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September 2004 Entity selection for professional firms The right entity for most professional practices maximizes tax savings and liability protection After looking at the variety of legal entities – P.C., P.A., LLP, PLC, etc. – available to them, many attorneys, physicians, architects, engineers and other professionals who are preparing to hang out their shingle are left scratching their heads, wondering how to choose the right entity. Here are the basic choice-of-entity options for most professional startups and a brief commentary that may help you narrow your choices. Single-member LLCs. For sole practitioners, Arizona and many other states permit single-member LLCs (SMLLCs) for most types of professional practices (see your tax professional or attorney for information on the exceptions). Oddly enough, federal tax rules ignore the existence of the SMLLC; it’s treated as a “disregarded entity” (unless an election is made to treat the SMLLC as a corporation, which is rarely advisable). Therefore, an SMLLC used to operate a one-owner professional practice is treated as a sole proprietorship, and the owner simply files Schedules C and SE with his or her Form 1040. In effect, this is pass-through taxation in its simplest form, which is good. Despite being invisible for federal tax purposes, the SMLLC still exists for liability protection purposes at the state level, assuming applicable legal requirements are met. For more on SMLLCs, see Jim Schmidt’s March 2004 article. Multimember LLCs and LLPs. For professional groups, the unincorporated limited liability entity options are multimember LLCs and limited liability partnerships (LLPs). Both are available in all 50 states, and both are treated as partnerships for federal tax purposes (unless an election is made to treat the LLC as a corporation, which is usually a bad idea). Therefore, as with an SMLLC, favorable pass-through taxation applies. LLPs are always treated as partnerships for both federal and state purposes, and they are expressly intended to be used by professional groups. With an LLP, however, the exact degree of liability protection offered by the entity is a key consideration. That is because some states’ LLP statutes protect LLP partners only against “vicarious liabilities” related to the professional malpractice of other partners and firm employees. In most states, including Arizona, however, LLPs offer protection against essentially all of the firm’s liabilities, making them similar to the protection offered by a corporation or LLC. Professional associations. A professional association (P.A.) is permitted as an alternative to a professional corporation in some states, including Arizona. The P.A. is an unincorporated entity that either elects to be taxed as a corporation (generally as a C corporation) or has enough attributes of a corporation that it is required to be taxed as such. C corporations. Setting up one or more professionals as shareholder-employees of a C corporation will typically maximize the availability of tax-advantaged fringe benefits for the ownership group. However, the taxable income of the corporation must be managed carefully to avoid double taxation. Typically, avoidance is achieved by “zeroing out” the corporation’s annual taxable income via deductible salaries, year-end bonuses, and benefits provided to or on behalf of the shareholder-employee group. Note: C corporations that meet the definition of a “personal service corporation” (PSC) are ineligible for the graduated corporation rate schedule. Instead, PSCs pay a flat 35% federal rate on all taxable income. S corporations. S corporations avoid the double taxation problem because, like partnerships and LLCs, they are pass-through entities. However, strict qualification rules must be met for a corporation to elect and maintain S status and thereby gain the advantage of pass-through taxation. Those restrictions can make S corporations very unwieldy for professional groups. In contrast, LLCs and LLPs qualify for pass-through taxation with no extra effort The partnership tax rules, which apply to multimember LLCs and LLPs, are also much more flexible than the S corporation rules. Further, from a liability protection standpoint, S and C corporations are identical; the only difference is how they are treated under the tax rules. For these reasons, S corporations are seldom advisable for professional practices. Narrowing your options. To determine the best fit for your specific situation, we urge you to contact your corporate attorney or tax professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
