Organizational Form for Postgraduate Law Firms

June 13th, 2013 / By Deborah J. Merritt

John Colombo has posted a useful paper examining the best organizational form for postgraduate law firms created by law schools. Several law schools are exploring that type of firm; we discussed the general idea in several earlier posts. Professor Colombo probes the important tax consequences of organizing these entities, an issue that no school would want to ignore.

Colombo’s analysis suggests, first, that a firm operating as a division of a law school would not endanger the school’s tax-exempt status. Even if the firm charged clients for representation, paid graduates employed by the firm, and generated net revenue, the firm would not negate the school’s tax-exempt status as long as its activities remained “functionally related to the educational mission of the underlying school.” Colombo offers more detail on meeting that and related IRS tests, but concludes that postgraduate firms should readily pass muster.

Some schools, however, might prefer to establish a law firm as a separate non-profit entity. In particular, schools (and their governing universities) might prefer to isolate the school from liabilities incurred by the firm. Professor Colombo’s analysis, however, shows that it would be difficult for a separate non-profit to qualify for tax-exempt status. The precedents conflict, but “the bulk of these precedents indicate that organizations conducting commercial-like businesses as their primary activity will face considerable hostility from the IRS in seeking exempt status.” Even if a school-related law firm ultimately won the day, few law schools would want a new project like this to face IRS opposition.

Fortunately, there is a solution for schools located in states that allow law practices to function as limited liability companies (LLC’s). If the law school creates an LLC to house the firm, with the school as the LLC’s only member, then “the law school will receive the state-law liability protection of a limited-liability entity, while having the tax exemption issues analyzed as though the firm were operated as a ‘division’ of the law school.” The firm, in other words, would receive the school’s tax-exempt status.

I can’t pretend to evaluate Professor Colombo’s assessment; I’ve figured out relevant parts of the personal income tax, but don’t have a clue about the taxation of businesses or other organizations. Colombo, however, is a pro in this area, and his analysis is cogent–even readable for those of us who don’t commune daily with the Internal Revenue Code. Tax treatment is only factor in choosing organizational form, but it’s a significant one. Any law school considering creation of a postgraduate law firm should read Colombo’s concise perspective on organizational form and tax exemption.

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