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Text File | 1996-11-06 | 7KB | 127 lines

@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 partnerships 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 the 1980s.  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 certain "qualified personal service
corporations," thus subjecting ALL taxable income of such
corporations to a flat rate tax of 35%.  (Of course, not
all kinds of service businesses are subject to each of the
above new restrictions on personal 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 35% 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 business
or one operating as an S corporation (or as a "limited
liability company" or "limited liability partnership," in
certain states), 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 corporation 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 personal 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 virtually
all states, a "professional corporation" (medical, law,
accountancy, etc.) does NOT confer limited liability on
its shareholders for purposes of malpractice claims,
however.

A number of states now allow professionals to operate their
practices in the form of a limited liability company ("LLC").
LLC laws have now been enacted in every state.  However,
many such states don't allow professionals to use the LLC
form -- but a number of those states allow a similar type of
organization called a "limited liability partnership," or LLP.
In states where professionals can operate in LLC or LLP
format, they will benefit from some reduction in personal
liability, but only to the same limited extent as with a
professional corporation; that is, practitioners will still
be personally liable for their own acts of professional
malpractice.  An LLP or LLC for a professional is treated
like a partnership for tax purposes (with the same
advantages and disadvantages, as compared with a C
corporation), but with the added benefit of SOME reduction
of personal liability exposure, which is not provided by a
regular partnership.  In addition, proposed IRS regulations,
once finally adopted, will allow one-owner LLCs to be set
up, where allowed by state law, and will treat such single
owner LLCs as sole proprietorships for federal income tax
purposes.  (Many states do not allow one-member LLCs at
present, but this will likely change soon after the very
favorable proposed IRS regulations go into effect.)

@IF173xx]Since your firm operates in a professional service business,
@IF173xx]it is probable that a professional corporation (or LLC) won't
@IF173xx]provide limited liability for @NAME.

@IF175xx]PLANNING POINT FOR YOUR FIRM, @NAME:
@IF175xx]┌───────────────────────────────────────────────────────────┐
@IF175xx]│Because your firm's business is consulting, however, rather│
@IF175xx]│than being in a "profession" such as law of medicine, you  │
@IF175xx]│should be able to obtain limited liability by operating the│
@IF175xx]│business in corporate form, without being a "professional  │
@IF175xx]│corporation."                                              │
@IF175xx]└───────────────────────────────────────────────────────────┘