The main reason business owners form corporations is to shield their personal assets from the business’s debts and lawsuits arising from its operation. For many years, most states prohibited certain personal service professionals, such as doctors and lawyers, from forming corporations because it was thought that they should not be allowed to shield themselves from the consequences of their mistakes. Over the past few decades, all states have changed their laws and now allow many types of professionals to incorporate. However, they must form professional corporations that are subject to special rules.
Professional Corporations
The laws governing professional corporations differ from state to state. The types of professionals who must form professional corporations usually include:
Most states impose restrictions on who may own a professional corporation and the work it can do. Typically, a professional corporation must be organized for the sole purpose of performing professional services, and all shareholders must be licensed to render that service. For example, in a medical corporation, all the shareholders must be licensed physicians. There can’t be any shareholders who are passive investors who don’t actually work in the professional corporation.
PC Shareholders Enjoy Limited Liability
In an ordinary corporation, a shareholder can lose only the amount the shareholder invests in the corporation. The shareholder’s personal assets—such as his or her personal bank accounts or home—cannot be reached by the corporation’s creditors. In contrast, a partnership creditor can reach the personal assets of any partner in a general partnership. Thus, for example, if a doctor in a general partnership carelessly injures a patient, the victim may sue any partner for his or her losses and collect any judgment or settlement against that partner’s personal assets.
When professionals such as doctors form a professional corporation, they enjoy a certain amount of limited liability: A shareholder in a professional corporation is not personally liable for the corporation’s business debts or for the careless acts of the other shareholder-professionals. Thus, for example, a doctor in a professional corporation is not personally liable if another doctor-shareholder carelessly injures a patient. However, the individual shareholders in a professional corporation are always personally liable for any losses caused by their own carelessness. Thus, a doctor-shareholder of a professional corporation is personally liable if he or she carelessly injures a patient. For this reason, professionals who incorporate still need professional liability insurance. Indeed, such insurance is often required by state law—for example, most states required doctors to have medical malpractice insurance even if they’re incorporated.
A professional corporation is a state law classification—it has nothing to do with the IRS or taxes. A professional corporation can be either a regular C corporation that is a separate taxpaying entity that files its own tax returns and pays taxes at corporate tax rates, or it can elect to be taxed as an S corporation in which profits or losses are passed through the corporation to be taxed on the shareholders’ personal tax returns.
Most professional corporations that are regular C corporations are classified as personal service corporations for tax purposes. These corporations pay corporate tax at a flat rate of 35% on all their net income. The reasoning behind this is that professionals who form C corporations shouldn’t have a tax advantage over professionals who have other types of business entities. Therefore, they must pay tax on all their income at the highest individual tax rate. A C corporation will be classified as a personal service corporation if substantially all the stock is owned by corporate employees engaged in the following activities or professions:
Nevertheless, professional corporations that are C corporations enjoy certain tax benefits. The tax law allows a C corporation to provide its employees with many types of fringe benefits which it can deduct from the corporation’s income as a business expense. These include:
The corporation’s employees, including the shareholders, are not taxed on these benefits, making them effectively tax-free.
To form a professional corporation, you must file articles of incorporation with the secretary of state and pay a filing fee. In contrast to an ordinary corporation, which may be formed any lawful purpose, a professional corporation’s articles must limit its corporate purpose to the practice of the profession that its shareholders are licensed to perform. Unlike ordinary corporations, professional corporations must also usually obtain approval from the state professional licensing board that regulates the profession. The state licensing board will ensure that all shareholders are licensed professionals in good standing. For more on how to form a professional corporation, see professional corporations on nolo.com.
Professional corporations aren’t as popular as they used to be because most states permit professionals to form regular limited liability companies or special professional limited liability companies. These provide the same limited liability as a professional corporation, but are simpler to operate and they avoid the IRS’s personal service corporation rules and have greater flexibility generally when it comes to taxes. However, some states—California, for example--do not allow professionals to form a limited liability company or professional limited liability company. Professional corporations remain popular in these states.
The law surrounding creation of a professional corporation is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, please consult a business lawyer.
