Five million business applications got filed in 2021. It’s important to know what type of business entity you are when you start a company. Choosing whether you create a professional corporation or limited liability company (LLC) can have major repercussions on your company.
This guide will discuss professional corporations. It’ll also go over why you might want to incorporate your practice, and what makes them different from an LLC.
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What Is a Professional Corporation?
A professional corporation is a business entity that licensed professionals might be required to form. Some of the professions that can form professional corporations include:
- Real estate agents
- Attorneys
- Physicians
- Architects
- Engineers
- Chiropractors
- Dentists
- Social workers
- Veterinarians
- CPAs and accountants
When considering forming a professional corporation, you’ll want to check with the laws in your state. Most states will limit the type of professionals that can form a professional corporation. Additionally, all the professionals in the corporation have to hold the necessary licenses.
The state law governs professional corporations. It also places certain restrictions on what individuals can own shares in the company. For example, only those of the same profession can be the owner of a professional corporation. In a law firm, only attorneys can own shares of the corporation.
How to Form a Professional Corporation
There are certain documents you need to file to get started forming a professional corporation. Each state varies with its process, there is a process that each state generally follows.
The first item you need to get started on is your articles of incorporation. This document gets filed with your local government to legally document that you’re creating a corporation. Articles of incorporation generally include the following information:
- Company name
- Agent for service of process
- Street address
- The type and amount of stock that’s issued
In this document, you’ll need to clearly state that you intend to operate your business as a professional corporation. You’ll also have to outline the purposes of your company.
For example, your professional corporation might include accountants. Your purpose would be to provide accounting services.
In addition to naming your company, a professional corporation has to include specific language. One of the below terms needs to get included in the name:
- Professional service corporation
- Service corporation
- Professional corporation
- Professional association
It’s acceptable to use abbreviations instead of the whole words, such as P.C. or P.A.
Your state might require you to obtain approvals from different licensing boards. This would include providing copies of each owner’s license.
What Are the Restrictions on Forming a Professional Corporation?
There are certain restrictions that only apply to professional corporations. One restriction is no dual practices. In some situations, a group of individuals might have more than one license.
For example, a group of lawyers might also be licensed to provide CPA services. If a professional corporation is set up for providing legal services, they can’t also provide accounting services. They can only conduct the services for which their professional corporation was formed.
All officers and half of the board of directors have to be licensed to practice the corporation’s profession. The secretary and treasurer of the corporation are exempt from this.
A professional corporation also doesn’t have to have a single owner. Partners can form one so long as they’re of the same profession.
Issued stock shares need to specify that they’re shares from a professional corporation. The stock shares also have to state that transferring the stocks is restricted.
Understanding Professional Corporation Tax Laws
A professional corporation’s tax laws are nearly the same as a C-corporation with one main difference. Professional corporations have a flat tax rate instead of a graduated one.
In order for a professional corporation to qualify for this, the government requires that 95% of their business’s activities be within their declared field. 95% of the outstanding stock shares have to be held by both current and former employees who provided services. The heirs and estates of current and former employees are the only exceptions.
Professional Corporation Tax Guide: Tax Benefits
There are some tax advantages of professional corporations. Since the tax deductions are the same as regular corporations, they can deduct the cost of benefits and salaries paid to employees/owners.
Most professional corporations pay out most of their earnings in bonuses, benefits, and salaries. This doesn’t leave a lot of income that can get taxed.
A professional corporation isn’t a partnership. The organization can deduct any interest or business expense that it owes to its employees. The organization can also deduct losses from the exchange or sale of property between the employees and the corporation. A professional corporation can also create 401(k)s and retirement plans for their employees that have higher contribution limits than an unincorporated business can use.
Typically, the IRS requires corporations to use an accrual accounting method when they report their taxes. Professional corporations can use a cash accounting method and there’s no limit on taxable income. As a result, a professional corporation can delay reporting their taxable income until the year they receive payment for their services.
Limits on Liability for Professional Corporations
Shareholders of a professional corporation receive protection from liability for the corporation’s debt. If another owner is found guilty of malpractice, the other shareholders don’t have any liability as well. However, if an owner gets accused of malpractice and the plaintiff can prove that the entire corporation contributed to it, then the corporation can be held liable.
There are also limits on liability with a professional corporation. For example, if one owner is found to have committed malpractice, then there is no limit to their personal liability. They don’t have liability for the actions of others.
A professional corporation should ensure that it carries the right level of insurance. Each owner should also carry their own insurance policies, such as errors or malpractice policies.
Advantages of Professional Corporations
A professional corporation provides professionals with a variety of benefits. Let’s talk about some of the most common ones.
Tax Deferral
With a professional corporation, you can defer your taxes. The income that’s earned through a professional corporation is taxed at both the shareholder and corporate levels.
The corporate-level income gets taxed at a lower rate than the personal income level. You can defer the taxes you pay by deferring when income is distributed to the shareholder. The deferral will end when an owner receives a dividend and pays taxes on it.
For example, say you earn a professional income of around $500,000 as the sole owner of your business. You only need about $200,000 of the income before taxes for your personal salary. There’s $300,000 left in your corporation that’s taxed at the lower rate.
Leaving additional funds in your corporation can go toward business expenses. This can include purchasing assets or funding an insurance policy.
Dividend Payouts
As a professional organization, you can access both dividends and salary. Your salary gets taxed at the personal income rate. Dividends are usually taxed at a lower rate.
As the owner of a professional corporation, you can choose how to maximize your earnings. How you mix up how you receive your income depends upon your circumstances.
Flexible Benefits for Your Employees
As an employee of your organization, you can take advantage of different benefits. These wouldn’t be available to you as a sole proprietor. You can start various retirement plans that are also susceptible to creditor protection benefits.
Disadvantages of Professional Corporations
With general corporations, your company is formed into a corporate entity. This can shield your shareholders against some lawsuits. Additionally, the liability is also limited to the investments you made into the organization.
On the flip side, your liability isn’t limited by the business entity. All professionals have to uphold the standard set by their profession’s governing body. Any negligence or malpractice committed by one shareholder could get shifted to the entire organization.
As we mentioned before, all shareholders need to practice the same profession. That could potentially limit what the future holds for your organization. A professional corporation can hire contract workers that don’t practice the same profession.
Additional Regulations and Rules
When you choose to form a professional corporation, there are additional business forms that you have to file. You’ll also have to stay up to date on the changes in the policies that might affect your business.
Why Should I Form a Professional Corporation?
Protecting yourself against your organization’s debts and other misconduct is essential, especially when you’re practicing a certain profession. A professional corporation provides you with that protection, to some extent. Ensure you’re thoroughly protected by taking out additional insurance policies.
You’ll also have to follow certain corporate formalities when you set up a professional corporation. This includes conducting yearly meetings and recording the minutes. You’ll also have to hold shareholders’ meetings and follow the annual filings required by your state.
Additionally, you’ll have to have a process that prohibits the commingling of corporate and personal funds. You might have to spell this out in your company’s bylaws and have it brought up during the minutes of a shareholder meeting.
Your professional corporation should also have its own credit accounts, lines of credit, and checking accounts. All agreements need to be preserved in writing. This includes benefits plan agreements, lease agreements, and employment agreements.
Professional Corporation vs LLC — What’s the Difference?
An LLC gives the owners the tax advantages of a partnership while also providing them with the limited liability protection you’d find in a corporation. The main difference between an LLC and a professional corporation is straightforward. Some businesses aren’t allowed to form LLCs in accordance with their state laws.
Taxation Differences
If an LLC has a single member, then their taxes are handled like they were a sole proprietor. All their income goes through the LLC. The owner will report all losses and profits as self-employment income on their personal taxes.
A professional corporation pays corporation taxes. Unfortunately, this means that sole practitioners would get taxed twice.
That is because their income is first taxed at the corporation level. It’s then taxed as personal income. The owner can deduct various corporate expenses, such as payroll taxes and health insurance.
In most states, LLCs don’t have to pay state taxes. The owner of the LLC will pay state taxes on their individual tax return.
Keep in mind that some states require an LLC to pay state taxes. Some states also impose fees for LLCs. This fee can be called a renewal, registration, or franchise tax fee.
Both an LLC and a professional corporation can file their taxes as an S-corporation so they don’t get taxed twice. S-corporations elect to pass the following through to the company’s shareholders for its federal tax purposes:
- Business losses
- Income
- Credits
- Deductions
Then, the shareholders report the flow-through of losses and income on their personal tax returns. How much they pay in tax is assessed at individual income tax rates.
This allows S-corporations, and professional corporations who file as one, to avoid double taxation. S-corporations are also responsible for paying taxes on certain passive income and built-in gains.
Personal Liability
Both a professional corporation and an LLC can limit the owner’s personal liability to claims to business assets and debts. Creditors can’t come after the owner’s personal assets to collect on debts. However, neither type of business entity will protect a professional from negligence or malpractice.
Protection against malpractice is one main reason why a professional might file as a professional corporation. This business entity helps protect them from being financially liable for other people in the practice’s wrongdoing.
If you’re a solo practitioner, that advantage doesn’t matter to you. It only makes a difference if you plan to expand your practice with more professionals in the future.
Find Out if Forming a Professional Corporation Is Right for You
Determining what type of business entity you need to form can be confusing. However, if you’re a certain type of professional, then a professional corporation might be the best choice for your company.
For more information on starting a new business, check out one of our other articles.
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