Although it is permissible to practice as an accountant as a Sole Proprietor or a General Partnership (which is not advisable based upon the taxation and unlimited liability of those structures!), California has two business entities that dominate professional business structures for the practice of accounting: the California Limited Liability Partnership (LLP) and the California Accountancy Corporation. These business entities provide different benefits and responsibilities for accountants who choose to operate within them. This article aims to delineate the key differences, advantages, and potential pitfalls of each business entity, providing a comprehensive overview that will guide California accountants in making informed decisions about the most appropriate business entity for their accounting firm.

Introduction to LLP and Accountancy Corporation in California

What is a California LLP?

A California Limited Liability Partnership (LLP) is a partnership structure where two or more licensed professionals (including accountants) may be used for rendering professional services (such as the practice of accounting) with their liability limited to their own actions. Ideal for multi-partner accounting firms, a California Limited Liability Partnership protects its partners from personal liability for the debts of the California LLP.

What is a California Accountancy Corporation?

Conversely, a California Accountancy Corporation is a California professional corporation available under the Moscone-Knox Professional Corporation Act at the business entity that may be used by accountants to offer professional services in professional corporations. It offers limited liability, perpetual existence, and may be owned and operated by one or more accountants, making it the entity of choice for solo accountants who do not have a second accountant to partner with.

Accountant Liability in LLPs and Accountancy Corporations in California

Accountant Liability in a California LLP

In a California LLP, each accountant is protected from personal liability for the debts of the California LLP, as well as the negligent actions of other partners. However, this liability protection is not absolute.

An accountant is still personally liable for their own professional malpractice or wrongful acts. So, if an accountant in a California LLP commits a wrongful act while providing professional services, the aggrieved party can sue that accountant personally. Despite this, the personal assets of the other partners in the California LLP are generally protected from such claims, unless they are found to have supervised or ratified the wrongful act.

In addition, unlike in a General Partnership, a California LLP partner is not personally liable for the contractual obligations of the California LLP. These characteristics make the California LLP a desirable business entity for many multi-partner accounting firms in California.

All California LLPs are required to provide a certain level of security for potential claims that may arise from their professional practice, however, adequate malpractice insurance coverage can generally satisfy this requirement.

Accountant Liability in a California Accountancy Corporation

In a California Accountancy Corporation, accountant liability protection is quite different compared to a California LLP. The accountants, or shareholders, generally receive personal liability protection for both the debts of the California Accountancy Corporation and for the negligent or wrongful acts committed by other accountants in the California Accountancy Corporation. This protection is a significant advantage of the California Accountancy Corporation structure.

However, similar to a California LLP, an accountant in a California Accountancy Corporation is personally liable for their own professional malpractice or wrongful acts. Therefore, for professional malpractice claims filed by a client against an accountant within a California Accountancy Corporation, that accountant may be held personally liable.

The California Accountancy Corporation itself can also be held liable for the professional malpractice of its accountants. Therefore, both the accountant who committed the wrongful act and the California Accountancy Corporation could potentially be sued. Besides professional liability, shareholders in a California Accountancy Corporation are generally not personally liable for the contractual obligations of the California Accountancy Corporation unless a personal guaranty is given by that accountant shareholder.

Management of LLPs and Accountancy Corporations in California

Management of a California LLP

The management of a California LLP is typically governed by a partnership agreement, a document that outlines the rights, responsibilities, and operational procedures of the partners. In the absence of such an agreement, the California Revised Uniform Partnership Act provides statutory rules.

A California LLP typically operates under a democratic structure, where each partner has an equal say in the management decisions unless otherwise specified in the partnership agreement. Partners can make decisions about the daily operations of the business, set strategic direction, and oversee the implementation of various policies.

However, some California Limited Liability Partnerships may appoint a managing partner or a management committee to handle the day-to-day operations, freeing up the other partners to focus on the practice of accountancy. It should be noted that as each partner is a representative of the California LLP, they can bind the California LLP to business deals, contracts, and other obligations. Therefore, partnership agreements should be well-written documents agreed upon by the partners to regulate the authority of each partner.

Management of a California Accountancy Corporation

The management of a California Accountancy Corporation is primarily handled by its Board of Directors, who are appointed by the shareholders, who are typically the accountants working in the California Accountancy Corporation. The Board of Directors is responsible for the overall strategic direction of the corporation and makes high-level decisions about the operations of the accounting firm. However, on a day-to-day basis, the California Accountancy Corporation is managed by its officers (the President, Secretary, and Treasurer) who are appointed by the Board of Directors.

The President generally has the responsibility to handle the day-to-day operations of the California Accountancy Corporation, the Secretary is in charge of maintaining corporate records and minutes of meetings, and the Treasurer manages the funds of the California Accountancy Corporation. However, the exact duties of these officers can be outlined and expanded in the bylaws of the California Accountancy Corporation.

As the California Accountancy Corporation is an independent legal entity, the actions of the officers and directors do not create personal liability, except in cases of personal wrongdoing or malpractice. This separation of personal and corporate liability is a key feature of the California Accountancy Corporation structure.

Allocation of Profit and Loss in LLPs and Accountancy Corporations in California

Allocation of Profit and Loss in a California LLP

The allocation of profit and loss in a California LLP is typically determined by its partnership agreement. The partnership agreement will often stipulate the percentage or amount of profits and losses that each partner will receive, which may be based on their contributions to the California LLP, their performance, or their billables. In the absence of such an agreement, the California Revised Uniform Partnership Act provides that profits and losses are to be shared equally among partners, irrespective of their individual capital contributions, level of participation, or billable hours.

Allocation of Profit and Loss in a California Accountancy Corporation

Allocations of Profit and Loss in a California Accountancy Corporation Taxed as a Personal Service Corporation

The allocation of profit and loss in a California Accountancy Corporation is primarily determined by its bylaws or an agreement among the shareholders. The agreement often sets the formula for the distribution of profits and losses amongst shareholders, which may be proportionate to the shares held by each shareholder, their role in the California Accountancy Corporation, or other performance-based factors.

For California Accountancy Corporations taxed as personal service corporations, the dividends, which represent the portion of profits distributed to the shareholders, are usually paid out periodically as determined by the Board of Directors. The losses of the California Accountancy Corporation are also absorbed by the shareholders proportionate to their shareholding, which is a potential downside of this business structure. However, it should be noted that shareholders are not personally liable for the debts of the California Accountancy Corporation beyond their investment in the corporation. In the absence of a specific provision in the bylaws or agreement among the shareholders, the California Corporations Code provides that profits and losses are to be allocated in proportion to each shareholder’s ownership interest.

Allocations of Profit and Loss in a California Accountancy Corporation Taxed as an S Corporation

For California Accountancy Corporations taxed as S Corporations, the allocation of profits and losses is somewhat different. According to the Internal Revenue Service and the Internal Revenue Code, S Corporations must distribute profits and losses to shareholders based on the proportion of shares they own, irrespective of any specific agreement among the shareholders or provisions in the bylaws. This pass-through taxation allows S Corporations to avoid double taxation on corporate income and shareholders, and shareholders must report these profits and losses on their personal income tax returns, potentially increasing or decreasing their personal tax liability.

Taxation of LLPs and Accountancy Corporations in California

Taxation of a California LLP

Federal Taxation of a California LLP

California LLPs are viewed as pass-through entities for federal income tax purposes, according to the Internal Revenue Service. This means that the California LLP itself does not pay federal income tax. Instead, the profits and losses of the LLP pass through to the individual partners, who report these amounts on their personal income tax returns. The share of profits and losses of the California LLP allocated to each partner is generally determined by the partnership agreement.

California State Taxation of a California LLP

In terms of California taxation, California LLPs are subject to an annual tax of $800, which is the minimum franchise tax imposed by the California Franchise Tax Board. This tax is due for the privilege of doing business in the state and must be paid regardless of whether the LLP makes a profit. Similar to federal taxation, California income taxation is passed through to the partners who report it on their personal income tax returns.

Self-Employment Taxation of a California LLP

The partners of a California LLP are usually considered self-employed for taxation purposes. This means they are subject to self-employment taxes, which cover Social Security and Medicare taxes. Typically, an employer and employee each pay half of these taxes, but self-employed individuals are responsible for the full amount.

Self-employment tax is based on an individual’s net earnings from self-employment, which includes their share of income from the LLP. The current self-employment tax rate is 15.3%, which consists of 12.4% for Social Security and 2.9% for Medicare. The Social Security portion is subject to a statutory maximum which is generally increased annually, but there is no limit to the amount of income subject to the Medicare portion.

Taxation of a California Accountancy Corporation

Federal Taxation of a California Accountancy Corporation Taxed as a Personal Service Corporation

A California Accountancy Corporation taxed as a personal service corporation faces a unique set of federal taxation rules. For the purposes of federal income tax, the Internal Revenue Service treats a personal service corporation as a standard corporation, subjecting it to corporate-level taxation. Consequently, the personal service corporation pays a flat federal corporate tax rate of 21% on its taxable income, as stipulated by the Tax Cuts and Jobs Act of 2017, but if the California Accountancy Corporation does not qualify or if the Tax Cuts and Jobs Act of 2017 is not renewed in 2025, personal service corporations will pay a flat federal corporate tax rate of 35% on their taxable income.

A significant unique feature of personal service corporation taxation is that it must pay taxes on its accumulated earnings and profits if these are not distributed to shareholders as dividends by the end of the fiscal year. This stems from the accumulated earnings tax, which aims to prevent corporations from avoiding shareholder income tax by retaining, rather than distributing, their earnings and profits.

Furthermore, personal service corporations are also subject to the personal holding company tax if more than 60% of its adjusted ordinary gross income is from passive income sources, such as rents, royalties, dividends, interest, and annuities. This tax is assessed at a flat rate of 20% on undistributed personal holding company income.

California Taxation of a California Accountancy Corporation Taxed as a Personal Service Corporation

Much like at the federal level, a California Accountancy Corporation designated as a personal service corporation is also regarded as a standard corporation for tax purposes and is subject to corporate-level taxation. This implies that the net income of the corporation is taxed at the corporate level before any dividends are distributed to shareholders.

Furthermore, the California Franchise Tax Board imposes a franchise tax on all corporations for the privilege of doing business in California. The minimum franchise tax is $800 and applies even if the corporation is not active, operates at a loss, or does not distribute dividends. However, the actual franchise tax rate is 8.84% of the net income of the corporation.

The personal service corporation may also be subject to additional taxes if it accumulates earnings and profits instead of disbursing them as dividends. In such cases, an accumulated earnings tax may apply. It is designed to discourage corporations from retaining earnings to avoid shareholder taxes on dividends, and the accumulated earnings tax can be waived only under specific, qualifying conditions.

Finally, California Accountancy Corporations must be aware of the alternative minimum tax of 6.65%. This applies to corporations with substantial economic income that manage to lower their regular tax through deductions and credits. This ensures that such corporations pay a minimum amount of tax each year.

Federal Taxation of a California Accountancy Corporation Taxed as an S Corporation

An S Corporation is a type of corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. When a California Accountancy Corporation is taxed as an S Corporation, it benefits from a tax structure that eliminates the double taxation typically associated with corporate profits and shareholder dividends.

The income of an S Corporation is generally subject to only one level of tax. The corporation itself does not pay income tax. Instead, the income or losses of the California Accountancy Corporation are divided among and passed through to its shareholders. The shareholders then report the income or loss on their own individual federal tax returns.

S Corporations are also subject to certain passive income and built-in gains taxes. If an S Corporation has Subchapter C earnings and profits, and if more than 25% of its gross corporate income is considered passive income (e.g., dividends, interest, rents, royalties, and stock sales), it may be subject to a 21% federal tax on the excessive net passive income. The built-in gains tax applies if an S Corporation disposes of assets within five years after converting from a C Corporation.

A crucial consideration for S Corporations is the reasonable compensation requirement. The Internal Revenue Service requires that if an S Corporation has employee-shareholders who provide services to the corporation, those employees must receive reasonable compensation. If the Internal Revenue Service determines that the compensation of an employee-shareholder is less than reasonable, it may reclassify a portion of the net income passed through to the shareholder as wages, which can result in higher tax liability.

California Taxation of a California Accountancy Corporation Taxed as an S Corporation

A California Accountancy Corporation taxed as an S Corporation is subject to similar state taxation rules as the federal level, albeit with some distinct nuances. The S Corporation passes the corporate income, losses, deductions, and credits through to its shareholders, who then report this information on their personal state tax returns. However, the state imposes a 1.5% franchise tax on the net income of the S Corporation. This is in contrast to the federal level, where the S Corporation itself does not pay income tax.

The minimum franchise tax in California is $800, which applies even if the California Accountancy Corporation taxed as an S Corporation is not actively conducting business, operates at a loss, or does not distribute dividends. This tax, payable to the California Franchise Tax Board, is for the privilege of doing business within the State of California and is separate from any taxes owed by the individual shareholders.

Moreover, the California Accountancy Corporation taxed as an S Corporation may be subject to the alternative minimum tax of 6.65% if it has substantial economic income and lowers its regular tax through deductions and credits. This ensures that the corporation pays a minimum amount of tax each year.

Similar to the federal regulations, California also imposes restrictions related to passive income for an S Corporation. If the S Corporation has Subchapter C earnings and profits and more than 25% of its gross corporate income is considered passive income, it could be subject to a state tax on the excessive net passive income.

Furthermore, just like at the federal level, S Corporations in California must also ensure that they pay reasonable compensation to employee shareholders who provide services to the corporation. Failure to do so can lead to a portion of the net income allocated to the shareholder to be reclassified as wages, thereby potentially increasing the tax liability.

Self-Employment Taxation of a California Accountancy Corporation

Shareholders of California Accountancy Corporations, regardless of whether they are taxed as personal service corporations or S Corporations, are not liable for self-employment taxes. This is a critical distinction, as self-employment taxes can represent a significant financial burden for many business owners, including partners in a California LLP.

However, California Accountancy Corporations must adhere to the reasonable compensation requirement for employee shareholders. This means if an S Corporation has employee-shareholders who provide services to the corporation, they must receive reasonable compensation for their work. Compensation is considered “reasonable” if it reflects the market value of the services provided.

Wages paid to employee shareholders of a California Accountancy Corporation are subjected to regular employment taxes. These employment taxes encompass several components, including Federal Insurance Contributions Act (FICA) taxes and Federal Unemployment Tax Act (FUTA) taxes.

FICA taxes, which are shared by both the employer and the employee, consist of Social Security and Medicare taxes. Social Security tax is levied up to a statutory maximum wage, which maximum is generally increased annually, however, there is no wage limit for Medicare Taxes.

FUTA tax, on the other hand, is paid solely by the employer and is applied to the first $7,000 of an employee’s wages each year. This tax provides funds for state unemployment agencies to pay unemployment compensation to workers.

Conclusions to LLP versus Accountancy Corporation in California

When to Use a California Accountancy Corporation for an Accounting Firm

A California Accountancy Corporation may be a suitable choice for an accounting firm for a solo accountant or when its primary focus is managing potential liability and taxation. California Accountancy Corporations offer limited liability protection, which insulates personal assets from business debts and claims.

Furthermore, the option to be taxed as an S Corporation allows for the avoidance of double taxation, as income or losses are passed through to shareholders who then report it on their individual tax returns. However, this choice requires careful attention to the reasonable compensation requirement for employee shareholders providing services to the corporation.

When to Use a California LLP for an Accounting Firm

A California LLP may be the best option for an accounting firm when the primary objectives of the firm involve flexibility in ownership and management, a desire to ensure limited liability for all partners, and most importantly flexibility in the allocation of profits.

A California LLP allows each partner to participate directly in the management of the business, unlike an S Corporation where management may be determined by stock ownership.

Moreover, all partners in a California LLP enjoy personal liability protection from the actions of the other partners and debts of the California LLP.

One of the key reasons to consider a California LLP for an accounting firm is the flexibility it offers in profit allocation. The LLP structure allows the firm to distribute profits based on various metrics such as billable hours or performance, rather than strictly by ownership share. This means that partners who contribute more to the firm, through client acquisition, billable hours, or other valuable activities, can be appropriately rewarded. This flexibility can better align incentives and drive the success of the firm.

However, it is important to note that partners of a California LLP are liable for self-employment taxes, unlike shareholders of an S Corporation. Therefore, an LLP might be most advantageous for accounting firms willing to account for the self-employment tax in exchange for management flexibility and distribution of profits and losses in a manner that does not necessarily align with ownership percentages.

When to Use both a California LLP and California Accountancy Corporations for an Accounting Firm

If an accounting firm seeks the operational flexibility that a California LLP provides, yet also desires the tax advantages of a California Accountancy Corporation taxed as an S Corporation, there is a feasible solution. If each partner in the firm establishes their own California Accountancy Corporation, electing for it to be taxed as an S Corporation, and these California Accountancy Corporations are used to serve as the partners in the California LLP, this allows the firm to benefit from the versatility of California LLP management and profit distribution, while also capitalizing on the tax benefits offered by S Corporation status.

Let San Diego Corporate Law Help Structure Your Accounting Firm

For personalized, knowledgeable, and reliable legal guidance on structuring your accounting firm, reach out to San Diego Corporate Law today. Our experienced attorneys can assist you in making informed decisions, whether you are considering a California LLP, a California Accountancy Corporation, or a unique blend of both. Do not leave the future of your accounting firm to chance; contact us now and let us guide you toward the best structure for your accounting firm.