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F113.SBE
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1992-04-30
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@071 CHAP 2
┌─────────────────────────────────────────────┐
│ CHOICE OF ENTITY: PROFESSIONAL SERVICE │
│ BUSINESSES AND SIMILAR OPERATIONS │
└─────────────────────────────────────────────┘
Traditionally, C corporations (professional service corporations) have
been the legal vehicle of choice for most providers of professional
services, as well as some entertainers and professional athletes.
This was primarily to take advantage of qualified pension and profit
sharing plans, tax deductible fringe benefits (medical insurance,
etc.), income deferral from using a fiscal tax year and low tax rates
on net income retained by the corporation. Even professional partner-
ships were often structured so that the partners in the partnership
were mostly or entirely professional corporations set up by the
individual professionals (primarily to take advantage of certain
provisions of the tax laws regarding pension plans).
Most of these excellent reasons for operating as C corporations began
to disappear in 1982. Since 1984, Keogh and S corporation pension
and profit sharing plans have been given virtual "parity" with C
corporation plans; the 1986 Act did away with fiscal years for most
new personal service corporations and virtually prohibited the use
of separate pension plans for each corporate partner in a partnership;
and the Revenue Act of 1987 did away with graduated tax rates for
"qualified personal service corporations," thus subjecting ALL taxable
income of such corporations to a flat rate tax of 34%, higher than the
highest individual tax rate. (Of course, not all kinds of service
businesses are subject to each of the above new restrictions on per-
sonal service corporations, since the definitions vary slightly in each
instance.) In addition, all C corporations are now subject to eventual
double taxation on appreciated corporate assets when such corporations
are eventually liquidated, and are potentially subject each year to
alternative minimum tax where "adjusted current earnings" differ from
regular taxable income for various corporate income and deduction
items. Those corporations subject to the 34% flat tax rate must now
also be very careful in paying out enough salary each year to zero out
taxable income, to avoid paying this high tax rate.
Also, where a new business is expected to operate at a loss for a year
or more, such losses must be carried forward by a C corporation (for
15 years) until the corporation generates enough income to use up the
losses, or the carryovers expire. For an unincorporated service busi-
ness or one operating as an S corporation, these early losses may be
used by the individual owners immediately to offset their other income
of any kind. (These would not ordinarily be considered passive
losses.) Note, however, that for shareholders of an S corporation to
utilize losses, their losses may be claimed on their individual tax
returns only to the extent of their tax basis in their S corporation
stock, plus the amount of any loans they have made directly to the S
corporation (simply agreeing to guarantee a loan made to the corpora-
tion by a lender will NOT give the shareholder any tax basis).
Personal service corporations that are C corporations still enjoy an
advantage over S corporations and unincorporated businesses with regard
to deductibility of fringe benefits for employee-owners, though.
However, the rules prohibiting discrimination against rank-and-file
employees in coverage and benefits under these benefit plans have
gradually been tightened in recent years.
While it is not possible to make any blanket recommendation as to the
legal form a new personal service business should adopt, most advisers
today seem to agree that the typical professional service corporation
should probably avoid C corporation status and should strongly consider
becoming an S corporation or remaining unincorporated, instead. The
deck has simply become too heavily stacked against most kinds of per-
sonal service corporations (other than S corporations). Where limited
liability is important, an S corporation will now often be preferable
to operating as a proprietorship or partnership. Note that in virtual-
ly all states, a "professional corporation" (medical, law, accountancy,
etc.) does NOT confer limited liability on its shareholders for pur-
poses of malpractice claims, however.