates the success of lawyers and staff is key to a smooth transition. This might include mentorship programs, robust professional development opportunities, and fostering a collaborative work culture. A supportive platform not only helps retain existing talent but also enhances the firm’s reputation as a desirable place to work.

 

  1. Trained and Motivated Staff 

A well-trained and motivated staff is essential for maintaining operational continuity during a leadership transition. Cross-training employees on various roles and responsibilities ensure that knowledge is retained and transferred effectively. For example, ensuring paralegals are familiar with new practice management systems or administrative protocols reduces the risk of disruption.

 

  1. Implementation 

Strategic planning is only as good as its implementation. Moving from the planning phase to actionable steps is vital for securing the firm’s long-term interests. By setting clear timelines, assigning responsibilities, and tracking progress, the firm can ensure that the transition plans lead to tangible outcomes.

Conclusion

By focusing on these critical areas, your firm can develop a comprehensive, thoroughly analyzed, and ready-to-implement set of priorities. These steps will help your firm thrive in the post-founder era while ensuring smooth transitions, client retention, and operational excellence. Transitioning a founder-owned law firm may seem daunting, but with careful planning and execution, your firm can secure a prosperous future.

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©2024 PerformLaw
For more on Law Firms, visit the NLR Law Office Management section

Profits Interest as Equity-Based Incentive: Keeping Your Team Motivated

LLC, Business Team, Equity based incentiveSay you own one-half of an LLC that is taxed as a partnership. You and your partner invested the initial capital that was necessary to get the business up and running, and you both built the business with the help of a few key employees. With the business still in the growth phase, you want to make sure that you motivate and retain these key employees who are helping you grow your company. What should you do? You and your partner might want to consider causing the LLC to issue the key employees a profits interest in the LLC.

What is a Profits Interest?

From a tax-standpoint, an LLC can issue two basic types of membership interests: capital interests and profits interests. A capital interest is an interest in a partnership or LLC taxed as a partnership that entitles the recipient to share immediately in the proceeds of liquidation. A capital interest normally results from a capital investment and provides recipients with participation in current and future equity value, a share of income, and distributions. When someone receives a capital interest in an LLC in exchange for a corresponding capital contribution, this is typically a tax-free event. When someone receives a capital interest in exchange for services, this is taxable compensation to the service provider.

Profits interests are distinct from capital interests, providing no current right to share in the proceeds of liquidation as of the date of grant. Instead, they typically only provide a holder with the right to share in those profits of the business that arise after the recipient acquires the interest. The primary goal of issuing profits interests is typically to give a service provider the ability to participate in the growth of the enterprise without incurring tax on the receipt of the interest, and to enjoy at least some long-term capital gain treatment (instead of ordinary income treatment) on proceeds they receive on a sale of the LLC or similar liquidity event.

Structuring a Profits Interests

Usually, as long as the profits interest is structured properly and capital accounts are booked up on entrance of the profits interest member, the IRS should not treat the grant of a vested or unvested profits interest as a taxable event. Most practitioners design profits interests so that they meet IRS safe harbor standards for ensuring profits interest treatment. These standards include:

  1. The profits interest must not relate to a substantially certain and predictable stream of income from the entity’s assets, such as income from high quality debt securities or a net lease,

  2. The recipient of the profits interest must not dispose of it within two years of receipt, and

  3. The profits interest may not be a limited partnership interest in a publically traded partnership.

The issuing entity’s partnership or operating agreement should be closely examined upon the issuance of a profits interest. Things to consider with respect to newly issued profits interests include whether such recipients should have voting rights similar to that of members who contributed capital to the enterprise. Additionally, the agreement should be updated to clearly define how the profits interests will be valued relative to capital interests under current buy-out or redemption provisions. Oftentimes, practitioners ensure that a profits interest has no right to share in liquidation proceeds on the grant date by valuing the company as of that date, and providing that a profits interest holder will not share in distributions except to the extent a threshold established based on the value is exceeded. Also, booking up capital accounts is generally critical to ensuring that the profits interest does not entitle the recipient to any proceeds of liquidation if the entity was liquidated on the grant date.

To the extent the profits interest issued is unvested at the time of issuance, most practitioners opt to make an 83(b) election to ensure tax-free treatment upon receipt. When a profits interest is issued, it has no value. If the profits interest is vested, there is no question that it is taxed at the time of receipt, at $0. Unvested property is taxed at the time of vesting, on the property’s value at the time of vesting. Hence, if the profits interest has appreciated in value since the time of grant, then there would be ordinary income at the time of vesting. To avoid this treatment, recipients of profits interests can make an 83(b) election, which is an election to treat the profits interest as vested for tax purposes at the time of grant and to be taxed on the value of the profits interest at the time of grant. There is some IRS guidance that states that an 83(b) election is not necessary. However, that issue is beyond the scope of this article and a so-called “protective 83(b) election” is usually still made to assist in easing the minds of profits interest holders who want to ensure that the interest is not taxable when it vests.

Tax Consequences of a Profits Interest

The recipient of a properly structured profits interest is not taxed on receipt because the IRS views the profits interest’s value as $0. Because the profits interest is treated as having no value, there is no deduction that corresponds to the issuance of the profits interest for the entity. The profits interest will be treated as having a $0 basis, and no capital account. Going forward, the recipient should be treated as an equity owner under the terms of the governing partnership or operating agreement for the entity starting on the date on which the profits interest was granted. The recipient should receive a K-1 and pay taxes on income that is passed through from the entity. Capital accounts should be adjusted accordingly, just as is the case for any other member.

The Future of Profits Interests

The history of how profits interests are taxed is riddled with controversy. In addition, politicians continue to discuss the desirability of profits interests (also sometimes called “carried interests”), in the context of private equity and hedge funds. However, the foregoing analysis reflects the IRS’ stated position on profits interests based on several Revenue Procedures that were issued to address the topic pending additional guidance. Until the IRS or Department of Treasury issues additional guidance, the current rules will generally remain applicable to small businesses and startups who are issuing profits interests.

Overall, profits interests are a unique and creative way to give people who are rendering services to the LLC or partnership a stake in the enterprise. They can generally be viewed as similar to options, except that they also provide the holder with a stake in the losses of the entity. With the increasing use of LLCs for startup operations, the use of profits interests as an incentive compensation mechanism has grown in the past years.

ARTICLE BY Katie K. Wilbur of Varnum LLP

© 2016 Varnum LLP

Jumpstart Your Startup: Entity Selection and Formation

vonBriesen

When starting a business, you must decide what form of business entity to establish. The “choice of entity” decision is one of the most important decisions facing new business owners. There are several forms of business to choose from, each of which generates different legal and tax consequences. That said, there is no single form of entity that is appropriate for every type of business owner.

The most common forms of business are the sole proprietorship, partnership, C corporation, S corporation, and limited liability company.

Sole Proprietorship

A sole proprietorship is the simplest business structure. It is an unincorporated entity owned and run by one individual with no distinction between the business and the individual owner. The owner is entitled to all profits and is personally responsible for all the business’ debts, losses, and liabilities.

A sole proprietorship needs to obtain the necessary licenses and permits for the industry in which the sole proprietorship does business. If the business operates under a name different than the individual, registering that name (e.g., DBA name, short for “doing business as”) with a state agency may be required.

Because the business and the owner are one and the same, the business itself is not taxed separately. The owner is responsible for and reports income, losses and expenses for income tax purposes.

Partnership

A partnership is the relationship between two or more persons who join to carry on a trade or business. Each partner may contribute money, property, labor, and/or skill, and, in return, each partner shares in the profits and losses of the business.

Because partnerships involve more than one person, it is important to develop a partnership agreement. The partnership agreement should document how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership (i.e., bring in new partners or buy out current partners) and under what circumstances the partnership would be dissolved. In addition, owners of a partnership should determine which type of partnership to establish. The three most common types of partnership arrangements are:

  • General Partnership: Profits, liability, and management duties are presumed to be divided equally among all partners. If an unequal ownership distribution is preferred, the partnership agreement must document that preference. A general partnership ordinarily owns its assets and is responsible for its debts. It is important to note that in a general partnership, the individual partners are personally liable for all partnership debt, obligations and liabilities. No formal state registration and/or filing is required to form a general partnership.
  • Limited Partnership: A limited partnership requires at least one general partner and one limited partner. Limited partners are generally not liable for the debts and obligations of the limited partnership (though the general partners will be liable), but they must have restricted participation in management decisions. Limited partnerships ordinarily must be filed with a state.
  • Limited Liability Partnership: A limited liability partnership generally operates and is governed by the same rules as a general partnership, except: (1) its partners have limited liability for partnership debt, (2) it can choose to be taxed as a corporation or a partnership, and (3) it is formed by filing the appropriate documentation with a state.

Generally, a partnership must file an annual information return to report income, deductions, gains, and losses from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership income or loss on his or her individual tax return.

C Corporation

A C corporation is an independent legal entity incorporated in a single state, although it may do business in other states. Because a corporation is an independent legal entity, its existence continues until formally dissolved under the laws of the state in which it is incorporated. Ownership of a corporation is in the form of shares of stock, there is no limit to the number of stockholders, and there is no limit on the number of classes of stock a C corporation can issue. Additionally, the corporation itself, not the stockholders, is generally liable for the debts and obligations of the business.

For corporate governance, a corporation generally has a board of directors and bylaws. The initial directors may be named in the articles of incorporation or elected shortly after filing the articles of incorporation. Thereafter, directors are elected as set out in the articles of incorporation or bylaws.

For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. The profit of a C corporation is taxed to the corporation when earned, and then is taxed to the stockholders if and when distributed as dividends. This creates a double tax. The corporation does not receive a tax deduction when it distributes dividends to stockholders and stockholders cannot deduct any loss of the corporation.

S Corporation

An S corporation is similar to a C corporation, except that an S corporation passes income, losses, deductions, and credits through to its stockholders for federal tax purposes. Stockholders of an S corporation report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. Thus, an S corporation generally avoids double taxation on corporate income.

In order to become an S corporation, the corporation must make appropriate filings with the IRS. To qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation;
  • Have only allowable stockholders, which are individuals, certain trusts and estates, and may not include partnerships, corporations (unless owned as a qualified subchapter S subsidiary), or non-resident aliens;
  • Have no more than 100 stockholders;
  • Have only one class of stock; and
  • Not be an ineligible corporation (e.g., certain financial institutions and insurance companies).

S corporations file specific tax returns and tax forms with the IRS.

Limited Liability Company

A limited liability company (“LLC”) is a hybrid entity that is treated like a corporation for limited liability purposes, but for tax purposes can choose to be taxed either as a corporation, partnership, or, in some cases, a disregarded entity (i.e., single-member LLC). A limited liability company is created under state law by filing articles of organization with a state. The owners of an LLC are referred to as “members” and generally may include individuals, corporations, other LLCs and other types of entities. There typically is no maximum number of members.

LLCs with more than one owner should have an operating agreement. An operating agreement usually includes provisions that address ownership interests, allocation of profits and losses, and members’ rights and responsibilities, among others.

Since the federal government does not consider an LLC a separate legal entity, an LLC with at least two members is, by default, classified as a partnership for federal tax purposes unless it files with the IRS and affirmatively elects to be treated as a corporation for tax purposes. An LLC with only one member is referred to as a single-member LLC and is treated as one and the same as its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it affirmatively elects to be treated as a corporation. An LLC may also elect to be taxed as an S corporation.

The business structure you choose will have significant legal and tax implications. In order to identify the best structure for you, it is important to understand your business goals and how the characteristics of each type of business entity can help you achieve those goals.

Article By:

Patrick J. Cannon
Of:
von Briesen & Roper, S.C.