Opening up a small professional office can be really exciting, but also a bit overwhelming with all the options and new terms. It’s definitely wise to be doing your research and to be aware of all the options available to you when starting your practice.
Oftentimes, businesses start out as smaller one-person organizations or partnerships and grow over time. Once you start thinking about expansion and hiring new employees, you may begin exploring your options and considering new business structures. Among the most well-known business structures, of course, are corporations.
While both corporations and LLCs protect the owners' personal assets from business debts and obligations, some situations put this limited liability in jeopardy. A major consideration, especially for those who initially start out as sole proprietors or in partnerships, is that of liability. Liability is a term that means you personally can be held responsible if the company is sued or incurs debt.
For example, you took out a loan to get your one-woman sole proprietor company off the ground. Unfortunately, due to unforeseen circumstances never managed to turn a profit. The company cannot declare bankruptcy in this case because it isn’t legally separate from you as an individual. That means the bank can now come after your own personal assets as repayment for the business loan.
Corporations, along with Limited Liability Companies (LLCs), provide limited liability which solves this type of problem. By incorporating, you separate yourself as the owner from the company and shield yourself from financial liability should the company ever get into trouble. Anyone can start an LLC or a corporation; however, licensed professionals have more limitations. They are required to open up Professional Limited Liability Companies (PLLCs) or Professional Corporation (PCs) instead. These regulations vary from state to state.
When operating a small business, another consideration beyond liability is the burden of double taxation can make or break your company. For this reason, a lot of small business owners look to the S Corp status for the corporation to avoid the corporate taxes incurred as a C Corp. As a licensed professional who owns a Profession Corporation, or PC, you may be wondering whether this can apply to you.
The short answer is yes, assuming your business qualifies. Taxes and business state laws and federal laws can be a bit daunting, unless law happens to be what you’re a professional in. If you are in any one of the many other occupations—a physician, an architect, or an accountant, to name a few—you may want an easy to follow guide explaining all of these terms and business structures to you.
This guide will do just that. We’ll answer your main questions about PCs and S corps, and define any of the key terms you’ll need to know along the way. Keep in mind, this article is just to provide you with a general overview of corporate taxes and the process of starting your professional corporation. We highly recommend not making any important business decisions without first consulting your lawyer and accountant.
Before we get too deep into discussing structures and taxation, let’s first define what we mean by a professional corporation.
What is a Professional Corporation?
A PC is in many ways the same as a regular corporation in terms of the process and maintenance. They are registered according to the state they are operating in, which means the rules will vary depending on where you choose to incorporate.
The main difference between a PC and a regular corporation lies in who can be involved in the ownership and management of a PC. Generally, only professionals licensed in that particular profession can own stock in the company.
Further, a Professional Corporation will protect against malpractice suits or negligence from other members. Note, this does not mean incorporation will ever protect an individual professional from their own malpractice claims.
Most importantly, a professional corporation is classified as a regular or "C" corporation by the Internal Revenue Service. The corporation is considered a taxpayer under Subchapter C of the tax code and must file an annual federal income tax return and pay taxes on net income at a corporate tax rate.
What is an S Corp?
An S Corp is a special tax designation for corporations that Congress enacted in the 1950s to help alleviate the double taxation burden on small businesses. Because regular corporations are treated as taxpaying entities and pay taxes at the corporate tax rate on their profits, the owners then get charged taxes a second time on their own personal income.
The S Corp designation allows the taxes to flow straight to the employees, without incurring that corporate tax charge. This is referred to as pass through taxation. The shareholders are paid a salary which is subject to self-employment taxes, however, the profits distributed to shareholders are not necessarily immediately taxed. There are certain caveats and ways to structure your business earnings to optimize your earnings, however, your accountant would be in the best position to advise on this matter.
So why don’t all corporations opt for S Corp status? Well, it’s because this classification was created especially for small businesses, so there are some limitations to which businesses can classify themselves as an S corp. These limitations apply in the same regard to professional corporations as well.
The requirements that must be met in order to qualify for S Corp status are:
You may only have up to 100 shareholders.
All shareholders must be US citizens or permanent residents.
Shareholders must be individuals or certain estates or trusts that benefit individuals.
You can only offer one class of stock.
Your corporate tax year must adhere to the calendar year, or have be approved by the IRS.
As you can, see these limitations make it difficult for many corporations to raise funds, declare IPOs, and grow the number of members. However, when we’re talking about Professional Corporations, you’re already limited in who can be a member or owner, so you won’t be able to go public since your investors are limited to other licensed professionals in your industry.
How Do I Set Up An S Corp?
We’re not going to go into all of the details of setting up a corporation (which vary state by state). But we will provide general overview of the main steps involved in establishing your PC:
Name your Corporation
Each corporation’s name must be unique within the state they are operating. PCs must also include a designation at the end of their name specifying that they are a Professional Corporation, or including a professional abbreviation.
Draft up your Articles of Incorporation
In order to be officially registered with the state, you must file these documents. Here you will clearly establish the intent to operate as a PC and spell out the purpose for the corporation. This means just clearly stating what service you will perform.
Obtain Local Approval
Before opening your doors as a PC, you must apply for approval from your relevant state licensing board. For doctors, this would be the state Medical Board, for example.
You will also need copies of valid licenses to practice for all of your members.
Once you’ve completed your incorporation, you may elect to switch from the default C Corp designation to an S Corp. The tax code also requires all of the professional corporation's current shareholders to agree to the change. The next step, is to complete IRS Form 2553 and have all your members sign it.
However, your professional corporation doesn't become an S corporation automatically upon submitting this form.The IRS will then review your company’s eligibility and make a decision whether or not you qualify. The corporation will then be notified if eligible in writing and you will know the exact date of your S Corp election.
Going forward, the corporation must file yearly profits and losses on Form 1120S. Even though they’re not taxed at the corporate rate, the profits and losses are divided up among shareholders by filing a Schedule K-1. Afterwards, each individual has to report this on their own Form 1040 when filing personal income taxes.
This special taxation, known as “pass-through” taxation is the main difference between how a regular C Corp and an S Corp operate. The same requirements to hold yearly shareholder meetings, keep corporate minutes, and file annual reports apply to S Corps as well.
Is an S Corp Right For My Business?
It’s difficult to say that one is better than the other across the board for PCs. Generally, C Corporations will work better for large organizations with more structure. They have more potential to grow and can have many more shareholders. Keep in mind the general restrictions on ownership in PCs will limit things like going public with an IPO or having various VCs investing in your company, unless of course they are licensed in your field too.
S Corporations, on the other hand, are purposely built for small businesses.So if you don’t plan on growing too big or expanding overseas, then the lower overall tax will likely be worth it.
That being said, we again stress the importance of consulting both a legal and financial professional before making this decision about your business entity. Even if you are a corporation of one and hold all the decision-making power, you still want to consider what the best possible option is for your unique business situation. An expert in these fields will be able to advise you precisely on the pros and cons of both options in detail.