Law firms and growth – Is it worth incorporating?

While the traditional law firm was historically a partnership, this seems to be changing.

Research now suggests that over half of law firms are now incorporated, reflecting a significant shift in the landscape away from partnership as the dominant company structure in the sector.

You may, understandably, be asking ‘why’?

We’re going to take a look at why you might choose to incorporate and why you may want to stay as a partnership to help you decide whether incorporation is right for your firm.

Partnerships vs limited companies – An overview

A limited company is one which has been incorporated, making it a legal entity separate from its shareholders, owners or directors. It must be registered with Companies House and requires the filing of certain documents each year, including a confirmation statement.

By contrast, a partnership is a business in which two or more people work together to generate a profit. There are three types of partnership:

• General – The simplest type of partnership, it requires only that owners jointly run the business and share the losses, profits and expenses of the business.
• Limited – In a limited partnership, there must be at least one general partner who runs the business with unlimited liability and one limited partner, whose liabilities are limited to their initial investment amount as they do not help to run the business.
• Limited liability – All partners have limited liability, so they are each only liable for the capital they brought to the business.

The tax perspective

The major difference between incorporated businesses and partnerships are how they are taxed, which may have a significant impact on which one you choose to use.

In a partnership, partners don’t pay Corporation Tax. Instead, they are seen as legally indistinct from their business and therefore pay Income Tax and National Insurance on any profits through Self-Assessment.

This can be a double-edged sword, as directors of an incorporated company will also have to pay these taxes on any salaries paid to them, but also must pay Corporation Tax if applicable.

Corporation Tax is paid on taxable profits after operational expenses have been met.

However, the rate of Corporation Tax is generally lower than that of personal taxes, so this may represent a saving.

Other financial liabilities

As well as tax, your business structure will substantially impact responsibility for other financial obligations, such as losses and debts.

Under a partnership, partners are personally liable for at least some, if not all, of the company’s capital – meaning they can be pursued for debts if the business becomes insolvent.

Limited companies are separate to the people who run it, so company directors are far less at risk when it comes to meeting debts.

Salaries and dividends

One of the major downsides of incorporation from a financial perspective is the effect of double taxation.

Profits are taxed under Corporation Tax and salaries and dividends are also taxed on a personal basis for directors.

However, this can be avoided by planning around personal taxes and achieving the right balance between salaried income and dividends for company directors.

Partnerships, on the other hand, may offer considerable flexibility when it comes to drawing down income from its profits.

Although you may find that, as company income varies, so does the income that each partner receives, which can be difficult if you need security.

Capital

Partnerships can make it easier to acquire new capital by bringing in new partners without going into debt.

When a new partner buys into the practice, your firm has access to this contributed capital as well as enhanced growth potential and financial stability by placing its financial health on multiple shoulders.

On the other hand, incorporation can make it easier to borrow capital from commercial lenders and limits partners’ personal liabilities if the firm cannot repay its debts.

Corporations can also sell stocks which may provide significant capital and facilitate long-term financial planning and investment.

If you’re considering incorporation and want to know more, get in touch with our team to find out how we can help you.