The Entity Choice for Your Professional Practice

Professionals, including doctors, dentists, pharmacists, physical therapists, veterinarians, lawyers, accountants, engineers and architects, are expected to perform their services with a high level of expertise. If they fail to conform to certain standards, they can be liable for their actions in a court of law. This professional liability cannot be shielded by using an entity, such as a corporation or limited liability company (LLC), which is known for its personal liability protection. The only protection for personal assets in the case of professional liability is carrying adequate professional liability (malpractice) insurance.

With that said, why does it matter how a professional sets up his or her practice? Because there are other concerns that adopting a formal entity can address.

Reasons for adopting a formal entity
While a professional cannot protection against his or her own malpractice, it is possible to gain other protection:

• Protection from the malpractice of co-owners. If a co-owner commits a wrongful act or other professional liability, others within the firm can be shielded from this financial exposure. A professional remains liable for his/her own negligent acts, as well as the acts of any other professional within the firm that he or she supervises. (The adverse publicity from a firm member’s malpractice may still indirectly impact innocent professionals within the firm.)
• Protection from commercial debts. If the firm enters into a lease or contracts to buy property from which there is a legal dispute, any damages arising from these or other similar commercial claims must be directed toward the firm; the professionals’ personal assets are protected. Commercial creditors must proceeds against the firm for any recovery.

Corporations for professionals
Whether in practice alone or with other professionals, the firm can become a professional corporation. This is shown by the designation “PC.” (Some states use the designation “SC” for service corporation.)

Usually, a professional corporation must be restricted to providing a single type of service (e.g., medicine, law), with all owners licensed to practice this service. However, some states allow more than one service within a corporation, provided they are related (e.g., an orthopedic surgeon and an orthopedist).

For professionals to incorporate their practice, states usually have special rules not applicable to other corporations:

• File special articles of incorporation designed for professional corporations.
• Professionals must provide the state with the number of their professional license.
• Professionals must carry a set amount of malpractice insurance (the minimum is set by the state in which they practice).

Check with your state to determine whether a particular type of professional is governed by the laws for professional corporations.

Tax implications. If the corporation is a regular, or “C”, corporation, it pays tax on its profits. Owners report as income only compensation or other taxable amounts paid out to them.

Under federal tax law, there is a unique designation for C corporations that perform services in the fields of health, law, accounting, engineering, architecture, actuarial science, performing arts, or consulting--they are called personal service corporations (PSCs). The main consequences for being a PSC are:

• A flat tax rate of 35% on corporate profits. However, this tax can effectively be avoided by “zeroing out” corporate income--paying professionals sufficient compensation to leave little or no taxable income within the corporation.
• Owners must use the same tax year as the corporation. If owners report on a calendar year basis, as most do, then the PSC usually must use this tax year as well. It can adopt a different tax year (e.g., a fiscal year ending June 30), but this requires a special election and annual payments, so it is not often done.

S corporation election. Professional corporations can opt to become pass-through entities by make an S corporation election. This enables the corporation’s profits to be taxed directly to its owners, eliminating the flat tax concern. Each owner pays tax at his or her tax rates, which may be lower than the top 35% rate for individuals. While the corporation files a return, Form 1120S, to report income, expenses, etc., these items are allocated to owners on Schedule K-1.

The tax year rules are similar for S corporations; owners in most cases must have the same tax year as the firm.

Note: In the past, professionals were eager to incorporate so they could take advantage of certain retirement plans to shelter income. These plans had been limited to C corporations; today there is no retirement plan edge for these corporations. All firms can take advantage of qualified retirement plans to shelter the professionals’ earnings and provide retirement savings for them.

LLCs for professionals
Professionals are allowed in all states to form a limited liability partnership (LLP), sometimes referred to as a registered LLP (RLLP). This type of entity affords owners the same liability protection as a professional corporation. Owners remain liable for their own negligence (and negligence of those they supervise), but are not financially responsible for the wrongful acts of co-owners or for the commercial debts of the entity itself.

As in the case of professional corporations, owners in LLPs must carry a set amount of professional liability insurance (the amount is fixed by the state). If the insurance lapses, so too does the limited personal liability protection that accompanies the LLP.

LLPs are formed by existing general partnerships that want to convert to this protected status. Today, almost all former general partnerships in various professional disciplines have formed this type of entity, which can be noted by the “LLP” designation following the name of the firm.

Tax implications. Unless the firm opts to be treated as an association taxed as a corporation, it continues under federal tax law to be taxed as a regular partnership. The LLP is not a separate taxpaying entity. Instead, owners report their share of the firm’s income and expenses on their personal returns--the LLP is a pass-through entity. The firm files Form 1065, as well as a Schedule K-1 for each owner to list the owner’s share of the firm’s income, expenses, credits, etc.

Starting from scratch
While the LLP is the entity of choice for existing general partnerships that want personal liability protection, practices just starting out have other choices. Instead of first becoming a partnership and then obtaining LLP status, the firm can be a professional limited liability company (PLLC). This entity affords the same liability protection for owners within the firm.

The PLLC can be used for a sole practitioner. While a one-person firm is not concerned about liability protection from the acts of co-owners, a one-person firm can gain protection from commercial debts by forming a PLLC.

Opting for a formal entity, such as a PLLC, can provide benefits beyond personal liability protection. Having an entity often makes it easier to obtain insurance, provide various fringe benefits, market the firm and even obtain financing.

PC versus LLP/PLLC. When just starting out, a firm can decide between corporate or unincorporated status. Which is better? Today, more firms are selecting the LLP/PLLC option. There are usually fewer formalities than those attending corporate status. For instance, corporations require a board of directors as well as officers. For an LLP/PLLC, the firm’s internal agreement governs its operations; fewer requirements and restrictions apply.

However, there is an important drawback to the LLP/PLLC to note. While professional corporations have an indefinite life, a significant change in the ownership of an LLP/PLLC can results in its automatic termination. For example, if there is a four-member LLP and two members leave to form their own firm, this 50% change in ownership ends the legal status firm. It usually must re-organize to remain operational. The firms operating agreement should address contingencies for the withdrawal, retirement, disability, death, or bankruptcy of a member.

Also, incorporation enables owners to avoid the need to pay quarterly estimated taxes. Owners of PCs are employees, so they can meet their tax obligations through sufficient income tax withholding. In contrast, owners of LLPs/PLLCs are self-employed individuals who must pay their taxes via quarterly installments of estimated tax.

Changing entities
General partnerships can easily become LLPs to give owners a measure of personal liability protection. States usually allow the change with a simple filing (the firm’s existing partnership agreement can be the basis for the change, so no new agreement is required). The cost for registering the firm is usually modest--$100 to $200.

Sole practitioners operating as sole proprietorships can also easily change to a PC or become a PLLC. State law dictates the procedure and cost involved with each alternative.

Can or should PCs switch to the more common LLP status? Corporations that want to end their current status to become an unincorporated business face certain tax costs that may make it inadvisable to do. When a C corporation liquidates, there can be tax cost at the corporate and owner levels. Most existing PCs have opted to remain as such, rather than go through the formalities and tax cost of making the switch.

This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex and the U.S. Small Business Administration.

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