The definition of the “unauthorized practice of law” differs from state to state, and the penalty, in some states, is criminal. There are some exceptions: For example, interpreting tax law is allowed for tax professionals because it is required for us to do our jobs. Other matters are excluded because they are not defined as a practice of law, such as forming an LLC or corporation. However, some functions of forming entities are unauthorized.
For years, accountants have formed various entities for their clients. This, along with obtaining an Employer Identification Number and making a tax election, is perfectly okay for a non-lawyer to do in most states. However, when you form a partnership or limited partnership, the document that governs those entities is a partnership agreement. An LLC’s governing document is the Operating Agreement, while a corporation’s is its by-laws. A simple Google search will give you a “boiler plate” version of these documents. It is fine for accountants to hand those out to clients, as long as we don’t change them, but you should be aware even this simple action can expose you to liability.
Recently, the IRS responded to a request for a private letter ruling. The issue revolved around a legal document preparation company that formed an LLC for a client, gave them a boiler plate operating agreement and elected S-Corporation taxation.
The LLC had their S-Corporation tax return prepared by a retail tax chain, which never asked to see the Operating Agreement. The returns were prepared by this chain for a couple of years. Deciding the LLC was at a point where it needed professional advice, the company next engaged the services of an experienced enrolled agent. The EA, doing their due diligence, not only asked for the back tax returns that were filed, but asked to see the organizing documents of the LLC, including the Operating Agreement.
While analyzing the paperwork, the EA discovered a provision in the Operating Agreement that precluded the LLC from S-Corporation status. While the provision didn’t state that there were different classes of membership, it did say that the members were to receive dispportant distributions, effectively creating two classes of stock.
The EA petitioned the IRS for a Private Letter Ruling. Since a lawyer had not prepared the Operating Agreement, the legal document preperation companyand the original tax preparer failed to read it. The boiler plate agreement was an inadvertent termination of the S-Corporation status. Once the error in the document was found, the EA referred the clients to an attorney who amended the agreement so that it would comply with the rules of an S-Corporation.
In their response, the IRS agreed with the EA, and concluded that since no one bothered reading the Operating Agreement, the termination was effectively inadvertent and retroactively restored the election.
It is important to note that the determination that a termination was inadvertent must be made by the Commissioner. That is, the taxpayer can’t simply take the position that the termination was inadvertent and thus ignore the event. Rather, to retain the S status, the entity must apply for and obtain a private letter ruling that will contain the IRS’s determination. This means paying the user fee to obtain the ruling, as well as incurring the professional fees involved in getting the ruling through the IRS National Office.
The lesson here is: Don’t give a client a boiler plate governing document. Have an attorney draw one up.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...