EXECUTIVE SUMMARY

IT HAS BEEN MORE THAN A DECADE since the AICPA amended Rule 505, Form of Organization and Name, of its Code of Professional Conduct’s Rules of Practice to permit the practice of accountancy in LLCs and LLPs, but there still is confusion about the scope of liability protection they offer. WHETHER A CPA PRACTICE is organized as an LLC or an LLP, each member or partner remains liable for individual misconduct. Many factors affect legal liability exposure including the nature of the business entity, the state in which it has been formed, the precise terms of the LLP or LLC agreement and a broad range of federal and state laws. LAWS PERTAINING TO LLCs AND LLPs are determined by each state and may differ significantly. LLC and LLP statutes may provide a shield of protection from certain civil suits but do not provide protection from criminal or securities violations. THE SCOPE OF LIABILITY PROTECTION an LLP offers may differ depending on whether it is formed in a state with “full” or “partial” shields. COURTS MAY HOLD AN OWNER PERSONALLY LIABLE for wrongdoing if he or she has used the LLC to commit a fraud, has not properly capitalized the LLC or has misled third parties into believing the practice is being conducted by individuals rather than by the LLC. WHEN FORMING OR REVISING a professional entity, CPAs should exercise care about the partners they select and the contractual authority they give each person. They should review the governing statutes—and consult an experienced attorney.

SANDRA K. MILLER, JD, LLM, is a professor of business law and taxation at Widener University, Chester, Pa., and is an American Bar Association committee advisor to the National Conference of Commissioners on Uniform State Laws. JAMES J. TUCKER III, CPA, PhD, is an associate professor of accounting and taxation at Widener University. He has written numerous articles on auditing and corporate financial reporting. Their e-mail addresses are sandra.k.miller@widener.edu and james.j.tucker@widener.edu, respectively.

ince the litigation explosion of the mid-1980s CPA-firm partners have looked for ways to limit personal liability. Firms operating in multiple states have had special concerns, given the geographic, cultural and jurisdictional disparities they must manage. This article will explore some of the litigation risks of operating an accounting practice as a limited liability partnership (LLP) or limited liability company (LLC), clarify LLP and LLC similarities and differences and recommend strategies that help minimize exposure.

LIABILITY BY ENTITY
Until 1992 accountants could practice only as sole proprietors or in general partnerships or in professional corporations. Each had drawbacks: Sole owners risked liability for employee violations through the legal doctrine respondeat superior (literally “let the master answer”). General partnerships faced unlimited personal liability for partner negligence and partnership debts. Professional corporations offered protection that varied greatly by state and was not available to all multistate practices. S corporations limited the number of shareholders, curtailing growth, and conversion to a corporate form had significant tax consequences.

Those shortcomings, exacerbated by a deluge of litigation, led the AICPA in January 1992 to overwhelmingly approve an amendment to Rule 505, Form of Organization and Name, of its Code of Professional Conduct’s Rules of Practice to permit the practice of accountancy in any form permitted by state law or regulation, including the then-emerging LLCs and LLPs.

Although more than a decade has passed since the rule change, there still is confusion about the difference in the scope of liability protection these forms offer. What is certain is that whether a firm is an LLC or LLP, each principal remains liable for individual misconduct under civil and criminal laws, and the veil of limited liability can be pierced in some circumstances. Moreover, the protection limited liability offers differs according to whether the firm’s state provides a “full” or “partial” shield (see “LLP Statutes by State”).

THE LLC AND LLP LANDSCAPE
LLC or LLP agreements contain provisions affecting a partner’s obligations to the entity or to other partners, and those terms may create liability. While state statutes pertaining to LLCs and LLPs provide a shield against certain civil suits, they may differ significantly, and they don’t protect a partner from prosecution for criminal or securities violations. CPAs forming or revising a partnership should develop the firm’s governing documents with care and after consultation with legal counsel.

An LLC practice offers a full shield, subject to exceptions. Like a sole practitioner or general partner, each member of an LLC is liable for his or her own acts of negligence and/or civil and criminal violations. LLC statutes generally protect owners from personal liability for the ordinary business debts of the entity, though there are exceptions. Because laws change constantly it’s wise to monitor LLC statutes and related state legislation. For example, the Rhode Island General Assembly amended its workers’ compensation law to impose personal liability upon corporate officers, LLC managers and members, and partners in general or limited partnerships for knowingly failing to provide workers’ compensation insurance.

In exceptional cases courts may hold an individual LLC owner personally liable for LLC debts by piercing the so-called “corporate veil” of limited liability. This may occur when an owner has used the LLC to commit a fraud, has not properly capitalized the LLC or has misled third parties into believing the practice is being conducted by individuals rather than by the LLC. The law is just beginning to develop in this area.

The LLC shield is not a complete bar to personal liability. State laws typically include provisions to recover property that has been fraudulently conveyed to others. Furthermore, the IRS can seek to collect tax from an individual member if there has been a fraudulent transfer or a failure to pay trust fund taxes for which the LLC member is deemed a “responsible person.” A plaintiff may use a variety of state statutes to reach the personal assets of the LLC owner (another reason to monitor relevant state laws for changes).

LLP statutes exist in all 50 states, but the protection they afford can vary significantly. In full-shield states, a partner is generally liable for his or her own malpractice and misconduct but not for malpractice committed by other members of the LLP when he or she is not involved. Partners are not liable for other types of liabilities, including ordinary business debts of the partnership. Thus, the full-shield LLP offers much the same liability protection as the LLC. Generalizations, however, can be misleading. The precise wording and scope of the liability shield contained in each LLC or LLP statute may differ. Always review statutes carefully, along with any LLC or LLP agreements in effect (see “Using LexisNexis to Find the Latest State Statutes”).

In partial-shield states, a partner usually is liable for his or her own malpractice and misconduct but not for that committed by other members of the LLP when he or she is not involved. However, in general, partners are liable for the ordinary business debts of the partnership. There is significant variation in the wording of state statutes as noted above.

Here’s an example that compares partial-shield vs. full-shield liability: ABC Limited Liability Partnership (LLP) is a CPA firm with three partners: A, B and C. Partner A is found guilty of malpractice in which partners B and C are not involved. ABC LLP is liable for a malpractice claim of $10 million. The firm has assets and insurance coverage totaling $6 million. Soon after the malpractice judgment, the partnership ceases operations, owing $250,000 to its leaseholder.

Full-shield results: The plaintiff in the malpractice judgment can sue and seek damages from partnership assets and the personal assets of partner A; partners B and C are not personally liable. Since a full shield eliminates personal liability of the partners for contractual obligations and normal business debts, the lessor may seek damages only from partnership assets but not from the personal assets of partners A, B and C.

Partial-shield results: The plaintiff in the malpractice judgment can sue and seek damages from partnership assets and the personal assets of partner A. Since partners B and C were not involved, they are not personally liable. But because a partial shield does not eliminate personal liability for contractual obligations and normal business debts, all three partners are potentially personally liable for the $250,000 owed to the leaseholder.

CONTROL YOUR EXPOSURE
There are several basic precautions you can take to minimize your legal liability:

Select your associates and business entity carefully. Each partner and/or member may have authority under the relevant agreement and state law to legally bind the LLP or LLC, so get to know your potential partners well.

Consult an attorney when deciding which business form to choose. Usually LLCs and full-shield LLPs provide the most protection. Multistate practitioners may wish to ask their attorneys for an update on relevant statutory and case law that answers the question of which state’s LLP shield would apply if the firm were to organize in one state and conduct business in others.

Consider internal controls to reduce the risk of unauthorized transactions. Every firm should develop a system of controls that ensures owners and employees will not engage in conduct beyond the scope of their intended authority. State agency laws tend to protect third parties in their dealings with an entity, and a firm could be legally bound in certain circumstances if a partner appears to have the authority to consummate a transaction.

Carefully review employment practices. LLPs and their individual partners have been sued for violations of Title VII of the Civil Rights Act of 1964. For example, in Middlemist v. BDO Seidman, 958 P2d 486 (Colo. Ct. App. 1997), the plaintiff sued both the LLP and—because the CPA had been fired—the partner who had been her immediate supervisor. The Colorado Appellate Court ruled in favor of the defendant accounting partner and held that a Title VII violation must be brought against the employer—that is, the LLP firm—rather than the individual partner. However, the court acknowledged that certain types of claims, such as an assertion of assault and battery or a negligent or intentional infliction of mental distress, conceivably could be filed against the individual.

Satisfy registration, tax, insurance and other requirements. A shield is in force only if the firm is properly registered with the state as an LLP or LLC. Review all filing requirements annually. Check that the entity is properly registered and has met all relevant insurance and other requirements. Update the business registration and insurance as needed, especially if there has been an exceptional event such as a merger.

Manage liability exposure resulting from firm reorganization. Accounting partnerships are frequently expanded, merged or reorganized. For a succession plan, fully examine the legal exposure and tax implications of a restructuring for each partner. Complicated tax situations can ensue even when expanding an LLC from one member to two. Examine the federal and state tax consequences of any restructuring with care.

Accurately represent the firm’s name and designation as an LLP or LLC. You must use the proper firm name and designation (LLP or LLC) at all times to achieve the limited liability shield. Precise wording in billing, engagement letters and even internal files have an impact upon the legal liability of the firm and its partners.

In the case of Water, Waste, & Land v. Lanham, 955 P2d 997 (Colo. 1998), the plaintiff, a development and engineering firm that had performed work for an LLC, successfully sued one of the owners in his individual capacity. Water, Waste & Land had performed work for the LLC, which was owned by two members, Lanham and Clark. When arranging to have work done, Clark failed to properly fill out a contract and verbally authorized the plaintiff to do the work. Clark gave the plaintiff a business card that showed the initials of the business name but did not include the letters LLC. The business card included the LLC’s address, which happened to be the same as Lanham’s personal address. The Colorado Supreme Court ruled that Clark had acted as an agent of Lanham and ultimately held both Lanham and the LLC liable for the bill.

The case underscores the risk of personal liability even when business owners have formed an LLC. It also shows the importance of using the LLC on all firm documents and completing contracts properly. The decision illustrates the courts’ inclination to protect third parties in their dealings with agents of a business.

Consider the implications of employee supervision. Under some circumstances partners can be held liable for the wrongdoing of those they supervise, so a firm choosing to operate as an LLP may wish to form the LLP in a full-shield state. State shields’ variations in protection make it particularly important to get the input of legal counsel when organizing a multistate practice. Whether your firm decides to be an LLP or LLC, it should be extremely cautious regarding which partner or partners you choose to have supervise employees. The structure of the firm should take into consideration the liability implications of employee supervision.

Exercise care in constructing all employment policies. Consult an attorney in advance of major employment decisions and develop the necessary factual support to defend against potential lawsuits. Implementing and enforcing a sound employment policy is the best defense to employment-related legal liability, as illustrated by the 1998 case of Faragher v. City of Boca Raton, 524 US 775 (1998). Here, an employer was allowed to raise a defense to a charge of sexual harassment by having and enforcing a sound sexual harassment policy.

Consider the consequences of a partner dispute or the departure of one or more partners. It is not surprising that many firms dissolve under the pressures of professional practice. Practitioners should consider including provisions in the LLP agreement that address the consequences should a partner decide to leave the firm for any reason.

WRAP-UP
Regardless of whether an accounting practice is organized as an LLC or an LLP, each member or partner remains liable under civil and criminal laws for individual misconduct. A variety of factors affect legal liability exposure: the nature of the business entity selected, the state in which the entity has been formed and the precise terms of the agreement. A broad range of federal laws and state laws also affects it. It is advisable to consult legal and tax counsel before rather than after major transactions. Be sure to stay current, comply with all relevant laws and methodically review the firm’s practices and legal documents to ensure all legal matters are properly addressed.