Choosing the right business structure is a crucial decision for solo professionals in California. The choice of business entity determines how the professional practice is taxed, the extent of personal liability protection and personal asset protection available to the licensed professional, and the administrative requirements the licensed professional will need to manage in operating the practice.

A future article titled “What are the Business Structure Options for Two or More Professionals in California?” will discuss the additional options available when two or more professionals start a practice together, however, for professionals practicing solo in California, the options are limited to sole proprietorships and California Professional Corporations.

This article provides an overview of the various business structure options available to professionals practicing solo in California, helping professionals to make an informed choice that aligns with their professional goals and liability concerns in the most tax efficient format possible.

Executive Summary: Putting the Conclusion First for Busy Professionals

Summary of Practicing as a Professional Sole Proprietor

The primary benefit of a sole proprietorship is its simplicity. There are few legal formalities to establish a professional sole proprietorship and tax reporting is equally straightforward. However, a professional sole proprietorship is not a separate legal entity, which means that professional sole proprietors are personally liable for all debts, liabilities, obligations, and legal judgments (including malpractice liability) and the lack of a separate legal entity also means there is no distinction between personal and professional business assets for professional sole proprietors, meaning the debts, liabilities, and legal judgments for which a professional sole proprietor is liable are satisfied from the personal assets of the professional.

Summary of Practicing with a California Professional Corporation

While inherently more complex than professional sole proprietorships, the complexity of a California Professional Corporation may be reduced by working with the experienced corporate attorneys at San Diego Corporate Law. As a separate legal entity, California Professional Corporations significantly reduce liability risks and are more tax efficient for most professionals. For professionals in high-liability practices, this reduction in risk can be substantial. The separate legal entity status of California Professional Corporations also means there is a distinction between personal and professional business assets for professional owners, meaning the debts, liabilities, and legal judgments against a professional practice are not generally satisfied from the personal assets of the professional owner.

Choosing Between a Sole Proprietorship and California Professional Corporation

For most professionals, the California Professional Corporation is the right chose because the tax benefits coupled with limited liability protection and ability to separate personal assets from professional business assets far outweighs the increased administrative complexity compared to practicing as a sole proprietorship.

Contact San Diego Corporate Law for Assistance Selecting and Forming the Best Business Structure for Your Professional Practice

Take the next step toward securing the ideal business structure for your professional practice, whether that is a California Professional Corporation or another business structure. Contact the experienced corporate attorneys at San Diego Corporate Law today to schedule a consultation and receive personalized, expert guidance tailored to your needs. Our team is here to help you make informed decisions with confidence.

Practicing as a Sole Proprietor

Practicing as a sole proprietor is the simplest and most straightforward business structure for solo professionals in California. It requires minimal paperwork to set up compared to other business entity options and offers flexibility in managing the practice. However, along with these advantages come distinct disadvantages that professionals must consider carefully before considering sole proprietorship as the business structure for their practice.

Administrative Requirements of Practicing as a Sole Proprietor

One of the primary benefits of a sole proprietorship for practicing is the simplicity of establishing a sole proprietorship and the continued simplicity of operating as a sole proprietor.

Sole proprietorships require minimal effort to establish, with few legal formalities involved. Typically, the initial steps of setting up a sole proprietorship include obtaining a local business license to operate legally in the municipal jurisdiction in which the practice will operate and, if applicable, registering a fictitious business name (often referred to as a d/b/a).

Unlike other business structures, there is no need to file complex paperwork or create a formal business entity, which saves both time and money, but as discussed below, there are tradeoffs in exchange for this simplicity.

Taxation of Professional Sole Proprietors

Tax considerations are a critical aspect to be examined when planning to practice as a professional sole proprietor. Professional sole proprietors are subject to business income taxation, self-employment taxation, and additional Medicare taxes. Understanding how these taxes apply to a professional practice is essential for a professional when choosing a business structure in which to operate their professional practice.

Business Income Taxation When Practicing as a Sole Proprietor

For professional sole proprietors, business income taxation is both simple and straightforward compared to that of other business entities. Sole proprietors report their business income and expenses on Schedule C (Profit or Loss from Business) to their personal income tax return, using Internal Revenue Service Form 1040. This allows professionals to consolidate both personal and business income on a single tax form.

Self-Employment Tax When Practicing as a Sole Proprietor

While simple and straightforward, taxation of professional sole proprietors is not tax efficient. One significant consideration for sole proprietors is self-employment tax. Since a professional sole proprietor does not receive a salary from their business, they are responsible for paying self-employment taxes to cover Social Security and Medicare contributions. This self-employment tax is reported on Schedule SE, with the current rate totaling 15.3% of net profit in addition to federal and state income taxes, however, a professional sole proprietor can deduct half of the self-employment tax paid as an adjustment on their tax return, which provides some financial relief.

Additional Medicare Tax When Practicing as a Sole Proprietor

High-earning professional sole proprietors may also be subject to the Additional Medicare Tax. This tax applies to individuals whose income exceeds certain thresholds, which are determined based on filing status. For professional sole proprietors filing as single, the threshold is $200,000, while it is $250,000 for professional sole proprietors filing a joint tax return with a spouse. The Additional Medicare Tax rate is 0.9% and applies only to the earnings above the specified threshold. Sole proprietors must calculate and report this tax on Form 8959, ensuring compliance with Internal Revenue Service requirements. It is important for high earners to account for this additional tax in their financial planning to avoid unexpected liabilities.

Conclusions About Taxation of Professional Sole Proprietors

Understanding the tax implications of a professional sole proprietorship is integral when deciding which of the available business entities will be the most tax efficient, and understanding self-employment and the Additional Medicare Tax liabilities is the first step in planning and efficiently managing future tax liabilities.

Personal Liability Protection and Personal Asset Protection When Practicing as a Sole Proprietor

Practicing as a professional sole proprietor, while simple, also comes with challenges regarding personal liability protection and asset protection because a professional sole proprietorship is not a separate legal entity, and thus does not offer a legal distinction between the professional and the professional practice.

Personal Liability for Professionals When Practicing as Professional Sole Proprietors

One of the primary risks faced by sole proprietors is personal liability. The lack of distinction between the professional and the professional practice means that the professional sole proprietor is personally liable for all debts, liabilities, obligations, and legal judgments incurred by the professional practice personally, including claims for professional negligence, better known as malpractice, for errors and omissions.

Person Asset Protection for Professionals When Practicing as Professional Sole Proprietors

The lack of distinction between the professional and the professional practice that makes personal liability a primary risk to professional sole proprietors also means that all assets of the professional, be they strictly personal assets or assets used in the practice, are subject to claims by creditors and legal claimants against the personal assets (such as homes, bank accounts, investments, and other property).

Conclusions About Personal Liability and Asset Protection for Professional Sole Proprietors

The exposure to personal liability for debts, liabilities, obligations, and legal judgments (including those for professional negligence) coupled with the inability to separate personal assets from professional business assets underscores the importance for professionals choosing a business structure for their professional practice to understand liability risks and take proactive measures to safeguard their personal wealth and future earnings from such claims.

Conclusions About Practicing as a Sole Proprietor

When deciding whether to establish a professional practice as a sole proprietor, it is essential to weigh the benefits and drawbacks of this business structure. While sole proprietorships offer simplicity to professionals, sole proprietorships come with significant risks and limitations. The advantages and disadvantages of operating a professional sole proprietorship are compared below together with a recommendation for when a sole proprietorship is the best legal structure for a professional practice.

Advantages of Sole Proprietorship

The primary benefit of a sole proprietorship is its simplicity. There are few legal formalities to establish a professional sole proprietorship and tax reporting is equally straightforward.

Disadvantages of Sole Proprietorship

While sole proprietorships are simple to establish, they carry significant risks and are not tax efficient for most professionals.

A professional sole proprietorship is not a separate legal entity, which means that professional sole proprietors are personally liable for all debts, liabilities, obligations, and legal judgments (including malpractice liability). For professionals in high-liability practices, this risk can be substantial.

The lack of a separate legal entity also means there is no distinction between personal and professional business assets for professional sole proprietors, meaning the debts, liabilities, and legal judgments for which a professional sole proprietor is liable are satisfied from the personal assets of the professional.

When is a Sole Proprietorship the Right Business Structure for a Professional Practice?

A professional sole proprietorship can be an ideal option for a professional starting a small-scale practice with the expectation of low net profit and low liability risks. However, before choosing to practice as a professional sole proprietor, it is essential to weigh the benefits of simplicity against the risks of personal liability and the future growth of the professional practice. Professionals in high-risk practice areas or those who anticipate rapid growth may want to avoid practicing as a professional sole proprietorship in favor of a business entity that is more tax efficient and provides limited liability protection together with the separation of personal assets from professional business assets.

For a more detailed understanding of the differences between professional sole proprietorships and of California Professional Corporations and when a professional sole proprietorship is the best choice of business structure for a professional practice, see “When Not to Use a California Professional Corporation” for more information.

Practicing as a California Professional Corporation

Practicing with a California Professional Corporation is not as simple or straightforward as practicing as a professional sole proprietor, however, a California Professional Corporation provides the tax efficiency, limited liability protection, and separation of personal assets of the professional from the professional business assets of the practice that professional sole proprietorships lacks.

Administrative Requirements of Practicing as a California Professional Corporation

In order to enjoy the tax efficiency, limited liability protection, and separation of personal assets a California Professional Corporation provides, a professional is faced with a step up in complexity of establishing a California Professional Corporation. While this formation process is complex, professionals may rely upon the experienced corporate attorneys at San Diego Corporate Law to draft and file all the required legal documents for the California Professional Corporation, leaving professionals with essentially the same tasks they would undertake to establish a professional sole proprietorship. It is also worth noting that legal fees and costs are usually qualified business expenses that are tax deductible.

In addition to the initial formation of a California Professional Corporation, every year after the initial formation of a California Professional Corporation, a Statement of Information must be filed with the California Secretary of State and a shareholder and board of directors meeting must be held. Just as with the formation of a California Professional Corporation, a corporate attorney can assist in the annual requirements of practicing with a California Professional Corporation.

Despite the additional administrative requirements of practicing with a California Professional Corporation compared to a professional sole proprietorship, the right corporate attorney can make the difference in requirements comparable.

For a more detailed understanding of the administrative requirements for forming and maintaining a California Corporation, see “The 7 Steps for Forming a California Professional Corporation” for more information.

Taxation of California Professional Corporations

As with professional sole proprietorships, tax considerations are a critical aspect to be examined when planning to practice with a California Professional Corporation. While business owners of a California Professional Corporation are subject to business income taxation, payroll taxes for wages, and franchise taxes paid to the California Franchise Tax Board, these professional business owners are not subject to self-employment taxation or additional Medicare taxes. Understanding how these taxes apply to a professional practice is essential for a professional when choosing a business structure in which to operate their professional practice.

Business Income Taxation When Practicing with a California Professional Corporation

A California Professional Corporation is by default taxed as a personal service corporation (sometimes referred to as a professional service corporation), which is essentially a C Corporation (commonly referred to as a C-Corp) wherein corporate taxes applied to corporate profits are taxed directly at the federal and state levels at the corporate income tax rate, and any distributed dividends are subject to taxation again at the individual shareholder’s level (referred to as “double taxation”). However, a California Professional Corporation may (and almost always should) elect to be treated as an S Corporation (commonly referred to as an S-Corp), which fundamentally changes how income is taxed, so this article will focus on S Corporation taxation of California Professional Corporations.

Electing S Corporation status alters the tax treatment by enabling pass-through taxation. This means the profits and losses of the California Professional Corporation after payment of a reasonable salary to the professional are passed directly to the professional as the shareholder who reports them on their personal income tax returns to pay federal income tax and state income tax on the net profit of the California Professional Corporation to pay personal income tax of the net profits of the professional practice.

For more information about the election of S Corporation status for a California Professional Corporation, see “Can a California Professional Corporation Be an S-Corp?” for more information.

Self-Employment Tax When Practicing with a California Professional Corporation

Unlike professional sole proprietorships, which require the professional sole proprietor to pay self-employment tax on the entire net profit of the professional practice, a shareholder of a California Professional Corporation is not subject to self-employment taxes.

Instead of self-employment taxes on the entire net profit of the professional practice, with a California Professional Corporation employee and employer contributions to payroll tax are only paid on the reasonable salary of the professional. While the sum of the employee and employer contributions total 15.3%, the calculation of the tax is based upon the reasonable salary only and not the net profit of the California Professional Corporation, which may result in significant annual tax savings.

Additional Medicare Tax When Practicing with a California Professional Corporation

As discussed above for professional sole proprietorships, the Additional Medicare Tax is an extra 0.9% tax applied to earned income exceeding certain thresholds. However, because the Additional Medicare Tax is only applied to earned income and the net profit of a California Professional Corporation is not deemed to be “earned” income, the Additional Medicare Tax would only be applicable to a professional practicing with a California Professional Corporation if the reasonable salary of the professional exceeded the thresholds, meaning for all intents and purposes, practicing with a California Professional Corporation does not subject professionals to the Additional Medicare Tax.

Annual Franchise Tax for California Professional Corporations

California Professional Corporations must pay an annual franchise tax that professional sole proprietorships do not pay. The franchise tax paid by a California Professional Corporation taxed as an S Corporation is 1.5% of net profit with a minimum of $800 annually. While this is a tax not paid by a professional sole proprietorship, it pales in comparison to the self-employment taxes and the Additional Medicare Taxes paid by professional sole proprietors.

Conclusions About Taxation of California Professional Corporations

Understanding the tax benefits of a California Professional Corporation is integral when deciding which of the available business entities will be the most tax efficient, and understanding self-employment and the Additional Medicare Tax liabilities is the first step in planning and efficiently managing future tax liabilities.

For a more detailed understanding of the taxation of California Professional Corporations, see “What Tax Benefits Does a California Professional Corporation Provide?” for more information.

Personal Liability Protection and Personal Asset Protection When Practicing as a California Professional Corporation

Practicing as a California Professional Corporation, while more complex than practicing as a professional sole proprietorship, overcomes many of the personal liability protection and asset protection shortcomings of a professional sole proprietorship. A California Professional Corporation is a separate legal entity distinct from the professional owner, thus offering a legal distinction between the professional and the professional practice as well as personal and business assets of the professional.

Personal Liability for Professionals When Practicing with a California Professional Corporation

Practicing with a California Professional Corporation resolves most of the risks faced by sole proprietors for personal liability. The California Professional Corporation provides a separate legal entity distinct from the professional owner, meaning the professional owner is generally not personally liable for the debts, liabilities, obligations, and legal judgments incurred by the professional practice.

Under California law, claims for professional negligence, better known as malpractice, for errors and omissions of a professional are personal to the licensed professional and not shielded by the existence of the California Professional Corporation, however malpractice is an insurable risk and appropriately apportioned professional liability insurance may be used to indemnify the professional from this risk.

Person Asset Protection for Professionals When Practicing with a California Professional Corporation

The separate legal entity and distinction between the professional and the professional practice provided by a California Professional Corporation means that, unlike a professional sole proprietorship, the California Professional Corporation separates the personal assets of the professional owner from professional business assets of the practice. Therefore, claims by creditors and legal claimants against the California Professional Corporation are generally limited to the professional business assets of the California Professional Corporation and are not satisfied against the personal assets (such as homes, bank accounts, investments, and other property) of the professional owner.

Conclusions About Personal Liability and Asset Protection When Practicing with a California Professional Corporation

The limitation of personal liability for debts, liabilities, obligations, and legal judgments against the California Professional Corporation coupled with the ability to separate personal assets from professional business assets makes the use of a California Professional Corporation the choice for professionals who wish to limit their personal liability and protect their personal wealth and future earnings from most claims arising out of their professional practice.

For a more detailed understanding of the liability protection and asset protection of California Professional Corporations, see “What Liability Protection Does a California Professional Corporation Provide?” for more information.

Conclusions About Practicing with a California Professional Corporation

When deciding if establishing a professional practice as a California Professional Corporation is worth the additional cost and administrative requirements, it is essential to weigh the benefits and drawbacks of this business structure. While California Professional Corporations are more complex, California Professional Corporations resolve many of the significant risks and limitations inherent to practicing as a professional sole proprietor. The advantages and disadvantages of operating with a California Professional Corporation are compared below together with a recommendation for when a California Professional Corporation is the best legal structure for a professional practice.

Advantages of California Professional Corporations

While sole proprietorships are simple to establish, they carry significant risks and are not tax efficient for most professionals. California Professional Corporations significantly reduce liability risks and are more tax efficient for most professionals.

A California Professional Corporation is a separate legal entity, which means the professional owner is generally shielded from personally liable for debts, liabilities, obligations, and legal judgments (other than the insurable risk of malpractice liability). For professionals in high-liability practices, this reduction in risk can be substantial.

The separate legal entity status also means there is a distinction between personal and professional business assets for professional owners, meaning the debts, liabilities, and legal judgments against a professional practice are not generally satisfied from the personal assets of the professional owner.

Disadvantages of California Professional Corporations

The primary benefit of a sole proprietorship is its simplicity, and in turn the primary disadvantage of a California Professional Corporation, is the relative complexity of formation and operation. However, professionals may rely upon the experienced corporate attorneys at San Diego Corporate Law to draft and file all the required legal documents for establishing and maintaining the California Professional Corporation, leaving professionals with essentially the same tasks they would undertake to establish and maintain a professional sole proprietorship.

When is a California Professional Corporation the Right Business Structure for a Professional Practice?

A California Professional Corporation can be an ideal option for a professional starting a professional practice that is tax efficient, limits personal liability, and separates personal assets from professional business assets. Small-scale practices with the expectation of revenue growth can benefit from starting as a California Professional Corporation to avoid the future need to reestablish the practice as revenue grows. Similarly, small-scale practices in high-risk practice areas may benefit from the limited liability protection and separation of personal assets from professional business assets of a California Professional Corporation regardless of revenue or profitability.

For a more detailed understanding of the differences between professional sole proprietorships and of California Professional Corporations and when a California Professional Corporation is the best choice of business structure for a professional practice, see “When to Use a California Professional Corporation” and “Sole Proprietorship vs Professional Corporation in California” for more information.

Professionals in California May Not Practice as a Limited Liability Company (LLC) or Professional Limited Liability Company (PLLC)

A The experienced corporate attorneys at San Diego Corporate Law are frequently asked about limited liability companies and professional limited liability companies, so this will be briefly discussed here.

California law explicitly prohibits professionals from operating their practices as Limited Liability Companies (LLCs) or Professional Limited Liability Companies (PLLCs). This prohibition may be found in California Corporations Code Section 17701.04(e), which reads:

“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.”

This restriction applies to all licensed professionals for which a California Professional Corporation may be formed. Instead, California requires these professionals to form other types of business entities, such as California Professional Corporations.

For a more detailed understanding of the prohibition on the use of LLCs for professional practice in California, see “May a Licensed Professional Practice Using a California LLC?” and “Can I Use a PLLC in California?” and for more information.

If an LLC or PLLC is currently being used for a professional practice in California, see “10 Steps to Convert LLC to Professional Corporation in California” and “Four Reasons Not to Convert LLC to Professional Corporation in California” or “12 Steps to Convert a PLLC to a California Professional Corporation” and “Four Reasons Not to Convert Foreign LLC or PLLC to a California Professional Corporation” for more information about bringing the professional practice into compliance with California law.