When the experienced attorneys at San Diego Corporate Law speak to certified public accountants about the best corporate structure in which to operate their accounting practice, one of the most frequently asked business entity questions is about the difference between a California S-Corp and a California Professional Accountancy Corporation.

Many times, accountants and other tax advisors will recommend that a certified public accountant form a California S-Corp to render professional services for their accounting practice. However, it is important to understand that in California, a Professional Accountancy Corporation is often required for certified public accountants who wish to practice accountancy in corporate form as an S-Corp. While a California S-Corp can offer certain tax advantages, it does not meet the specific legal and regulatory requirements set forth by California law for accounting practice, which requires a California Professional Accountancy Corporation to practice accountancy in corporate form.

This article will introduce both California S-Corps and California Professional Accountancy Corporations, clarify the most common terminology used when referring to corporate entities for certified public accountants, and highlight the tax benefits of S Corporation taxation.

Executive Summary: Putting the Conclusion First for Busy Accountants

A California Professional Accountancy Corporation is a specific type of California Corporation used by certified public accountants to render professional services. A California Professional Accountancy Corporation may elect to be treated as an S Corporation for tax purposes, making it the right business entity for a certified pubic accountant who wants to practice accountancy while being taxed as a California S-Corp, which may provide significant tax savings.

A California Professional Accountancy Corporation taxed as an S Corporation benefits certified public accountant shareholders with paying taxes on their personal tax returns without the tax implications of self-employment tax of sole proprietorship or partnership and while avoiding double taxation and dividend income taxes, as California Professional Accountancy Corporations taxed as S Corporations pass net income through to shareholders without dividends paid to shareholders.

California Professional Accountancy Corporations also provide limited liability protection to shareholders for most debts, liabilities, obligations, and legal judgments, but licensed professionals remain liable for their own acts of malpractice.

By strategically managing compliance, taxes, liability, governance, business planning, and employee and client relations, a California Professional Corporation can maximize its benefits. Professional practices should consistently consult with legal, tax, financial, and business advisors to adapt and thrive in the dynamic business environment.

The experienced corporate attorneys at San Diego Corporate Law form California Professional Corporations for accountants throughout California. Contact us today to schedule an consultation to discuss how a California Professional Accountancy Corporation may help you take your accounting practice to the next level.

What is a California S-Corp?

A California S-Corp, or S Corporation, is a special type of California Corporation that is designed to meet certain tax regulations enforced by the Internal Revenue Service (IRS). A California S-Corp operates under Subchapter S of the Internal Revenue Code, which allows profits, and some losses, to be passed through directly to the personal income tax returns of shareholders without being subject to corporate tax rates.

IRS Requirements for California S-Corps

To qualify as a California S-Corp, a business must meet several IRS requirements: it must be a domestic corporation, have only allowable shareholders (which include individuals, certain trust estates, and certain tax-exempt organizations but not partnerships, corporations, or non-resident alien shareholders), have no more than 100 shareholders, have only one class of stock, and not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

California Requirements for California S-Corps

S-Corps in California also need to comply with state-specific requirements. These include filing Articles of Incorporation with the Secretary of State, obtaining an Employer Identification Number (EIN) from the IRS, adopting corporate Bylaws, and holding initial and annual meetings of shareholders and members of the board of directors.

Tax Benefits of California S-Corps

One of the primary benefits of a California S-Corp is the avoidance of double taxation, which is a significant concern with traditional California Corporations. By contrast, the net profit of a California S-Corp is only taxed at the shareholder level as income, but otherwise does not pay tax (other than the franchise tax paid to the California Franchise Tax Board). Additional benefits of the S-Corp include the potential savings on self-employment taxes, provided the shareholder-employees receive a reasonable salary for their services.

Taxation of Traditional California Corporations

A California Corporation must pay income taxes at the corporate level before the shareholders pay tax on dividends at the shareholder level. This income taxation of a California Corporation at both the corporate and shareholder level is double taxation.

Thanks to the Tax Cuts and Jobs Act of 2017, at the time of this writing in 2024, federal corporate income tax on California Corporations is 21% of net income. However, unless extended before expiration on December 31, 2025, when the Tax Cuts and Jobs Act of 2017 expires, the federal corporate income tax on California Corporations will go back to 28%. The California corporate tax rate on California Corporations is the greater of the $800 minimum franchise tax or 8.84% of net income.

After paying federal and California income taxes, the remainder may be paid to shareholders as dividends. The current federal dividend tax rate is between 0%, 15%, and 20% depending upon the income of the shareholder, and California taxes dividends as income at rates between 1% and 13.3% depending upon the income of the shareholder.

Taxation of California S-Corps

In a California S-Corp, profits are passed through the California S-Corp to the shareholders and only taxed once, at the shareholder level.

Thanks to the Tax Cuts and Jobs Act of 2017, at the time of this writing in 2024, federal income tax rates are between 10% and 37% for shareholders of California S-Corps. However, unless extended before expiration on December 31, 2025, when the Tax Cuts and Jobs Act of 2017 expires, the federal income tax rates could adjust back to 10% to 39.6% for shareholders of California S-Corps. California taxes California S-Corps the greater of the $800 or 1.5% of net income as a part of its annual franchise tax.

In summary, a California S-Corp offers a blend of corporate structure benefits with pass-through taxation, making it an attractive option for qualifying small businesses and startups focused on avoiding double taxation and optimizing tax savings. Nevertheless, its suitability depends on the individual needs of the business and its shareholders, and prospective shareholders should consult with tax and legal professionals such as the experienced attorneys at San Diego Corporate Law to determine if a California S-Corp is the best choice for their business.

Liability Benefits of California S-Corps

In addition to the tax benefits discussed above, another principal advantage of forming a California S-Corp is the limited liability protection it offers to its shareholders.

Separation of Personal Assets and Personal Liability Protection

The personal assets of shareholders, such as their homes, cars, and personal bank accounts, are typically protected from business debts, liabilities, obligations, and legal judgments against a California S-Corp. This personal liability protection is usually confined to the amount a shareholder invested into the California S-Corp. This limited liability can be a significant safeguard, especially in situations where the corporation faces lawsuits, creditor claims, or other financial challenges.

Limitations of Personal Liability Protection

It is important to note that liability protection is not absolute. Shareholders of a California S-Corp may still be at risk if they personally guarantee business loans or leases, commit fraudulent or illegal activities, commingle personal and business funds, fail to adhere to corporate formalities such as holding meetings of shareholders and the board of directors, or otherwise does not operate as a business entity separate and apart from its ownership.

What is a California Professional Accountancy Corporation?

A California Professional Accountancy Corporation is a specific type of California Corporation for rendering professional services. These California Professional Accountancy Corporations are governed by the Moscone-Knox Professional Corporations Act, the California Corporations Code, the California Business and Professions Code, and the California Board of Accountancy, ensuring they meet the stringent standards specific to the practice of accountancy.

Formation Requirements for a California Professional Accountancy Corporation

Forming a California Professional Accountancy Corporation involves meeting several state-specific requirements. The California Professional Accountancy Corporation must file Articles of Incorporation with the California Secretary of State, stating that it is a California Professional Accountancy Corporation. The Articles of Incorporation and Bylaws of a California Professional Accountancy Corporation must contain certain language specific to the profession of accountancy.

Ownership and Management of California Professional Accountancy Corporations

Ownership and management of a California Professional Accountancy Corporation are restricted to certified public accountants and certain other persons in specific circumstances. These restrictions ensure that the professional services provided are overseen by those who are adequately qualified and accountable to the relevant professional regulatory authorities. The other persons permitted to be shareholders are as follows:

California Business and Professions Code Section 5079(a) allows a California Professional Accountancy Corporation lawfully engaged in the practice of public accountancy to have shareholders who are not licensed as certified public accountants or public accountants if the following conditions are met:

(1)       Nonlicensee owners shall be natural persons or entities, such as partnerships, professional corporations, or others, provided that each ultimate beneficial owner of an equity interest in that entity shall be a natural person materially participating in the business conducted by the firm or an entity controlled by the firm.

(2)       Nonlicensee owners shall materially participate in the business of the firm, or an entity controlled by the firm, and their ownership interest shall revert to the firm upon the cessation of any material participation.

(3)       Licensees shall in the aggregate, directly or beneficially, comprise a majority of owners, except that firms with two owners may have one owner who is a nonlicensee.

(4)       Licensees shall in the aggregate, directly or beneficially, hold more than half of the equity capital and possess majority voting rights.

(5)       Nonlicensee owners shall not hold themselves out as certified public accountants or public accountants and each licensed firm shall disclose actual or potential involvement of nonlicensee owners in the services provided.

(6)       There shall be a certified public accountant or public accountant who has ultimate responsibility for each financial statement attest and compilation service engagement.

(7)       Except as permitted by the board in the exercise of its discretion, a person may not become a nonlicensee owner or remain a nonlicensee owner if the person has done either of the following:

(A)      Been convicted of any crime, an element of which is dishonesty or fraud, under the laws of any state, of the United States, or of any other jurisdiction.

(B)       Had a professional license or the right to practice revoked or suspended for reasons other than nonpayment of dues or fees, or has voluntarily surrendered a license or right to practice with disciplinary charges or a disciplinary investigation pending, and not reinstated by a licensing or regulatory agency of any state, or of the United States, including, but not limited to, the Securities and Exchange Commission or Public Company Accounting Oversight Board, or of any other jurisdiction.

Per California Business and Professions Code Section 5079(b):

(1)       A nonlicensee owner of a licensed firm shall report to the board in writing of the occurrence of any of the events set forth in paragraph (7) of subdivision (a) within 30 days of the date the nonlicensee owner has knowledge of the event. A conviction includes the initial plea, verdict, or finding of guilt, pleas of no contest, or pronouncement of sentence by a trial court even though that conviction may not be final or sentence actually imposed until appeals are exhausted.

(2)       A California nonlicensee owner of a licensed firm shall report to the board in writing the occurrence of any of the following events occurring on or after January 1, 2006, within 30 days of the date the California nonlicensee owner has knowledge of the events:

(A)      Any notice of the opening or initiation of a formal investigation of the nonlicensee owner by the Securities and Exchange Commission or its designee, or any notice from the Securities and Exchange Commission to a nonlicensee owner requesting a Wells submission.

(B)       Any notice of the opening or initiation of an investigation of the nonlicensee owner by the Public Company Accounting Oversight Board or its designee.

(C)      Any notice of the opening or initiation of an investigation of the nonlicensee owner by another professional licensing agency.

(3)       The report required by paragraphs (1) and (2) shall be signed by the nonlicensee owner and set forth the facts that constitute the reportable event. If the reportable event involves the action of an administrative agency or court, the report shall identify the name of the agency or court, the title of the matter, and the date of occurrence of the event.

(4)       Notwithstanding any other provision of law, reports received by the board pursuant to paragraph (2) shall not be disclosed to the public pursuant to the California Public Records Act (Division 10 (commencing with Section 7920.000) of Title 1 of the Government Code) other than (A) in the course of any disciplinary proceeding by the board after the filing of a formal accusation, (B) in the course of any legal action to which the board is a party, (C) in response to an official inquiry from a state or federal agency, (D) in response to a subpoena or summons enforceable by order of a court, or (E) when otherwise specifically required by law.

(5)       Nothing in this subdivision shall impose a duty upon any licensee or nonlicensee owner to report to the board the occurrence of any events set forth in paragraph (7) of subdivision (a) or paragraph (2) of this subdivision either by or against any other nonlicensee owner.

Pursuant to California Business and Professions Code Section 5079(c), the following definitions apply:

(1)       “Licensee” means a certified public accountant or public accountant in this state or a certified public accountant in good standing in another state.

(2)       “Material participation” means an activity that is regular, continuous, and substantial.

Under California Business and Professions Code Section 5079(d), all firms with nonlicensee owners shall certify at the time of registration and renewal that the firm is in compliance with California Business and Professions Code Section 5079.

Taxation of California Professional Accountancy Corporations

California Professional Accountancy Corporations are subject to double taxation unless they elect to be taxed as S Corporations, although the federal corporate income tax rates for California Professional Accountancy Corporations (referred to by the IRS as personal service corporations, and sometimes commonly referred to as professional service corporations).

Taxation of California Professional Accountancy Corporations without S Corporation Taxation

A California Professional Accountancy Corporation must pay income taxes at the corporate level before the shareholders pay tax on dividends at the shareholder level. This income taxation of a California Professional Accountancy Corporation at both the corporate and shareholder level is double taxation.

Thanks to the Tax Cuts and Jobs Act of 2017, at the time of this writing in 2024, federal corporate income tax on California Professional Accountancy Corporations is 21% of net income. However, unless extended before expiration on December 31, 2025, when the Tax Cuts and Jobs Act of 2017 expires, the federal corporate income tax on California Professional Accountancy Corporations will go back to 35%. The California corporate tax rate on California Corporations is the greater of the $800 minimum franchise tax or 8.84% of net income.

After paying federal and California income taxes, the remainder may be paid to shareholders as dividends. The current federal dividend tax rate is between 0%, 15%, and 20% depending upon the income of the shareholder, and California taxes dividends as income at rates between 1% and 13.3% depending upon the income of the shareholder.

Taxation of California Professional Accountancy Corporations Electing S Corporation Taxation

When a California Professional Accountancy Corporation elects to be taxed as an S Corporation, it is taxed identically to a California S-Corp, so profits are passed through the corporation to the shareholders and only taxed once, at the shareholder level.

Thanks to the Tax Cuts and Jobs Act of 2017, at the time of this writing in 2024, federal income tax rates are between 10% and 37% for shareholders of a California Professional Accountancy Corporation taxed as an S Corporation. However, unless extended before expiration on December 31, 2025, when the Tax Cuts and Jobs Act of 2017 expires, the federal income tax rates could adjust back to 10% to 39.6% for shareholders of a California Professional Accountancy Corporation taxed as an S Corporation. California taxes California S-Corps the greater of the $800 or 1.5% of net income as a part of its annual franchise tax.

In summary, a California Professional Accountancy Corporation electing to be taxed as a California S-Corp offers the same blend of corporate structure benefits with pass-through taxation as a California S-Corp, making it an attractive option for most professional practices to avoid double taxation and optimize tax savings. Nevertheless, its suitability depends on the individual needs of the professional practice and its professional shareholders, and prospective professional shareholders should consult with tax and legal professionals such as the experienced attorneys at San Diego Corporate Law to determine if a California Professional Accountancy Corporation taxed as an S Corporation is the best choice for their accounting practice.

Liability Benefits of California Professional Accountancy Corporations

In addition to the tax benefits discussed above, another principal advantage of forming a California Professional Accountancy Corporation is the limited liability protection it offers to its shareholders.

Separation of Personal Assets and Personal Liability Protection

The personal assets of shareholders, such as their homes, cars, and personal bank accounts, are typically protected from business debts, liabilities, obligations, and legal judgments against a California Professional Accountancy Corporation. This personal liability protection is usually confined to the amount a shareholder invested into the California Professional Accountancy Corporation. This limited liability can be a significant safeguard, especially in situations where the corporation faces lawsuits, creditor claims, or other financial challenges.

The most notable personal asset protection aspect of a California Professional Accountancy Corporation is limiting the malpractice liability of a shareholder from the acts of malpractice of employees and other shareholders of the California Professional Accountancy Corporation. In a sole proprietorship, a licensed professional is personally liable for acts of malpractice by professional employees through the legal theory of vicarious liability, and in a partnership structure each partner is jointly and severally liable for acts of malpractice by professional employees through the legal theory of vicarious liability and for acts of malpractice by professional partners under partnership liability rules.

Limitations of Personal Liability Protection

It is important to note that liability protection is not absolute. Shareholders of a California Professional Accountancy Corporation may still be at risk if they personally guarantee business loans or leases, commit fraudulent or illegal activities, commingle personal and business funds, fail to adhere to corporate formalities such as holding meetings of shareholders and the board of directors, or otherwise does not operate as a business entity separate and apart from its ownership.

Another important limitation on personal liability protection in a California Professional Accountancy Corporation is that professional shareholders remain liable for their own acts of malpractice. So, while a professional shareholder of a California Professional Accountancy Corporation may protect their personal assets and enjoy personal liability protection from acts of malpractice of professional employees and other shareholders, the California Professional Accountancy Corporation does not shield a professional from liability for their own acts of malpractice.

What About Using an LLC or PLLC for Professional Practice in California?

California Corporations Code Section 17701.04(e) prohibits the use of a California Limited Liability Companies or foreign Limited liability Companies or Professional Limited Liability Companies by certified public accountants in California for professional accounting as follows:

“Nothing in this title shall be construed to permit a domestic or foreign limited liability company to render professional services, as defined in subdivision (a) of Section 13401 and in Section 13401.3, in this state.”

Therefore, certified public accountants practicing accountancy in California should not form limited liability companies in California or any other state for their accounting practice.

Maximizing the Benefits of a California Professional Accountancy Corporation

Maximizing the benefits of a California Professional Accountancy Corporation requires a comprehensive understanding of the legal entity separate and apart from its professional shareholder(s), S Corporation status, income and self-employment tax liability, legal requirements, and strategic financial management. Here are key strategies to ensure that certified public accountants can fully leverage the advantages of California Professional Accountancy Corporations, especially those business entities making an S Corporation election under federal law.

Understanding the Regulatory Framework

It is essential to fully comply with the California Corporations Code, and particularly the Moscone-Knox Professional Corporations Act in Sections 13400-13410, as well as pertinent sections of the California Business and Professions Code.

Ensuring compliance involves maintaining all required licenses, adhering to ethical standards set by the California Board of Accountancy, and timely filing necessary documents with state authorities.

Engaging the services of experienced legal professionals such as the attorneys at San Diego Corporate Law can help keep California Professional Accountancy Corporation business structures in good standing and avoid costly legal issues.

Optimizing Tax Benefits

To achieve the maximum tax benefits, it is advisable to work with a competent accountant or tax attorney, which starts with diligently maintaining financial accurate financial records for a California Professional Accountancy Corporation to allow the accountant or tax attorney to assist with strategic tax planning.

The key to maximizing tax efficiency with a pass-through taxation of business structures such as California Professional Corporations taxed as S Corporations begins with allocating reasonable salaries to employee shareholders and distributing remaining profits through the shares of stock to reduce payroll taxes and avoid self-employment tax.

Considering the timing of income and expenses to optimize tax brackets and take advantage of any available deductions and credits for business expenses is another area where an accountant or tax attorney may make up for their professional fees in tax savings to the shareholders of the California Professional Accountancy Corporation. Engaging a knowledgeable tax advisor to navigate the complexities of the Tax Cuts and Jobs Act provisions and other pertinent tax laws is advisable for comprehensive tax optimization.

Limiting Liability Effectively

Although California Professional Accountancy Corporations provide significant liability protection, further measures can enhance its effectiveness. Shareholders of California Professional Accountancy Corporations should avoid personal guarantees whenever possible and ensure clear the separation of personal and business assets.

Maintaining separate business bank accounts for a California Professional Accountancy Corporation is mandatory.

Adhering to corporate formalities, such as holding annual meetings and recording minutes of both shareholders and the board of directors, reinforces the legitimacy of the California Professional Accountancy Corporation and avoids the loss of the limited liability protection a California Professional Accountancy Corporation is designed to provide.

Professional liability insurance, commonly referred to as malpractice insurance, is recommended to cover the personal malpractice liability that a California Professional Accountancy Corporation does not protect against.

Other business insurance, such as a business office policy, employment practices liability insurance, and similar insurance coverage is also advisable, as a plaintiff is unlikely to attempt to pierce the corporate veil or otherwise attempt to enforce a judgment against the personal assets of a shareholder if sufficient insurance coverage is in place to satisfy claims.

Enhancing Corporate Governance

Strong corporate documentation and governance structures are vital.

Attorney-drafted Articles of Incorporation, such as those drafted by the attorneys at San Diego Corporate Law, provide protections not included in California Secretary of State Form ARTS-PC, the Articles of Incorporation form used by some attorneys, most accountants, and nearly all online and non-attorney filing services.

Comprehensive Bylaws, in combination with attorney-drafted Articles of Incorporation, which outline the responsibilities of directors, officers, and shareholders can prevent internal conflicts and fortify the business structure of a California Professional Accountancy Corporation.

Holding annual shareholder meetings and meetings of the board of directors combined with the maintenance of detailed meeting minutes, or maintaining consents of shareholders and members of the board of directors, provides transparency to the corporate decision-making processes, ensuring that the California Professional Accountancy Corporation operates smoothly and keeps shareholders and board members informed.

Strategic Business Planning

A well-formulated business plan for a California Professional Accountancy Corporation can be an excellent tool for the strategic business planning needs of a professional practice.

A good business plan sets both short-term and long-term goals, includes market research, and creates a roadmap for sustainable growth of an accounting practice.

Financial planning for a California Professional Accountancy Corporation should include budgeting, forecasting, and performance tracking to ensure the California Professional Accountancy Corporation remains financially healthy.

Continuous innovation and adapting to market changes will help maintain a competitive edge for the accounting practice.

Employee and Client Relations

Happy employees and satisfied clients are the backbone of a successful professional practice.

Implementing robust human resource policies for a California Professional Accountancy Corporation that include training programs, performance incentives, and employee benefits can enhance productivity and loyalty.

Client relations can be bolstered by maintaining high standards of service, obtaining regular feedback, and ensuring clear communication channels.