Firm Legal Structure PDF

2.2 Firm Legal Structure Philip R. Croessmann, AIA, Esq., and David F. Kinzer III, CPA...

2.2 Firm Legal Structure Philip R. Croessmann, AIA, Esq., and David F. Kinzer III, CPA Regardless of their size and structure, architecture and engineering firms are organized and behave according to certain basic principles established in state and federal law. A n architecture firm may be established as a proprietorship, partnership, corpo- ration, or limited liability company. Although there are important legal, finan- cial, tax, and operational factors to consider when selecting a form of practice, certain legal requirements apply to all forms. SO LE P R OP R I E TO RS H I P S PA R T 2 : P R A C T I C E From a legal, compliance, and taxation standpoint, a sole proprietorship is the simplest form of practice. By definition, a sole proprietor is an individual conducting business in an unincorporated format. The sole proprietor makes no legal arrangements with other individuals, is not required to file state documents and federal tax forms to con- duct the practice, and has full, personal control of the firm. Although a sole proprietor- ship may have employees, the individual and the unincorporated firm are legally one and the same. Some of the simplicity inherent in this form of practice can be jeopardized if the proprietor fails to take special efforts to isolate the activities of the architecture practice from personal and unrelated business endeavors. In particular, keeping business and personal finances separate is part of an important management discipline that can con- tribute to the financial success of a practice. A sole proprietorship does not file a separate federal tax return; rather, relevant information is allocated and included with the pro- prietor’s personal tax return. Preparation of this information for the IRS can be made much easier by keeping personal and business financial matters separate, although there is no legal requirement to do so. For example, the IRS regards business expenses differ- ently—and more favorably—than personal expenses, permitting deductions for certain business expenses. Separate bookkeeping simplifies proper reporting of these expenses. Two other factors should be considered when determining whether to establish a sole proprietorship: legal liability and the effect of death or retirement on the firm. Liability. A sole proprietor’s liability for professional errors and omissions and for business debts is unlimited. Both a professional liability claimant and a vendor of busi- ness services or products can reach all of the assets of the proprietor—except those that may be protected pursuant to state bankruptcy statutes. A professional liability insur- ance policy will protect the proprietor, to a certain extent, “Risk Management“ assesses professional liability from losses associated with professional liability claims. insurance as part of a firm’s risk management strategy. Nonetheless, the proprietor remains fully liable for all adju- dicated business claims. Death or retirement. The death or retirement of the proprietor terminates the proprietorship. Unless a provision has been made for a successor to purchase the Philip R. Croessmann, an architect and attorney, is a member in the law firm of Westberg Croessmann, P.C., based in Arlington, Virginia. He has extensive experience in construction litigation and contract law and has authored many articles on these and related subjects. David F. Kinzer III is a licensed CPA in Virginia performing accounting, tax, and consulting services in the Washington, D.C., metropolitan area. His work focuses primarily on the design, architecture, and construction industries. 102 Starting and Organizing a Practice practice or assume the proprietor’s projects, the only way to wrap up a sole proprietor- ship is through an appropriate estate and liquidation plan. Because there are advantages to placing certain assets in trust, such as avoiding probate, a proprietor could consider the use of a trust instrument in conjunction with an estate plan. To determine the best options, a proprietor should “Insurance Coverage“ provides details about professional seek estate-planning counsel. liability coverage for design errors and omissions. P A RT N ER SH I PS A partnership is an unincorporated association of two or more persons or entities for the purpose of operating a business with the intention of making a profit. The partner- ship, however, is not a separate legal entity distinct from the partners, and general partnerships are not required to file state organizational documents or federal tax iden- tification forms. The Partnership Agreement Partnerships are more complex than proprietorships. A partnership agreement should PA R T 2 : P R A C T I C E be in writing and should address issues such as the following: Financial (capital) contributions of the partners Responsibility and authority of the partners Fiduciary duties of the partners Liabilities of the partners Operation and management of the partnership Distributions of profit and loss Transferability of interests Admission of new partners Resolution of disputes Dissolution of the partnership Nearly all states have enacted some variation of a model statute called the Uniform Partnership Act. The Act establishes certain legal requirements to govern relationships between the partners (unless the partners themselves have made other specific arrange- ments) and between the partnership and other parties. Establishing a partnership with a specific written agreement is preferable, for sev- eral reasons, to relying on state statutes to supply the terms of agreement between partners. For example, partnership statutes presume that all partners share income and losses equally, and do not commonly recognize a partnership’s intention to treat cer- tain parties differently with respect to income, losses, or both. Also, the laws do not take into account that certain assets or efforts contributed by the partners should be treated differently if the partnership succeeds or fails. Furthermore, most state statutes do not recognize a partner’s contribution of effort in excess of other partners’ efforts as the equivalent of making a cash contribution. Thus, if a partnership fails, the state law will allocate the losses according to capital contributions and will ignore the con- tribution of services. Partner Liability Each partner has potential liability for all of the business and professional liability debts of the partnership jointly Architects considering becoming a partner in a firm and severally. Therefore, in the event that a business vendor should carefully weigh the amount of liability they will or a professional liability claimant enforces a judgment take on, particularly whether their capital contribution against the partnership, each partner’s personal assets may might soon be lost to existing creditors and claimants. be reached to satisfy the full amount of the claim. What liabilities does an incoming partner assume or an outgoing partner retain? In most states, incoming partners become responsible only for partnership debts incurred after they became partners, except that the new partner’s capital is subject to 2.2 Firm Legal Structure 103  claims by prior claimants or debtors. Departing partners remain liable for all partner- ship debts incurred by the partnership while they were partners. This is because, tech- nically, when a partner retires or terminates the relationship with a partnership, the partnership is dissolved and a new partnership composed of the remaining partners automatically comes into being. However, a partnership agreement can be drafted to overcome this result. Another matter to consider before joining a partnership is whether the rules con- cerning death and disability are addressed to the incoming partner’s satisfaction. Often a retiring or deceased partner may be entitled to compensation far beyond what the partnership can or should pay for the partner’s contribution. Joining such an arrange- ment leaves a new partner at risk should the existing partners die or retire. Requirements for Professional Registration Many states require that all partners be registered architects in the state where the firm is located. Some states specify that a certain percentage of the partners must be regis- tered architects if the firm is to be classified as an architec- PA R T 2 : P R A C T I C E Architects engaged in general contracting—as ture partnership. If a partnership consists of practitioners developers, design-builders, or construction managers— of multiple disciplines, the registered partners must be may find it necessary to obtain a contractor’s license in identified with their respective disciplines—for example, states where they intend to engage in construction. “architects and engineers.” Income Taxes A partnership files a separate federal tax return (called an information return), but it does not pay federal income tax on profits. A schedule showing each partner’s share of the profits or losses and other reportable tax information is filed with the partnership’s tax return and is given to each partner. Partners must transfer the information to their individual income tax returns and pay taxes on their share of the partnership’s profits, whether or not those profits are distributed. Requirements related to partnership taxes and tax returns vary by state and locality. CO R P O RA TION S Corporations are separate legal entities that can conduct necessary business operations— including bringing suit and being sued—in their corporate name. Because corporations have “lives” of their own, they are perhaps the most complicated to establish and main- tain. Articles of incorporation must be filed with the state to notify the public of the corporation’s existence and some of its key characteristics. A federal tax number must also be obtained to identify the entity as a legal tax- Federal, state, and local income tax laws and regulations can be payer. There are legal requirements for boards of complex. They change frequently and are reinterpreted constantly, directors, shareholder meetings, and a variety of making it advisable to have a firm’s accountant keep the owners other organizational issues. A corporation can be apprised of changes that affect the practice. Table 2.2, at the end much more stable (in a legal sense) than a sole pro- of this section, provides a summary of some provisions. prietorship or a partnership because its existence transcends the individuals who own and manage it. Many states have separate statutes for general business and professional corpora- tions. General business corporations may be formed for any legal purpose and are subject to the requirements of the state’s general corporation laws. Every state allows the establishment of general business corporations, although some do not allow stock- holders or employees to practice architecture through the general corporation. Professional corporations, on the other hand, are established specifically to provide professional services and are subject to restrictions enumerated in the professional corporation statute. Professional corporations normally must be owned or at least con- trolled by professionals licensed to practice in the state. Moreover, the corporate entity usually does not protect individual stockholders or employees from professional 104 Starting and Organizing a Practice liability. Professional corporations may be required to pay income taxes as general business corporations or may be subject to special tax considerations. Practicing architecture in a corporate form is not permitted in a few states. Some states require architects who want to incorporate to do so as a professional corporation authorized and certified by the secretary of state. Most states permit practice through either a professional corporation or “Agreements with Owners“ notes legal issues that a general business corporation, but some states permit partnerships and corporations should be mindful of architects to choose either type of entity. The number of when entering into project agreements (or any business principals in the corporation who must be registered archi- agreement). tects varies according to the state in which the corporation conducts its practice. A corporation seeking to practice in a state other than the one in which it is incor- porated must register as a foreign corporation in the other state to avoid jeopardizing certain legal rights, including the right to enforce legal claims for fees. Ownership and Control PA R T 2 : P R A C T I C E A position as shareholder does not necessarily mean an individual’s compensation will be proportional to his or her ownership. Compensation in a corporation is based on an oral or written agreement between the corporation and an individual and may or may not be set in relation to the number of shares owned. Such legal differences also apply to management and control of the corporation. It is possible, although uncommon, for ownership of a corporation and its control and management to be in different hands. This is uncommon because most shareholders elect the board of directors, which then appoints the officers. Under most circumstances, the individual or group who owns the majority of shares is able to elect directors who will appoint the individual or group or its designees as officers. Employees offered shares of a corporation should consider the answers to these questions: Is the cost of the shares justified by an increase in compensation? Will the value of shares increase over time? Will the employee’s control over management of the firm increase? If owning shares does not increase the compensation to which an architect is enti- tled, there may be no value in purchasing them. This is particularly true if the number of shares to be purchased is small compared with the holdings of others, in which case the new shareholder may have little or no say about the election of directors and appointment of officers. Further, if there is no market for the shares or no buy/sell agreement that will allow the shareholder to sell the stock, the shares may have only minor investment value. Liabilities In a corporation, unlike in a proprietorship or a partnership, the personal assets of shareholders cannot be reached to satisfy the corporation’s bona fide business debts. If the corporation purchases services or goods in its own name and fails to pay for them, the vendor can look only to the assets of the corporation for payment, not to the assets of individual shareholders. Professional liability is a different matter. In many states, an architect remains personally liable for his or her professional errors or omissions, even if they were committed while the architect was employed by a corporation. Some states hold the owners of the corporation jointly and severally liable for professional errors and omis- sions in the same way they would be if they were partners. In other states, practicing architecture as a corporation shields architects from personal liability for errors and omissions. 2.2 Firm Legal Structure 105  Because the laws governing the liability of architects practicing in a corporation vary significantly from state to state, professional liability insurance is an important way to manage these risks. Those considering the purchase of shares of a corporation will want to look into how the firm handles professional liability risks. Is the corporation ade- quately insured against professional errors and omissions? What do the relevant state statutes say about the liability of the new shareholder for such errors and omissions? Changes in Ownership As in partnerships, a shareholder who retires or dies may have rights to compensation granted through his or her employment agreement. To determine whether a corpora- tion will be viable into the future, those deciding whether to buy shares should first understand the potential liability the corporation will have to departing shareholders. Similarly, provisions for incoming shareholders’ ultimate retirement or termination should be drafted in a way that fairly compensates the existing shareholders for the efforts they have made during their tenure. Ownership transition in a corporation is, in many respects, easier than in a partner- PA R T 2 : P R A C T I C E ship. Shares of more than one type and variety may be bought and sold under a large number of circumstances to facilitate an orderly ownership transition and to provide severance pay to retiring shareholders. The usual method for compensating departing shareholders is commonly known as a buy/sell agreement. These agreements require departing shareholders to sell their shares back to the corporation or its shareholders to keep the shares in the “family” of shareholders. This arrangement may be mandated by a state registration statute that requires all shareholders to be licensed architects. An effective buy/sell agreement establishes a purchase price and method of sale for the departing shareholder’s shares and may also determine the price to be paid by incoming shareholders. Because such devices affect the long-term Architects who plan to establish a corporate form of viability of a corporation, a prospective shareholder (or practice should seek legal counsel and accounting advice to his or her counsel) should carefully review the buy/sell ensure they understand the tax ramifications and conditions agreement to determine the corporation’s prospects for of practice in the states where they plan to practice. viability after the other shareholders depart. Income Taxes Unless a “Selection” is made under federal tax law, a corporation is a separate taxable entity. Individual shareholders who are employees of the corporation are taxed on their salaries. The corporation itself reports as gross income the professional fees received and deducts salaries and other business expenses. Any amount remaining is taxable at the corporate tax rate. The corporation has several options for using the remainder in a way that will make its distribution tax deductible. For example, the earnings may be used to pay bonuses, make contributions to a qualified profit-sharing or pension plan, or, under recent federal tax provisions, be distributed to shareholders as dividends. Under certain circumstances, if earnings are not distributed to shareholders, an accu- mulated earnings tax may be imposed on the corporation. Subchapter S Corporations A corporation may elect to be treated as an S corporation for federal income tax pur- poses if it meets certain technical requirements. The shareholders of an S corporation are treated similarly to the partners of a partnership for tax purposes. That is, the shareholders of an S corporation are taxed on their pro rata share of the corporation’s income, regardless of whether it is distributed. The S corporation itself, however, is subject to income tax only in special circumstances. Architects who establish an S cor- poration can avoid or mitigate the double tax that may be imposed on portions of corporate income, or they can take advantage of more favorable tax rates. 106 Starting and Organizing a Practice  TABLE 2.1 Comparative Legal Attributes of Legal Structures Legal Limited Liability Attribute Sole Proprietorship Partnership S Corporation Regular Corporation Company Liability Individually liable General partners Same as regular Shareholder’s liability Shareholder’s liability in for all liabilities of individually liable (for corporation in most cases is most cases is limited to business partnership’s liabilities; limited to capital capital contribution limited partner liable contribution only up to amount of his/her capital contribution Qualified Single individual No limitations; however, Only individuals, estates, No limitation No limitation except owners owner need at least two and certain trusts may be for professional LLCs, for partners (including shareholders (limited to which members must general partner) 75 shareholders) conform to the applicable licensing requirement Type of Individual More than one class of Only one class of stock More than one class One class of member ownership ownership partner permitted permitted of stock permitted interests PA R T 2 : P R A C T I C E Transfer of Assets of business New partnership may Shares can only be Ready transfer of A new limited liability ownership transferable rather be created; consent of transferred to individuals, ownership through company may be than business itself other partners normally certain types of trusts, or the use of stock created; consent of other required if partnership estates; no consent to certificates; members normally interest is to be Subchapter S election is restrictions may be required if partnership transferred needed; restrictions may imposed by interest is to be be imposed by shareholder’s transferred shareholder agreement agreement Raising Capital raised only Loans or contributions Loans or contributions Met by sale of stocks Loans or contributions capital by loan or increased from partners from shareholders; or bonds or other from members contribution by the “straight debt“ avoids corporate debt proprietor second class of stock Business Sole proprietor Action usually depends Same as regular Unity of action based Managed by action and makes decisions on unanimous corporation except on authority of board professional managers management and can act agreement of partners unanimous consent is of directors or the members immediately; or, at least, general required to elect S status; proprietor partners. Limited partner more than 50% of responsible and actively participating in shareholders needed to receives all profits management may lose revoke Subchapter S or losses limited liability status Flexibility No restrictions Partnership is Same as regular Corporation is a legal Great flexibility is given contractual agreement, corporation entity created by the in management and within which members state, functioning ownership can conduct business within powers subject to the granted explicitly or partnership agreement implicitly and subject and applicable state to judicial construction laws and decision TAX C O N S I DER A T I ON S As suggested so far, the various forms of legal organization are subject to different federal and state income tax methods. Additional income tax considerations follow. Tax Rates Under current law, federal income tax rates imposed on individuals are usually lower than the 35 percent corporate income tax rate imposed on architecture and other personal service corporations. As a result, many architecture corporations choose to file for chapter S status. Tax Year Sole proprietorships, partnerships, and corporations are generally required to use a calendar taxable year (i.e., January 1 through December 31) unless they can establish sufficient business reasons to adopt a fiscal year (a year that begins and ends on dates other than January 1 and December 31). A corporation engaged in architecture or 2.2 Firm Legal Structure 107  TABLE 2.2 Comparative Tax Attributes of Legal Structures Limited Liability Tax Attribute Sole Proprietorship Partnership S Corporation Regular Corporation Company Taxable year Usually calendar year Generally a Generally a calendar Any type of year Generally a calendar year is year is required, available; however, calendar year is required, unless unless §444 or a personal service required, unless §444 or a business business purpose test corporation has §444 or a purpose test is met is met restrictions business purpose test is met Ordinary/ Drawings from the Generally not Payment of salaries Payments of salaries are Generally, not distributions to business are not taxable; taxable, but deductible by deductible by taxable, but owners net profits are taxable and distribution in excess corporation and corporation and taxable distribution in proprietor is subject to tax of basis is taxable as taxable to recipient; to recipient; payments of excess of basis is on self-employment capital gain distributions generally dividends are not taxable as capital income not taxable; however, deductible by gain certain distributions corporation and can be taxable as generally are taxable to dividends; distributions recipient shareholders PA R T 2 : P R A C T I C E in excess of basis = capital gains Limitation on Subject to at-risk, hobby Subject to basis Subject to No losses allowed to Deductible by losses loss, and passive activity limitation; partner’s shareholder’s basis, individual except upon owners subject to deductible by loss rules. investment, plus his including loans to the sale of stock or basis limitation; owners or her share of corporation; at-risk liquidation of partner’s partnership and passive activity corporation. Corporate investment, plus his liabilities; at-risk and loss rules may apply carryback and carryover or her share of passive activity loss rules may apply. Closely partnership rules may apply held corporations limited liabilities; at-risk by at-risk and modified and passive passive activity rules activity loss rules may apply Dividends Fully taxable Conduit—fully Same as partnership 100% dividend-received Conduit—fully received taxable deduction taxable Former election No No Yes No Yes required to obtain tax status Capital gain Taxed at individual level Conduit—taxed at Conduit—taxed at Taxed at corporate level Conduit—taxed at individual level shareholder level; individual level possible corporate built-in gains tax Capital losses Carried forward Conduit—carried Same as partnership Carry back three years Conduit carried indefinitely; limited to forward indefinitely and carryover five years forward indefinitely $3,000 per year at partner level; as short-term capital loss at partner level; limited to $3,000 offsetting only capital limited to $3,000 per year gains per year Section 1231 Taxed at individual level— Conduit Conduit; possible Taxable or deductible at Conduit gains and combined with other corporate built-in gains the corporate level losses §1 231 gains or losses of tax individual; net gains are capital gains for individual; net losses are ordinary losses for individual Basis for All income is reported on Profit and loss Pro rata portion of No income allocated to Profit and loss allocating owner’s return agreement may have income based on per shareholders agreement may income to “special allowances“ share, per day have “special owners of income and allocation allowances“ of deductions if they income and have substantial deductions if they economic effect have substantial economic effect 108 Starting and Organizing a Practice Tax Attribute Sole Proprietorship Partnership S Corporation Regular Corporation Limited Liability Company Basis for All losses flow through to Profit and loss Pro rata portion of No losses allocated to Profit and loss allocating a net owner’s return agreement may have income based on per stockholders agreement may operating boss “special allocation“ share, per day have “special of income and allocation allowances“ of deductions if they income and have substantial deductions if they economic effect have substantial economic effect Group 100% of self-employed Cost of partners’ Cost of benefits to Cost of shareholder- Cost of partners’ hospitalization person’s health insurance benefits generally more than 2% of employee coverage benefits generally and life premiums may be treated as shareholders treated generally deductible as treated as insurance deducted from gross compensation, as compensation, a business expense if compensation, premiums and income deductible by the deductible by the plan is “for the benefit deductible by the medical partnership and corporation and of employees“; normally company and reimbursement includable in the included in excluded from includable in partner’s income; shareholders’ income; employee’s income partners’ income; plans 100% self- 100% of self-employed 100% self- employment health health insurance employment health PA R T 2 : P R A C T I C E insurance premiums premiums available as insurance available as a a deduction premiums deduction available as a deduction Retirement Limitations and Limitations and Limitations and Limitations on benefits Limitations and benefits restrictions basically restrictions basically restrictions basically from defined benefit restrictions same as regular same as regular same as regular plans and from defined basically same as corporations corporations corporations contribution plans; regular special restrictions for corporations top-heavy plans; 401 (k) limitation began in 1992 Organization Not applicable Amortizable over 60 Amortizable over 60 Amortizable over 60 Amortizable over costs months months months 60 months Charitable Subject to limits for Conduit Conduit Limited to 10% of Conduit contributions individuals; gifts for use taxable income before of private foundations, special deductions 20% of AGI; gifts to public charity, cash, 50% of AGI; appreciated property, 30% of AGI; other limitations for specific items contributed Tax Graduated from 26% of Conduit Conduit Taxed at corporate Conduit preferences the first $175,000 of level; 20% on (Alternative AMTI, 28% of anything preferences and Minimum Tax) over that; applied to adjustments in excess of minimum taxable income, $40,000 or regular tax including tax preferences liability, whichever is in excess of $20,000 greater (does not apply ($40,000 for joint to corp. with < 7,500K returns); payable to gross revenue averaged extent exceeds regular over 3 years) tax Character of Taxed at individual level; Conduit Conduit Taxed at corporate level Conduit income and limitation on investment deductions interest deductions Self- Half of SE tax paid Same as Not applicable Not applicable Same as employment deductible from gross proprietorship proprietorship tax income 2.2 Firm Legal Structure 109  other personal services, whether organized as a professional corporation or a regular business corporation, should consult an accountant to confirm that it is entitled to use a fiscal year for tax planning purposes. Accounting Method An architecture firm organized as a sole proprietorship, partnership, or S corporation is entitled to compute its taxable income under the cash method of accounting. Under this method, fees are reported as income only when actually received and not when billed. Similarly, expenses are deductible only when actually paid, not in the year in which they accrue. An architecture firm organized as a corporation that has not made an S election may use the cash method only if its gross receipts do not exceed certain amounts and if certain other requirements of the Internal Revenue Code are met. Other Taxes Many states and some cities impose their own income taxes and professional services or gross receipts taxes. Other federal taxes that may affect individual architects and PA R T 2 : P R A C T I C E architecture firms include employer and employee Social Security taxes (and the com- parable self-employment tax in the case of partnerships and sole proprietorships) and the unemployment tax on compensation paid to employees. LI M I T E D LIA B I LI T Y C O M P A NIES Limited liability companies (LLCs) are complex hybrids of corporations and partner- ships. They are separate entities under state law that can conduct business in their own name, and they have many of the characteristics of a corporation. They are, however, classified as partnerships for federal tax purposes. This distinction makes them suitable as investment vehicles and as a business structure for individuals who wish to pass losses through to their personal income while still limiting their liability. The use of LLCs for architecture practice varies among states. States either permit architecture firms to use general LLCs without any restrictions, prohibit the use of gen- eral LLCs for the practice of architecture, or have statutes creating professional LLCs. Ownership and Control Under the organizing statutes, the owners of an LLC are called members. LLCs do not have to be managed by the members of the company. State statutes generally provide that an LLC may be managed by professional managers, who are afforded limited liability for their acts on behalf of the company yet do not have to be members of it. On the other hand, an LLC that is managed directly by its members or any group of members can provide significant management and ownership flexibility, and can offer creative opportunities for attracting capital. A detailed operating agreement should be developed to tailor management to the needs of the company. Operating agreements, like corporate bylaws and partnership agreements, grant authority to managers and members and establish how the organization will conduct its business. Liabilities Like a corporation, the members of an LLC have limited personal liability. In many states, however, architects remain liable for their professional errors or omissions, even if they were committed while the architect was an employee of the company. While laws regarding architect liability vary among the states, design professionals generally cannot avoid professional liability through the use of an LLC. Other Options Some states permit still other options: Design Professional Corporation (DPC), Lim- ited Liability Partnership (LLP), and others. Thus, architects should always seek pro- fessional advice before choosing an option for their firm. 110 Starting and Organizing a Practice 2.3 Legal Issues Architects and the Law Donald W. Doeg, Esq., PE, LEED AP Architects, like other professionals, render their services in a difficult and complex environment. In order to be successful, knowledge of the basic components of the legal requirements that govern their profession is essential. Legal Overview Architects, like many other professionals, are confronted with legal issues on a regular basis and thus must have a basic understanding of the law in order to successfully prac- tice architecture in today’s complex world. A wide spectrum of sources creates legal requirements that dictate standards under which an architect must practice. These PA R T 2 : P R A C T I C E sources include, but are not limited to: statutes passed by federal, state, or local legisla- tive bodies under their constitutional authority; administrative rules and regulations; building codes and standards; local ordinances; obligations established by contract between two or more parties; and law established by precedent of prior interpretations by the courts and administrative agencies regarding these requirements. In order to meet the applicable standard of care (which will be discussed in more detail later in this section) it is the architect’s obligation and duty to practice in compli- ance with all applicable laws, codes, and regulations. While most of the existing con- struction-related law will apply to architectural practice in some manner, there are laws and other legal obligations that may not be applicable to particular parties, such as the architect. For instance, certain OSHA obligations are directed to the means and meth- ods by which a contractor performs its work on a project. Unless the architect specifi- cally assumes some specific obligation through its contract, those obligations may not extend to the architect. In a very broad sense, issues of law impacting architects can be broken into two ▶ “Managing and Avoiding general categories: party disputes and administrative proceedings. Party disputes, the Disputes“ discusses the effective focus of this section, occur when problems arise on a project, such as delays, failures, and strategic use of methods for or potential failures relating to the work performed, fee controversies, and a long list resolving project disputes. of other issues. Problems don’t always result in disputes and disputes don’t always result in legal action. However, it is important to understand that the outcome of many of those disputes will rest heavily on whether the parties have met their legal obligations. Administrative issues and proceedings also play a very significant role in an archi- tect’s life. Administrative issues arise from regulations developed to implement civil statutes and other legal requirements, such as the area of professional licensing. Typi- cally, this area of the law is overseen by public officials charged with ensuring compli- ance with certain laws, standards, and regulations. Under their statutory authority, state registration boards, code officials, and other administrative agencies are given the ▶ “Building Codes and power to develop, implement, and enforce regulations needed to do their jobs. Indi- Standards“ and “Community viduals and entities subject to regulation typically have opportunities to seek variances Planning Controls“ further discuss or appeal decisions through administrative channels (e.g., zoning boards of appeal). the myriad regulations When administrative avenues have been exhausted, it is possible to seek review of concerning building design, administrative decisions in the courts. planning, and zoning. Don Doeg is a principal at Updike, Kelly & Spellacy, P.C., in Hartford, Connecticut, and the chairman of the firm’s Construction Law and Design Professional Law practice groups. His practice is devoted to assisting clients in all aspects and stages of construction projects, includ- ing resolution of any dispute that may arise. 2.3 Legal Issues 111  CO M M ON C LA IM S AG A I NS T A RC HI T EC T S If formal disputes arise relating to construction projects, attorneys will articulate their clients’ claims in the lawsuits based upon various legal theories. The two legal theories most often alleged in claims against architects are “negligence” and “breach of contract.” Negligence Overview of Negligence The existence of negligence is often more difficult to determine than whether a breach of contract has occurred. Under the law, there are four components that must be proven in order to prevail when asserting a negligence claim. They are as follows: Duty. The architect must owe a legal duty to the person making the claim. In other words, the architect has a legal obligation to do something or refrain from doing something. Breach. The architect fails to perform the duty or does something that should not have been done. PA R T 2 : P R A C T I C E Cause. The architect’s breach of duty is the proximate cause of harm to the person making the claim. That is, was the claimant injured or harmed as a consequence of the act and/or omission of the architect without any intervening cause? Damage. Actual harm or damage must have resulted from the breach. Standard of Care In claims against professionals, including architects, it is often difficult or impossible for a layperson to unilaterally determine the duty component of negligence as defined above. As such, the law has established that that duty is to meet a standard of reasonable care for the performance of the work. The standard of care for an architect is generally defined as what a reasonably prudent architect would do in the same general locale, in the same time frame, given the same or similar facts and circumstances. The architect’s legal responsibilities to a client are examined in light of what reasonably prudent archi- tects would have known and done at the time services were performed. In order to prove whether the standard of care has been met in a particular instance, the courts in most states require expert witness testimony. That is, since a layperson judge or jury would not have the requisite knowledge to determine what a reasonably prudent architect would have done under similar circumstances, each of the parties must retain an expert witness to provide an opinion as to the applicable standard of care for the case (what should or should not have been done by the architect). The judge or jury is ultimately charged with applying the standard of care that they believe is most cred- ible to the facts of the case and determining whether the architect acted appropriately. Despite the thoughts of some owners and/or their attorneys, the law does not require perfection from an architect based upon a typical standard of care scenario. If given enough time, an experienced third-party reviewer would likely find some glitches or inconsistencies on any set of architectural drawings currently in existence. However, ▶ “Owner-Generated the mere existence of a few minor glitches or inconsistencies within project documents Agreements“ discusses a does not mean that the author has failed to meet the prevailing standard of care. systematic approach to Despite the existence of alleged “flaws,” another expert may well opine that the stan- evaluating terms in agreements dard of care has nonetheless been met. The outcome of these types of disputes is provided by owners. dependent upon the particular facts in each case. It should also be noted that since architecture is an integration of art and building ▶ “Insurance Coverage” science, in virtually all situations there is more than one way to design a project or even covers the terminology and the a portion of a project. The fact that another architect would have used different details necessary considerations and or materials does not necessarily dictate a violation of the prevailing standard of care. alternatives when selecting The successful practice of architecture is based upon reasoned judgment and skill and insurance for one’s firm. the law recognizes that even if there is differentiation among various designs, it does not necessarily mean any of them were performed negligently. 112 Starting and Organizing a Practice  The standards of care applicable to a particular project can be modified by contract or conduct. The most frequent example of this practice is an attempt by owners to elevate the standard of care. Rather than applying the typical standard of care described above, some owners’ contracts seek to require a standard of “best practices,” “highest prevailing standards,” or some other similar language that elevates the mandated stan- dard of care for those projects. Architects should be wary of such heightened standards for at least two reasons: (1) the new standard may not be adequately defined in the industry, which may lead to a great deal of subjectivity and debate if a conflict ever arises; and (2) such standards may not be insurable under many typical professional errors and omissions policies. Each of the components of the aforementioned definition of the professional stan- dard of care can be subjective in nature. Depending on the specific issue at hand, courts have given some latitude to the “in the same general locale” component. For instance, it would not be prudent for an architect in the southern states to incorporate a large factor for snow load on the roofs of their designs, and, similarly, architects in the north central states may not have the same concerns about hurricane loads as their colleagues in the southeastern states. Yet in other instances, courts have held that knowledge PA R T 2 : P R A C T I C E about basic design concepts and/or certain building products (both good and bad) should be known by architects throughout the country. This nationwide knowledge can be applied in several manners by the courts. For instance, the level of knowledge of certain questionable materials may be consistent throughout the country (e.g., use of asbestos or the risks of fire-retardant plywood) regardless of the size or nature of the specific architectural practice. In other situations, architects with certain building type specialties (e.g., large sports stadiums, large museums, and major hospitals) may have a national practice and may be compared to other architects with the same specializa- tions, even if their respective offices are many states away. The “in the same time frame” component has also been heavily litigated. In gen- eral, the applicable standard of care is the one in place at the time of the project, not the one in place at the time of the dispute, which can be years later. As such, experts who subsequently assert that the prevailing standard should have resulted in the use of materials or techniques that were unknown or in their formative stages at the time of the project are not persuasive with the courts. Last, but not least, the “same or similar circumstances” component must also be strongly considered. For instance, the owner’s budget will significantly impact a project. The standard of care must be deter- mined for an architect working within the same budget, and under the same con- straints, as were encountered for the underlying project. Alternatively, the “same or similar circumstances” also includes the type of project and the experience of the architect. That is, a small local architectural firm designing residences in a certain locale will not be held to the same standard as a national architectural firm that rou- tinely designs large and complex facilities such as sports stadiums or healthcare facili- ties. Unfortunately, meeting the relevant standard of care may not be enough to protect an architect from litigation. A lawsuit can be commenced by almost anyone, in most states even by a party with whom the architect had no contractual relationship. However, if an architect is mindful during the course of the project of the standard of care that must be met, it will go a long way toward both diminishing the chances of the commencement of litigation as well as providing good defenses to the architect if litigation does arise. Modifying the Standard of Care by the Architect’s Actions Even though the law requires only reasonable and prudent behavior, an architect can expand or raise the standard of care. This may be done either consciously or inadver- tently. The standard of care can be altered in literally countless ways by the architect’s actions, such as promising a specific project result (e.g., that the roof or basement will not leak); taking on the contractor’s responsibilities (e.g., dictating means and methods or designing something that the contractor was required to do as part of a performance 2.3 Legal Issues 113  ▶ “Risk Management Strategies“ specification); or promising a specific supplier performance result (e.g., delivery of addresses how to determine certain materials by a specific date). whether a risk is worth taking It is important to realize that raising the standard of care increases the architect’s and how to manage risks. liability exposure by making the architect responsible for more than the professional standard requires. Sometimes design professionals—under pressure from clients or contractors or propelled by their own drive for perfection—raise the standard of care that will be applied to their services without intending to do so. Damages Damages for negligence claims are typically measured by the standard of the plaintiff being entitled to compensation to remedy the negligence of the architect. If the case were litigated or arbitrated, the judge, jury, or arbitrator would have to decide what that compensation would entail based upon the arguments set forth by the litigants. For instance, if litigation resulted in a finding that an architect improperly designed a set of stairs that did not meet the applicable building code and those stairs were subsequently constructed in accordance with those faulty plans, an owner may be entitled to the cost of removing the stairs and installing another set of stairs that met the applicable code. PA R T 2 : P R A C T I C E Breach of Contract Claims Overview of Breach of Contract Claims “Breach of contract” claims are relatively self-explanatory. Such claims are based upon an allegation that a specific duty or duties existed pursuant to a contract between two parties and one of those parties either failed to perform that duty or did not perform it properly. For instance, an owner-architect agreement may specifically require that the architect provide record drawings at the conclusion of the project. If the architect fails to do so, a breach of contract claim may ensue. The elements of a breach of contract action are the formation of an agreement, performance by one party, breach of the agreement by the other party, and damages. To form a valid and binding contract there must be a mutual understanding of the terms that are definite and certain between the parties. Each must be found to have been based on an identical understanding by the parties and an agreement must be definite and certain as to its terms and requirements. Contractual Protections Logic dictates that the quality of the architect’s contract will have a large impact on the potential claims and defenses against the architect. It is imperative that the architect spend time on each and every contract to understand and negotiate each of the clauses. Each and every contractual clause may prove to be either a significant defense available to the architect or a huge detriment. Owner-architect contracts can be either written or oral. Written contracts are preferred by almost everyone in the design industry. Perhaps the largest benefit of a written contract is the fact that it preserves a written articulation of the agreement between the parties, including all critical components, which can be referenced if a subsequent dispute arises. Coming to a common understanding of the terms of the original agreement often proves very difficult if an oral agreement is in place and a dispute subsequently arises. In addition, the applicable statutes of limitation may vary depending upon whether the contract was in written or oral form. ▶ The “AIA Documents Program“ It is important to recognize that written architectural contracts take many forms, details what AIA Contract depending upon the particular project and parties. The most common construction con- Documents offer the parties tracts in the industry are form contracts that are published by various construction indus- involved in the design and try groups, the industry standard being the AIA documents. The provisions included in construction of buildings. these form contracts have been formulated over many years’ use in the industry. While many parties opt to use the industry forms “as is,” there are other situations in which one or both parties may seek to modify one or more of the provisions, sometimes 114 Starting and Organizing a Practice significantly. In addition to the industry form contracts, there are many other types of contracts prepared by specific owners, design professionals, or others that also are used. The following are some key provisions that, if properly included in an architectural contract, will go a long way toward protecting the architect. The Absolutely Essential Terms: Whether an agreement is written on the back of a napkin or consists of a long-form agreement, it is absolutely critical that the agree- ment include a written summary of the project scope, the time frame in which it will be performed, and the fee agreement for the project. The Project Scope: It is critical to describe the scope of work to be accomplished. In some instances, it is equally or even more critical to describe any exclusions (e.g., in some instances the architect does not plan to be involved in the construction admin- istration phase, but the owner may not comprehend that fact). The Project Time Frame: Many disputes have occurred because the owner and archi- tect did not specifically discuss the time frame for the project and assumed vastly different parameters for the start and completion dates (and other critical mile- stones) of the work. PA R T 2 : P R A C T I C E Project Fees: It is essential that the architect and owner agree on the type of payment (e.g., lump sum, hourly, not to exceed, etc.) and the time frames for the payment (e.g., monthly, one payment at end of project, percentage of project completion). ▶ “Defining Project Services“ Other Key Terms: The following are a few of the many contract terms that can addresses the centrality of scope have a significant impact on an architect’s exposure should problems arise during the definition in developing effective course of the project. These terms are but a few of the many critical contract provisions agreements for professional that may exist for a particular project: design services. Limitations of Liability Clauses: These clauses will limit claims by the owner against ▶ “Architectural Services and the architect to a certain amount (e.g., a set dollar limit or the balance of the remain- Compensation“ discusses the ing insurance policy) should a dispute between the parties arise. These clauses have variables for architects to been enforced in many, but not all, states. consider in setting compensation, Mutual Waiver of Consequential Damages: This is a standard clause in many AIA form as well as various methods of contracts, but is often stricken by owner’s counsel. Consequential damages are those compensation and strategies for that are not direct damages, but only arise as a consequence of some act or omission. getting paid. In the prior example, if an architect failed to design a set of stairs to code and they subsequently had to be replaced prior to a certificate of occupancy being granted, the cost to do the replacement work would be direct damages. The delay in the opening of the facility would be consequential damages and, if the waiver was part of the con- tract, the owner would not be able to collect damages of this type from the architect. Indemnification Provisions: Many owners attempt to add indemnification clauses to the agreements with their architects, which, in essence, are a contractual require- ment that the architect reimburse the owner for damages caused by the architect’s acts and/or omissions. It is absolutely critical that the architect confer with his/her insurance broker and/or attorney prior to agreeing to any such clause. Many of these clauses, as proposed, are so broad and onerous that they are not insurable by the architect’s professional malpractice carrier and therefore put the architect at tremendous risk if the language is not modified. Changes in Scope of Service It is equally important that architects properly document any changes to their agree- ment with the owner during the course of the project. Almost every project is a very dynamic process, with changes occurring rapidly that impact the architect’s scope of work and fee as well as the project schedule. Just as it is critical to properly document the agreement between the parties in the initial contract, it is equally important to document any subsequent changes during the course of the project. If a subsequent dispute arises, written change orders documenting any changes to the original 2.3 Legal Issues 115  agreement will be essential to allow a court to determine the agreement between the parties. It is essential that the architect documents these changes and brings them to the attention of the owner. If possible, a formal change order should be prepared and signed by all parties. In some instances, it may be difficult to get the owner to sign off on a change order during the course of a project. In those instances, it is critical to nonetheless document the changes in writing and send it to the owner advising them that a change has been made to the contract scope/time frame/fee and outline those changes. That documentation will be very helpful in proving the changes were known and agreed upon should a subsequent dispute arise. Damages Damages for breach of contract claims are typically measured by the standard of the plaintiff being entitled to compensation that would put them back in the position they would have been in if the contract had not been breached. If the case were litigated or arbitrated, the judge, jury, or arbitrator would have to decide what that compensation would entail based upon the arguments set forth by the litigants. In the previous exam- ple regarding the failure to produce record drawings, a judge, jury, or arbitrator may PA R T 2 : P R A C T I C E decide that the owner is entitled to the cost of having another design professional prepare those documents. Vicarious Liability In General Agency relationships are common in everyday practice. That is, one party acts on behalf of another relating to a particular project or task. However, certain obligations and liabilities arise out of these relationships. The world of construction is no different. For instance, an architect’s employee acts as an agent of the architect on a project. A corporate officer acts as an agent of a corporation in signing an agreement for profes- sional services. Partners are agents and, under the law, also principals for each other. That is, partners are agents when they act for other partners (principals) and principals when their other partners (as agents) act for them. Under an owner-architect agreement, the architect may have an agency relation- ship with the owner for certain designated activities. The central question in agency ▶ “Project Design Team relationships is the scope of authority the agent has been granted to act on behalf of Agreements“ addresses the principal. Thus, architects acting as agents of the owner need to know the limits of agreements between architects their authority in dealing with the contractor and other third parties. Firms will want and consultants and those who every person who can be perceived as acting as the firm’s agent to understand the lim- establish joint ventures between its of his or her agency authority. Staying within the limits of their authority is the best firms. protection agents can give themselves and the principals they serve. For Consultants In many typical projects, the architect enters into a contract with the owner for all, or virtually all, of the design services for the project. The architect, in turn, retains con- sultants (typically engineers in various disciplines) to perform portions of the overall scope of design work. Consultants who perform professional services on behalf of archi- tects under the terms of an architect/consultant agreement are independent consul- tants. In those situations, the consultant may sometimes act as an agent of the architect. While the law will hold these consultants to the standard of reasonable care appli- cable to their professional expertise, the architect may be found to have liability for the consultants should an issue arise during the course of a project. In essence, many courts have found that the architect was contracted to provide the entire scope of design services and therefore has liability if a problem arises. While the architect may likely have a claim against its consultant for indemnification in such instances, such a claim may not fully exonerate the architect for future claims by an owner if, in the interven- ing period, the consultant has become financially unable to take responsibility or the consultant’s insurance coverage proves to be inadequate. 116 Starting and Organizing a Practice  In some instances the owner, not the architect, engages certain consultants and the architect’s obligations with respect to those consultants may be limited. Typically, the architect has far more limited exposure relating to the acts and/or omissions of those consultants. In these types of situations, the terms of engagement should be clearly stated in writing. Architects usually are not responsible for project consultants hired directly by the owner unless the architect agrees to this responsibility in the owner- architect agreement or acts in a way that makes the architect responsible, such as sign- ing a Certificate for Payment or a Certificate of Substantial Completion for the consultant’s work. For Employees Similarly, the architectural firm is responsible for its employees during the course of a project. The courts will generally hold the architectural firm itself responsible for the acts and/or omissions of each employee. A possible exception to this responsibility is if the employee clearly acts beyond its role and tasks required of it by the architectural firm. For instance, if, unknown to the architectural firm, the employee sells illegal drugs while on the job site, the architectural firm will likely not be culpable for those acts. PA R T 2 : P R A C T I C E Alternative Project Relationships ▶ “Project Delivery Methods“ The types of relationships between members of the construction community seem to presents an overview of available constantly evolve and expand. In addition to the conventional owner, design team, and models for project delivery. construction team relationship, a number of other alternative relationships are being employed in the industry. Two examples of these alternative relationships are contrac- tor-led design-build and joint ventures. Contractor-Led Design-Build: In this variation of the conventional construction proj- ect delivery, the owner contracts with one entity, the contractor, to provide all design and construction services for the project. The architect typically subcontracts directly with the contractor to provide services for the project. While this type of arrangement may offer many advantages on certain types of projects, it also raises certain potential risks to the architect that do not exist with the more conventional project arrangement. For instance, the conventional construction project arrangement is set up, in part, to provide a layer of checks and balances that protect the owner. In such situations, the architect typically has certain obligations to identify problems relating to the contractor’s work and the contractor has similar obligations regarding the architect’s work. These obligations may not exist, or at a minimum are severely compromised, in a design-build relationship. Many architects have been placed in very difficult situa- tions when their client, the contractor, wishes to perform work in a way the architect may not agree with. The drafting of the agreements in these types of arrangements is critical in order to protect the architect from these types of problems. Joint Ventures: It is common for the courts to consider the parties to a joint venture to be jointly and separately responsible for the actions