Professional Corporations Law and Legal Definition
A professional corporation is a variation of the corporate form available to entrepreneurs who provide professional services—such as doctors, lawyers, accountants, consultants, and architects. "Professionals," Frederick W. Dailey explained in his book Tax Savvy for Small Business, "are treated as small businesses under the tax code. Most of them operate as sole proprietorships or partnerships, and are subject to the same tax rules as other similar businesses. However, certain professionals who offer services may form and operate a special type of entity, called a professional corporation." Some states require professionals to form this type of entity if they wish to incorporate. In a professional corporation, the owners perform services for the business as employees.
The first laws that permitted the formation of professional corporations were intended to give professionals some of the tax advantages enjoyed by corporations without also giving them the benefit of limited liability. If a regular corporation—a distinct entity under the law—becomes insolvent, its creditors can only claim business assets for the repayment of debts, not the personal assets of its owners. This is in contrast to regular proprietorships and partnerships, which are not legally distinct from their owners or partners. Since personal responsibility is a key factor in being a professional, the law could not allow professionals to escape liability for their own actions by incorporating. The lines between different forms of business organization have been blurred in recent years, however, as more tax advantages have become available to sole proprietorships and partnerships, and more limited liability has been granted to professional corporations.
PERSONAL SERVICE CORPORATIONS
Most professional corporations qualify as personal service corporations (PSC) for federal tax purposes, provided that they also qualify under state law. To qualify as a PSC under Internal Revenue Service (IRS) rules, a professional corporation must be organized under state law and then pass two federal tests: the function test and the ownership test. The function test requires that substantially all (95 percent) of the business activities of the professional corporation involve services within specific occupations in the fields of health, law, engineering, accounting, actuarial science, consulting, or performing arts. The ownership test requires that substantially all the professional corporation's outstanding stock be held directly or indirectly by qualified people, either: 1) employees who are currently performing professional services for the corporation; 2) retired employees who did so prior to their retirement; 3) or their heirs or estates. If a professional corporation organized under state law does not qualify as a PSC, then it is treated as a general partnership for federal tax purposes.
PSCs are taxed like regular C corporations but with a flat corporate tax rate of 35 percent rather than a graduated rate depending on the level of income earned. The PSC files a corporate tax return and also issues Form K-1 to all shareholder/employees to show their individual shares of the corporation's profit or loss. Any income that is retained in the PSC is subject to the corporate tax rate, while any salaries paid to employees are considered tax-deductible business expenses. Like most small corporations, however, PSCs are likely to pay out all business income to shareholders in the form of salaries, bonuses, and fringe benefits, thus reducing corporate taxable income to zero. Of course, the shareholder/employees still must pay personal income taxes on the income they receive.
ADVANTAGES AND DISADVANTAGES
Organizing as a professional corporation offers many potential advantages to qualified small business owners. Some of the primary advantages involve tax breaks that are not available to unincorporated businesses. For example, professional corporations can create retirement plans and 401(k) plans for their employees that have higher contribution limits than plans available to individuals or unincorporated businesses. In addition, professional corporations can provide health and life insurance as a tax-free benefit to their employees by establishing a Voluntary Employees' Beneficiary Association (VEBA). They can also take tax deductions for disability insurance, dependent care, and other fringe benefits provided to employees. In most cases, such benefits are tax-deductible for the corporation, and also are not considered taxable income for the employees.
Another advantage available to professional corporations is perpetual existence. Unlike sole proprietorships and partnerships—which legally dissolve when an owner dies or leaves the company—professional corporations can continue operations without interruption if a shareholder/employee dies or withdraws. Another advantage is that professional corporations may enable shareholder/employees to avoid personal liability for another employee's negligence. In most cases, one owner is liable for another's actions only if he or she would have been liable as a shareholder of a regular corporation. In contrast, all members of a regular partnership are exposed to personal liability.
There are also a few potential disadvantages associated with the professional corporation form of organization. For example, passive loss limitations may apply that restrict the amount nonactive shareholders can deduct for tax purposes in the event of business losses. In the case of a partnership, all partners are able to deduct their share of business losses from their personal taxable income. Since most professional corporations have only active shareholders and do not experience losses, however, this tax liability is not usually an issue. The flat corporate tax rate that applies to professional corporations may be another source of disadvantage. Retaining earnings within the business will rarely make sense due to the higher tax bracket, and this may reduce the firm's flexibility in distributing income to shareholder/employees. In contrast, most regular corporations can "split income"—or adjust the amount paid out to shareholder/employees—so that both the company and the individual can gain the most favorable tax bracket possible.
CHOOSING AMONG THE ALTERNATIVES
Many states now provide professionals with several options about how to organize their businesses. The main alternatives to forming a professional corporation or personal service corporation include organizing as a limited liability company (LLC) or as a limited liability partnership (LLP). These options differ in the costs and tax benefits involved, as well as in the amount of liability protection afforded. For example, limited liability companies combine the liability protection afforded by professional corporations with the taxation flexibility provided by partnerships. LLCs are taxed similarly to S corporations, so the income flows through to the shareholder/employees rather than accruing to the business and then being distributed to owners and employees. Limited liability partnerships are similar to regular partnerships except that they provide additional protection for partnership assets against malpractice suits. However, the partners in an LLP are required to carry hefty insurance or guarantee deposits in exchange for this protection.
The main advantages of organizing as a professional corporation, as outlined above, include tax benefits and transferability of ownership. However, the flat corporate tax rate prevents shareholder/employees from retaining earnings in the professional corporation, which may limit opportunities for expansion and growth. In addition, professional corporation owners may face the problem of double taxation upon liquidation of the business. Income from the sale of real estate or equipment might accrue to the business, for example, where it would be taxed at the corporate rate. If this income were then distributed to shareholders as dividends (since the company was no longer in business and thus could not pay it out as salaries and benefits to employees), then it would be subject to taxation again as personal income.
Dailey, Frederick W. Tax Savvy for Small Business: Year-Round Tax Advice for Small Businesses. Nolo Press, 2005.
Demkin, Joseph A. The Architect's Handbook of Professional Practice. John Wiley & Sons, Inc., 2003.
Hafter, Jacob L., and Stephen M. Greenberg. "Professional Corporations Remain the Most Popular Form of Entity for Medical Practices." New Jersey Law Journal. 15 December 2003.
Schneeman, Angela. The Law of Corporations, and Other Business Organizations. Thomson Learning, 2002.
Hillstrom, Northern Lights
updated by Magee, ECDI
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