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Rise of unincorporated businesses linked to regulatory, ethical issues

Mark Reutter, Business & Law Editor


The rapid expansion of non-incorporated businesses, such as limited liability companies (LLCs) and limited liability partnerships (LLPs), raises questions ranging from government regulation to professional ethics, according to the latest issue of the University of Illinois Law Review.

Beginning in 1977, many state legislatures have authorized the establishment of such entities, which are more loosely structured than a shareholder corporation. They have proven especially popular among lawyers, doctors, engineers and other professionals.

A primary reason why professionals choose to be unincorporated is flexibility – a partner can make contracts directly with clients rather than through the corporation – along with limited liability, a feature of corporations.

(Stockholders in a corporation are protected from the debts of the corporation, while partners of a traditional “unlimited” partnership are personally liable for the firm’s obligations.)

Another advantage of limited liability groups is the avoidance of so-called double taxation. A corporation is taxed on its income and again when profits are distributed to stockholders. The income derived from a LLC or LLP, however, is not taxed; instead the owners pay personal taxes based on their share of the enterprise. This can lead to significant tax savings.

Despite their rapid expansion, unincorporated entities have been conspicuously unexamined by legal scholars, according to Larry E. Ribstein, a professor at the Illinois College of Law.

“Uncorporations already have gone a long way toward replacing traditional partnerships and close corporations in closely held and professional firms,” he wrote, “and raise questions about the survival of the traditional public corporation form for publicly held firms.”

A major unexplored issue is the ethical responsibilities of lawyers who represent unincorporated entities. Is the lawyer retained by an LLP representing the individual partners or the enterprise itself, asked Richard W. Painter, an Illinois law professor.

“The little case law that exists is confusing,” Painter noted. As a result, he recommended that lawyers define their relationship with partners through “private ordering,” or explicit written agreements, at the outset of representation. Courts and bar associations should then enforce these contracts when ruling on lawsuits and other disputes between parties.

A related question centers on how a lawyer should disclose evidence of fraud, kickbacks and other criminal behavior in a partnership. The Securities and Exchange Commission (SEC) has ruled that unincorporated firms that issue stock to the public are covered under the Sarbanes-Oxley Act, which set new standards for business ethics following the corporate scandals of 2001-02.

Because LLCs and LLPs do not have executive officers or boards of directors, Painter suggested that a lawyer first report the alleged misbehavior to all partner members or to a special panel of members. If the partners do not take appropriate action, the lawyer is then obligated – like his counterpart in corporate America – to report the illegalities to the SEC.

Outside of SEC fraud provisions, uncorporations are unregulated by the federal government. Saul Levmore, a law professor at the University of Chicago, predicted that partnerships will come under federal regulation “following a shocking scandal” and “the distance between corporate and uncorporate law (will) narrow.”

Papers by Ribstein, Painter and Levmore were part of a Illinois College of Law symposium called “Uncorporation: A New Age?”