In California, forming a California Professional Corporation is a popular choice for licensed professionals rendering professional services. However, this legal structure is not suitable for every professional practice. Understanding the limitations and disadvantages of practicing in a California Professional Corporation is crucial before incorporation.

Liability Protection in California Professional Corporations

One of the key reasons licensed professionals practice in a California Professional Corporation is to limit personal liability. Unlike business entities such as sole proprietorships or partnerships, California Professional Corporations provide a layer of protection by separating personal assets of the licensed professional from the business debts, liabilities, obligations, and legal judgments against the California Professional Corporation.

This limited liability protection is particularly important for licensed professionals who employ other licensed professionals as employees or independent contractors to render professional services where the risk of malpractice claims from the practice of these other licensed professionals is significant. By operating as a California Professional Corporation, licensed professionals can protect their personal assets and future earnings while still complying with state regulatory requirements and governmental agency regulating the rendering of professional services in California.

Tax Benefits for Professional Services in a California Professional Corporation Taxed as an S-Corp

When choosing the optimal business structure for rendering professional services, understanding the tax implications is vital. A California Professional Corporation electing S Corporation status can offer significant tax advantages, particularly regarding self-employment and payroll taxes.

By default, self-employed individuals are responsible for paying the entirety of Social Security and Medicare taxes, equal to 15.3% of net profit up to the statutory cap (at the time of this writing in 2024, this cap is $168,600), 2.9% of net profit on all net profit, and an additional Medicare tax of 0.9% in addition to the 2.9% for single taxpayers earning $200,000 or more and $250,000 for married taxpayers who file taxes jointly.

However, a California Professional Corporation taxed as an S-Corp can be used to reduce the burden of self-employment taxes. This is achieved by paying a fair market salary to the licensed professional shareholder(s), which is subject to payroll taxes equal to 15.3% of the salary paid up to the statutory cap (at the time of this writing in 2024, this cap is $168,600) and 2.9% for wages in excess of the statutory cap, while distributing remaining profits in the form of shareholder distributions which are not subject to payroll tax or self-employment tax. This method can lead to substantial tax savings for licensed professionals.

When Do the California Professional Corporation Benefits Not Make Sense for a Licensed Professional?

While most licensed professionals will benefit from practicing with a California Professional Corporation in California, this business entity is not the best choice for every licensed professional or every professional practice.

This article explores scenarios where establishing a California Professional Corporation might not be beneficial for a licensed professional. Concerns related to self-employment taxation, personal income tax, personal liability protection, and other ownership issues are addressed to allow licensed professionals to make informed decisions, ensuring that the separate legal entity chosen aligns with their business objectives and complies with California law, such as the California Corporations Code, the California Business and Professions Code, and other laws and regulations together with the rules and regulations of governmental agencies regulating the professional practice, such as the governing board for the profession.

If a licensed professional (i) is not concerned about liability protection or separation of personal and professional assets; and (ii) does not expect to realize a tax benefit in the next few years of practice, then that professional may wish to forego the formation of a California Professional Corporation. However, some licensed professionals form California Professional Corporations solely for liability protection, and many licensed professionals form California Professional Corporations solely for tax benefits. If either liability protection or tax benefits favor the formation of a California Professional Corporation, then the California Professional Corporation should be used by the licensed professional.

Executive Summary: Putting the Conclusion First for Busy Professionals

For most licensed professionals in most professional practices, the experienced corporate attorneys at San Diego Corporate Law recommend the use of a California Professional Corporation for the limited liability protections and tax benefits a California Professional Corporation provides.

However, if a licensed professional works alone, does not have employees, is comprehensively insured, and has a practice that earns less than $50,000 or $60,000 of net income per year without plans for the net income to grow over time, the additional administrative costs of operating a professional practice as a sole proprietorship may be appropriate for that licensed professional.

For licensed professionals with employees and who earn less than $50,000 or $60,000 of net income per year without plans for the net income to grow over time, a California Professional Corporation is advisable to protect the licensed professional shareholder from liabilities arising from their employees, the vicarious liability arising from the actions or inactions of their employees, and the malpractice liability of their employees.

Regardless of liability concerns, a licensed professional earning in excess of $60,000 net income annually should strongly consider practicing in a California Professional Corporation, as the tax savings realized should pay the additional administrative costs of practicing in a California Professional Corporation.

Licensed professionals starting a practice with plans to grow the practice over time should weigh the administrative burden of starting a practice as a sole proprietor or general partnership and within a few years having to establish the practice a second time as a California Professional Corporation as general liability, employment liability, and malpractice liability increases as net income grows above the $60,000 tax versus administrative cost threshold. Medical and mental health professionals should also consider the administrative burden of a second round of insurance paneling if they choose to start as a sole proprietorship or general partnership and later establish a California Professional Corporation.

It is worth noting that LLCs and PLLCs are not permitted for use with professional practices in California.

Contact San Diego Corporate Law for Expert Guidance

Navigating the complexities of choosing the right business structure for your professional practice can be challenging. For personalized advice tailored to your unique circumstances, reach out to the experienced attorneys at San Diego Corporate Law. Our team is dedicated to helping licensed professionals assess whether a California Professional Corporation or another business structure is the optimal choice for maximizing benefits and minimizing risks. Schedule a consultation today to ensure your professional practice is structured for success.

When is Liability Protection Not a Concern for a Licensed Professional?

Licensed professionals often choose to operate within a California Professional Corporation to limit their personal liability and separate their personal assets from business debts, liabilities, obligations, and legal judgments against their professional practice. However, not all licensed professionals share the same concerns with respect to liability protection. Understanding the differences in liability protection between sole proprietorships and general partnerships versus the liability protection provided by a California Professional Corporation is crucial for licensed professionals deciding on the appropriate business structure for their practice.

General Liability

For licensed professionals choosing a business structure for their practice, it is important to understand the differences in general liability protection between sole proprietorships and general partnerships versus California Professional Corporations.

As used in this section, general liability means liability for contracts entered with vendors, claims of bodily injury, property damage, and other types of liability not arising from an employment relationship or professional errors and omissions.

For example, a long-term lease of office space or specialized equipment, a bodily injury that occurs as a result of a visitor slipping and falling in the office of a licensed professional, property damage to a leased space or neighboring property caused by the professional practice, or claims of libel, slander, and other reputational harm arising from professional advertising.

General Liability for Sole Proprietors and General Partnerships

Sole proprietors and general partners face significant liability exposure, given the lack of separation between personal and business assets. In a sole proprietorship, the owner is solely responsible for all business debts, liabilities, obligations, and legal judgments against the professional practice for general liability claims.

Similarly, general partnerships involve joint and several liability among partners. Each partner is personally liable for all business debts, liabilities, obligations, and legal judgments against the professional practice arising from general liability.

This means that if a visitor is injured on the premises or if the business causes damage to the property of a third party, the personal assets of the sole proprietor or each of the general partners of a general partnership have unlimited liability for these claims. This unlimited personal liability places a considerable burden on a sole proprietor or individual partners if the professional practice lacks sufficient insurance coverage or fails to manage risk effectively. It is crucial for sole proprietors and general partners to recognize these risks and consider implementing protective measures like comprehensive insurance policies or restructuring the business to limit personal liability exposure.

General Liability for California Professional Corporations

A California Professional Corporation offers substantial protection against personal liability for licensed professionals. Unlike sole proprietors and general partners, who have unlimited personal liability for business debts, liabilities, obligations, and legal judgments against the professional practice, licensed professional shareholders of a California Professional Corporation usually enjoy protection from general liability. This means that personal assets, such as homes and personal bank accounts of these licensed professional shareholders, are typically safeguarded against claims arising from the general liability of the professional practice operated as a California Professional Corporation. The California Professional Corporation is recognized as a separate legal entity, responsible for its own debts, liabilities, obligations, and legal judgments against it, thus isolating the personal financial exposure of its licensed professional shareholders.

However, it is important to note that the liability protection provided by a California Professional Corporation has limitations. Licensed professional shareholders may still be personally liable for their own negligent or wrongful acts, and the liability protection does not extend to liabilities secured by the personal guaranty of the licensed professional shareholder, and the California Professional Corporation must be operated diligently and in compliance with California laws and regulations to ensure limited liability protection is extended to its licensed professional shareholders.

Regardless of the limitations outlined above, the general liability protections provided to licensed professional shareholders are substantial and allow licensed professionals to operate their professional practices with confidence.

General Liability Conclusion

Many, but not all, general liabilities are insurable risks for a professional practice, whether operated as a sole proprietorship, general partnership, or California Professional Corporation. However, should an incident arise which is not covered by general liability insurance coverage, if coverage of an incident is denied by an insurer, or if liability for an incident exceeds the insurance coverage, the limited liability status of a California Professional Corporation would protect a licensed professional as opposed to unlimited personal liability for a sole proprietor or a general partner.

Employment Liability

Licensed professionals selecting a business structure for their practice should understand the distinctions in employment liability protection among sole proprietorships, general partnerships, and California Professional Corporations.

As used in this section, employment liability means both liability to employees as well as vicarious liability to third parties based upon the actions or inactions of employees.

For example, employment liability to employees involved wage and hour law, sexual harassment and hostile work environment claims, privacy and information privacy claims, discrimination, and wrongful termination, whereas vicarious liability to third parties would include a business being liable for an auto accident caused by an employee on company time.

Employment Liability for Sole Proprietors and General Partnerships

Similar to general liability concerns, sole proprietors and general partners face significant liability exposure given the lack of separation between personal and business assets. In a sole proprietorship, the owner is solely responsible and has unlimited liability for employment related claims against the professional practice by employees and unlimited liability for third party claims for employee actions or inactions wherein the professional practice is vicariously liable for the behavior of its employee.

Similarly, general partnerships involve joint and several liability among partners. Each partner has unlimited personally liable for all claims against the professional practice by employees based upon their employment and also unlimited personal liability for third party claims of vicarious liability against the professional practice based upon employee behavior.

This means that if an employee brings a claim for a meal break violation or wrongful termination (or any other number of common employee claims), the personal assets of the sole proprietor or each of the general partners of a general partnership have unlimited liability for these claims. Similarly, if an employee assaults or injures a third party, or damages the property of a third party, sole proprietors and general partners have unlimited liability for the third-party claim under the legal theory of vicarious liability.

Unlimited personal liability imposes a significant burden on sole proprietors or individual partners, especially if the professional practice is inadequately insured or fails to manage risks effectively. It is essential for sole proprietors and general partners to acknowledge these risks and consider protective measures, such as employment practices liability insurance to protect against employee claims, comprehensive general liability insurance for vicarious liability claims, and/or restructuring the business to mitigate personal liability exposure.

Employment Liability for California Professional Corporations

A California Professional Corporation offers substantial protection against personal liability for licensed professionals both from employees and because of employees. Unlike sole proprietors and general partners, who have unlimited personal liability for claims from employees and vicarious liability claims for incidents caused by employees, licensed professional shareholders of a California Professional Corporation usually enjoy protection from both forms of employment liability. This means that personal assets, such as homes and personal bank accounts of these licensed professional shareholders, are typically safeguarded against claims arising from employment liability of the professional practice operated as a California Professional Corporation. The California Professional Corporation is recognized as a separate legal entity, responsible for the claims of employees and claims of third parties based upon employee behavior under the legal theory of vicarious liability, thus isolating the personal financial exposure of its licensed professional shareholders.

It is important to note that the California Professional Corporation is liable for employee claims and third-party claims based upon vicarious liability. While this is preferred to unlimited personal liability, such liability may be devastating to a professional practice even while shielding the assets of the licensed professional shareholders.

As with general liability, a California Professional Corporation must be operated diligently and in compliance with California laws and regulations to ensure limited liability protection is extended to its licensed professional shareholders for both employee claims and vicarious liability claims from third parties.

Despite the aforementioned limitations, the employment liability protections for licensed professional shareholders are substantial, enabling them to conduct their practices with confidence.

Employment Liability Conclusion

Many, but not all, liabilities to employees for employment practices may be insured with an employment practices liability insurance policy. Similarly, many, but not all, general liabilities are insurable risks for a professional practice whose employees expose it to claims from third parties arising from the legal theory of vicarious liability. Whether operated as a sole proprietorship, general partnership, or California Professional Corporation, comprehensive insurance coverage is important. However, should an incident arise which is not covered by employment practices liability insurance or general liability insurance coverage, if coverage of an incident is denied by an insurer, or if liability for an incident exceeds the insurance coverage, the limited liability status of a California Professional Corporation would protect a licensed professional as opposed to unlimited personal liability for a sole proprietor or a general partner.

Malpractice Liability

Malpractice can be defined as professional errors and omissions that occur when a professional fails to perform their duties to the accepted standards of practice, resulting in harm or damage. Malpractice liability refers to the legal responsibility professionals may face for failing to meet these standards, leading to potential claims and lawsuits.

Understanding how malpractice liability is assigned is crucial for professionals when choosing a California business entity for their professional practice. In a California professional practice, the repercussions of malpractice can be severe. This section will delve into the nuances of malpractice liability, examining the liability of professional practice owners and their practices from the risks associated with professional errors and omissions.

Malpractice Liability for Sole Proprietors and General Partnerships

Sole proprietors and general partners have unlimited liability for their own acts of malpractice. This means that they are personally responsible for any malpractice claims brought against them by clients or patients.

General partners of general partnerships also have unlimited liability for malpractice claims alleged against the other general partners of a general partnership because general partners have joint and several liability for all business debts, liabilities, obligations, and legal judgments against a professional practice.

In addition, and as previously discussed for vicarious liability, sole proprietors and general partners of general partnerships have unlimited liability for malpractice claims arising from the alleged errors and omissions of their professional employees under the legal theory of vicarious liability.

This unlimited personal liability for malpractice claims of partners and employees makes sole proprietorships and general partnerships less desirable business entities for professional practices, as it exposes the personal assets of owners to unlimited liability for the alleged malpractice of others.

Malpractice Liability for California Professional Corporations

Like sole proprietors and general partners of a general partnership, licensed professional shareholders of a California Professional Corporation have unlimited liability for their own acts of malpractice. This means that these licensed professional shareholders are personally responsible for any malpractice claims brought against them by clients or patients based upon their own errors and omissions.

However, licensed professional shareholders of a California Professional Corporation are protected from liability claims arising from alleged acts of malpractice by employees or other professional shareholders. The structure of a California Professional Corporation allows it to act as a separate legal entity, thus insulating individual licensed professional shareholders and their personal assets from personal liability other than their own direct acts of malpractice. In legal terms, this configuration means that while licensed professional shareholders of a California Professional Corporation are responsible for their personal acts of professional negligence, they are not personally accountable for the professional negligence of the employees and other professional shareholders of their California Professional Corporation.

This protection exists because the California Professional Corporation and not the licensed professional shareholder is the employer of employee or other professional shareholder alleged to have committed an act of malpractice, thus vicarious liability for the malpractice is a liability of the California Professional Corporation rather than the licensed professional shareholder. Consequently, while the California Professional Corporation may be sued for malpractice claims related to employee or other professional shareholder errors and omissions, the personal assets of the licensed professional shareholders are generally safeguarded.

The limited liability framework relies upon the diligent operation of the California Professional Corporation in compliance with California laws and regulations.

Malpractice Liability Conclusion

Regardless of which business structure a licensed professional chooses, they always have personal liability for their own acts of malpractice. However, operating as a sole proprietorship or general partnership exposes the personal assets of owners to unlimited liability for the alleged malpractice of employees and co-owners. In contrast, forming a California Professional Corporation offers protection from personal liability for acts of professional negligence committed by employees or other professional shareholders. While malpractice insurance is available to indemnify for errors and omissions, insurance coverage limits and the potential for a claim to be denied by a malpractice insurance coverage still make malpractice liability a concern for licensed professionals.

Conclusions About Liability Protections

The decision on which business entity to choose for a professional practice should be made carefully and with consultation from a legal professional, such as the experienced corporate attorneys at San Diego Corporate Law. Adequate insurance coverage for general liability, employment practices liability, and malpractice liability is also essential to protect against claims regardless of which professional business entity is used for a professional practice. Ultimately, understanding liability and choosing the appropriate business structure can provide peace of mind and safeguard both personal and professional assets, however, licensed professionals who are properly insured and both properly insured and actively mitigate risks may feel as though the limited liability protections provided by a California Professional Corporation are not a primary concern for their personal assets and professional practice.

When Does a California Professional Corporation Not Provide a Tax Benefit for a Licensed Professional?

While the organizational structure of a California Professional Corporation can offer substantial liability protection for licensed professionals, it is crucial to assess its implications from a tax perspective as well. Forming such a California Professional Corporation may not always result in favorable tax outcomes, and understanding when this applies can help licensed professionals make informed decisions.

Factors influencing the tax benefits of a professional business entity include the net income of the professional practice prior to allocating funds to owners, other income earned by owners, and the overall tax strategy of the owners.

Certain tax scenarios may negate the advantages typically associated with the use of a California Professional Corporation, such as when professional practice net income is relatively low or when other sources of income of an owner satisfy the FICA cap. In these cases, the tax benefits of passing income through to shareholders may not outweigh the increased administrative costs, complexities in tax filing, and corporate compliance requirements of a California Professional Corporation.

California Professional Corporations are by default subject to double taxation at personal service corporation rates (sometimes referred to as professional service corporation rates), however, California Professional Corporations may also elect to be taxed as S Corporations. As S Corporation taxation is beneficial for most professional practices, this article will focus on S Corporations and omit a discussion on professional C Corporation and double taxation matters.

This section evaluates these concerns for licensed professionals, allowing them to determine whether forming a California Professional Corporation aligns with their financial goals and tax efficiency strategies.

FICA Tax Liability

The FICA tax is a mandatory payroll tax in the United States that funds Social Security. Both employees and employers share the responsibility of paying FICA taxes.

For employees, the FICA tax is deducted directly from wages or salaries, with rates set at 6.2% from the gross income of the employee. Employers are required to match these contributions by paying an additional 6.2% on behalf of the employee, bringing the overall contribution to 12.4% per employee.

For self-employed persons, including sole proprietors and general partners of general partnerships, the FICA tax is based not on wages or salaries, but is instead assessed as 12.4% of the net income of the business allocated to the self-employed person.

The FICA tax is levied only on income or net income up to a specific threshold, which is adjusted annually for inflation. At the time of this writing in 2024, the FICA cap is the first $168,600 earned.

FICA Tax Liability for Sole Proprietors and General Partners

As sole proprietors and general partners in general partnerships, individuals bear the full burden of the FICA tax obligation on their entire net income up to the FICA cap. Unlike employees, who share the FICA tax responsibility with their employer, self-employed individuals are required to pay both the employer and employee portions of the tax, resulting in a total rate of 12.4% for FICA.

The following are some examples of FICA tax liability for a licensed professional with various net income:

$50,000 net income x 12.4% = $6,200 FICA tax liability

$150,000 net income x 12.4% = $18,600 FICA tax liability

$300,000 net income x 12.4% = $20,906 FICA tax liability (limited by $168,600 FICA cap for 2024)

FICA Tax Liability for California Professional Corporations Taxed as S Corporations

When a California Professional Corporation elects S Corporation status for taxation purposes, it alters how FICA tax liability is handled for its licensed professional shareholders. Unlike sole proprietors or general partners, who pay FICA taxes on their entire net income, California Professional Corporations taxed as S Corporations provide an opportunity to potentially reduce FICA tax liability by allocating a portion of business profits as distributions rather than wages. Licensed professional shareholders who are actively involved in the day-to-day operations of the California Professional Corporation must still receive reasonable compensation, which is subject to FICA taxes. This reasonable salary is subject to the 12.4% FICA tax up to the annual wage base limit, split into a 6.2% contribution from the wages of the licensed professional shareholder as an employee of the California Professional Corporation and a matching 6.2% paid by the California Professional Corporation.

Beyond the reasonable salary that licensed professional shareholders must draw, any additional profits may be paid to as distributions to the licensed professional shareholder not subject to FICA taxes. This distinction enables licensed professionals within California Professional Corporations electing taxation as S Corporations to strategically structure their income to minimize FICA tax obligations, provided that Internal Revenue Service guidelines for determining reasonable compensation are strictly followed.

The following is an example of FICA tax liability for a licensed professional with a minimum fair market value salary as established in accordance with the Internal Revenue Service guidelines regardless of whether they also receive $100,000, $250,000, or some other amount in the form of a distribution through the shares of stock of the California Professional Corporation:

$50,000 salary x 12.4% = $6,200 FICA tax liability

This approach requires careful planning and documentation to withstand potential scrutiny by tax authorities, and failing to comply with reasonable compensation standards can result in reclassification of distributions as wages, thereby incurring additional FICA tax liabilities and penalties. However, a $50,000 salary is capable of being deemed a reasonable salary in accordance with Internal Revenue Service standards regardless of the total net income of the California Professional Corporation.

FICA Tax Liability Conclusion

Comparing FICA tax liability of sole proprietors or general partners, which is assessed against the total net income of the business, a California Professional Corporation electing S Corporation taxation may bifurcate its income into a salary paid to a licensed professional shareholder as an employee subject to the FICA tax and distribute the remainder through the shares of stock of the California Professional Corporation not subject to the FICA tax.

Based upon the examples above, a California Professional Corporation taxed as an S Corporation that pays a $50,000 fair market salary to a licensed professional shareholder as an employee could save that licensed professional shareholder up to $14,706 per year based on the 2024 FICA tax cap of $168,600 compared to a sole proprietorship or general partnership.

Medicare Tax Liability

The Medicare tax is another mandatory payroll tax in the United States that funds the federal Medicare insurance program. Both employees and employers share the responsibility of paying Medicare taxes.

For employees, the Medicare tax is deducted directly from wages or salaries, with rates set at 1.45% from the gross income of the employee. Employers are required to match these contributions by paying an additional 1.45% on behalf of the employee, bringing the overall contribution to 12.9% per employee.

For self-employed persons, including sole proprietors and general partners of general partnerships, the Medicare tax is based not on wages or salaries, but is instead assessed as 2.9% of the net income of the business allocated to the self-employed person.

Unlike the FICA tax that is levied only on income or net income up to a specific threshold, there is no cap on the amount of Medicare tax an employee, sole proprietor, or general partner may have to pay.

Medicare Tax Liability for Sole Proprietors and General Partners

As sole proprietors and general partners in general partnerships, individuals bear the full burden of the Medicare tax obligation on their entire net income. Unlike employees, who share the Medicare tax responsibility with their employer, self-employed individuals are required to pay both the employer and employee portions of the tax, resulting in a total rate of 2.9% for Medicare.

The following are some examples of Medicare tax liability for a licensed professional with various net income:

$50,000 net income x 2.9% = $1,450 Medicare tax liability

$150,000 net income x 2.9% = $4,350 Medicare tax liability

$300,000 net income x 2.9% = $8,700 Medicare tax liability

Medicare Tax Liability for California Professional Corporations Taxed as S Corporations

When a California Professional Corporation elects S Corporation status for taxation purposes, it alters how Medicare tax liability is handled for its licensed professional shareholders. Unlike sole proprietors or general partners, who pay Medicare taxes on their entire net income, California Professional Corporations taxed as S Corporations provide an opportunity to potentially reduce Medicare tax liability by allocating a portion of business profits as distributions rather than wages. Licensed professional shareholders who are actively involved in the day-to-day operations of the California Professional Corporation must still receive reasonable compensation, which is subject to Medicare taxes. Responsibility for the Medicare tax is split into a 1.45% contribution from the wages of the licensed professional shareholder as an employee of the California Professional Corporation and a matching 1.45% paid by the California Professional Corporation.

Beyond the reasonable salary that licensed professional shareholders must draw, any additional profits may be paid to as distributions to the licensed professional shareholder not subject to Medicare taxes. This distinction enables licensed professionals within California Professional Corporations electing taxation as S Corporations to strategically structure their income to minimize Medicare tax obligations, provided that Internal Revenue Service guidelines for determining reasonable compensation are strictly followed.

The following is an example of Medicare tax liability for a licensed professional with a minimum fair market value salary as established in accordance to the Internal Revenue Service regardless of whether they also receive $100,000, $250,000, or some other amount in the form of a distribution through the shares of stock of the California Professional Corporation:

$50,000 salary x 2.9% = $1,450 Medicare tax liability

This approach requires careful planning and documentation to withstand potential scrutiny by tax authorities, and failing to comply with reasonable compensation standards can result in reclassification of distributions as wages, thereby incurring additional Medicare tax liabilities and penalties. However, a $50,000 salary is capable of being deemed a reasonable salary in accordance with Internal Revenue Service standards regardless of the total net income of the California Professional Corporation.

Medicare Tax Liability Conclusion

Comparing FICA tax liability of sole proprietors or general partners, which is assessed against the total net income of the business, a California Professional Corporation electing S Corporation taxation may bifurcate its income into a salary paid to a licensed professional shareholder as an employee subject to the Medicare tax and distribute the remainder through the shares of stock of the California Professional Corporation not subject to the Medicare tax.

Based upon the examples above, a California Professional Corporation taxed as an S Corporation that pays a $50,000 fair market salary to a licensed professional shareholder as an employee could save that licensed professional shareholder $2,900 per year based on a $150,000 annual income or $7,250 per year based on a $300,000 annual income compared to a sole proprietorship or general partnership.

Additional Medicare Liability

The Additional Medicare Tax is an increased taxation measure aimed at high-income earners, implemented as part of the Affordable Care Act. Unlike the standard Medicare tax, this additional tax is only applicable to individuals and couples whose income exceeds certain thresholds. Specifically, the tax applies to wages and self-employment income above these set limits at a rate of 0.9%, and it applies solely to the income that surpasses the threshold.

The Additional Medicare Tax threshold for single taxpayers is $200,000, $250,000 for married taxpayers who file taxes jointly, and $125,000 for married taxpayers who file separately.

Additional Medicare Tax Liability for Sole Proprietors and General Partners

As sole proprietors and general partners in general partnerships, individuals bear the full burden of the Additional Medicare tax obligation on their entire net income in excess of the thresholds.

The following are some examples of Additional Medicare tax liability for a single licensed professional with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$300,000 net income x 0.9% = $900 Additional Medicare tax liability ($100,000 above threshold)

The following are some examples of Additional Medicare tax liability for a married licensed professional filing jointly with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$300,000 net income x 0.9% = $450 Additional Medicare tax liability ($50,000 above threshold)

The following are some examples of Additional Medicare tax liability for a married licensed professional filing separately with various net income:

$50,000 net income x 0.9% = $0 Additional Medicare tax liability (below threshold)

$150,000 net income x 0.9% = $225 Additional Medicare tax liability ($25,000 above threshold)

$300,000 net income x 0.9% = $1,575 Additional Medicare tax liability ($175,000 above threshold)

Additional Medicare Tax Liability for California Professional Corporations Taxed as S Corporations

While the Additional Medicare tax applies to wages, including wages earned by licensed professional shareholders involved in the day-to-day operations of a California Professional Corporation, the fair market value wages required by the Internal Revenue Service are unlikely to come close to the thresholds for the Additional Medicare tax, regardless of marital status or tax filing status, with proper tax planning as follows:

$50,000 salary x 0.9% = $0 Additional Medicare tax liability (below threshold)

Additional Medicare Tax Liability Conclusion

While not as large as the FICA and Medicare tax examples at the net income rates used as examples above, the Additional Medicare tax is not nominal and can become quite large for the owners of large practice groups or owners of professional practices with high net income.

Deductibility of Health Insurance Premiums and Other Fringe Benefits

Deducting health insurance premiums and other fringe benefits to licensed professional shareholders is a critical aspect of tax planning when choosing a business entity for a professional practice. This section will outline the tax implications and benefits associated with offering health insurance and other fringe benefits to licensed professional shareholders and employees. Understanding these deductions enables more strategic financial planning and can significantly impact the overall tax liabilities.

Deductibility of Health Insurance Premiums and Other Fringe Benefits for Sole Proprietors and General Partners

For sole proprietors and general partners, the deductibility of health insurance premiums and other fringe benefits for their benefit can constitute a significant tax advantage. Sole proprietors can deduct health insurance premiums they pay for themselves as an above-the-line income tax deduction, reducing their adjusted gross income.

This deduction is available regardless of whether the sole proprietorship shows a profit but cannot exceed the net profit from the business. However, it is important to note that Medicare or Social Security taxes cannot be reduced by these deductions. For general partners, similar provisions apply if the premiums are paid by the partnership and reported as guaranteed payments.

These deductions not only lower taxable income but also reflect an incentive within the tax code encouraging the provision of health-related benefits by these smaller business structures.

Deductibility of Health Insurance Premiums and Other Fringe Benefits for California Professional Corporations Taxed as S Corporations

For California Professional Corporations taxed as S Corporations, the deductibility of health insurance premiums and other fringe benefits for the benefit of the licensed professional shareholder is an integral element of tax strategy to understand.

Shareholders who own more than 2% of the California Professional Corporation can deduct health insurance premiums and other fringe benefits for their benefit paid on their behalf by the California Professional Corporation, however, these premiums are treated as compensation to the shareholders and are reported as such on their W-2 forms, underlining their inclusion in taxable income.

Proper handling of these deductions ensures that the California Professional Corporation remains compliant with tax regulations.

Deductibility of Health Insurance Premiums and Other Fringe Benefits Conclusion

Understanding these deductions is essential for choosing the appropriate business structure and optimizing tax obligations. While health insurance premiums may be treated as business expenses of sole proprietorships, general partnerships, and California Professional Corporations taxed as S Corporations, licensed professional shareholders of California Professional Corporations must add these premiums and other fringe benefits to the calculation of their income tax (but not their FICA or Medicare tax liabilities).

Additional Costs to Operating as a California Professional Corporation

California Franchise Tax Board Minimum Annual Franchise Tax

California Professional Corporations taxed as S Corporations are subject to the California minimum annual franchise tax imposed by the California Franchise Tax Board. The minimum franchise tax for a California Professional Corporation is the greater of an $800 annual minimum or 1.5% of net income.

Sole proprietorships and general partnerships are not subject to this franchise taxation. These business structures forego the annual minimum tax, allowing them a different financial advantage in maintaining operations without this mandatory state-imposed financial obligation. However, owners of sole proprietorships and general partnerships should remain aware of other state tax requirements that might apply, ensuring comprehensive compliance across varying business models.

Other Administrative Costs to Operate a California Professional Corporation

Operating a California Professional Corporation involves several administrative costs beyond the minimum annual franchise tax compared to sole proprietorships and general partnerships.

For example, a California Professional Corporation will have expenses related to maintaining state and federal compliance for keeping its FinCEN Beneficial Ownership Information Report up to date, filing an annual statement of information, and the drafting of meeting minutes for its annual meetings of shareholders and its board of directors that sole proprietorships and general partnerships do not require.

For both general partnerships and California Professional Corporations, additional administrative costs for bookkeeping, legal consultation to ensure adherence to corporate governance requirements, and tax preparation are likely higher than equivalent costs for a sole proprietorship.

Sole proprietorships and general partnerships without employees will generally not incur payroll costs, but California Professional Corporations will require payroll services even if the licensed professional shareholder is the only employee of the California Professional Corporation, which is an added expense. However, sole proprietorships and general partnerships with employees will incur equivalent payroll costs that are comparable to those of California Professional Corporations.

The additional financial obligations of a California Professional Corporation can add up to a few thousand dollars per year depending upon the costs of tax preparation and payroll services.

Conclusions About Tax Benefits

The additional costs associated with operation as a California Professional Corporation vary but are generally a few thousand dollars per year compared to a sole proprietorship or general partnership that does not pay an annual franchise tax to the California Franchise Tax Board and does not have employees requiring payroll. In addition, sole proprietorships may enjoy lower tax preparation costs than general partnerships or California Professional Corporations.

However, depending upon the net income of the professional practice, these additional expenses may be paid for by the FICA, Medicare, and Additional Medicare tax savings possible with a California Professional Corporation.

For $50,000 of allocated net income, a sole proprietor would expect to pay $7,650 in self-employment taxes ($6,200 FICA + $1,450 Medicare), equivalent to that which would be paid by a licensed professional shareholder of a California Professional Corporation.

For $150,000 of allocated net income, a sole proprietor would expect to pay $22,950 in self-employment taxes ($18,600 FICA + $4,350 Medicare), compared to $7,650 in payroll taxes (employee and employer contributions combined of ($6,200 FICA + $1,450 Medicare) for a $50,000 salary from a California Professional Corporation, a tax savings of $15,300.

For $300,000 of allocated net income, a sole proprietor would expect to pay $30,506 in self-employment taxes ($20,906 FICA + $8,700 Medicare + $900 Additional Medicare), compared to $7,650 in payroll taxes (employee and employer contributions combined of ($6,200 FICA + $1,450 Medicare) for a $50,000 salary from a California Professional Corporation, a tax savings of $122,856.

Thus, for lower net income, say $50,000 or below, a California Professional Corporation will likely cost more in additional administrative expenses than the tax savings realized.

At around $60,000 of net income per year, the tax savings versus additional expense of operating a professional practice as a California Professional Corporation starts to break even depending on the costs of the additional expenses incurred.

Above the $60,000 of net income per year, the tax savings begins to exceed the additional expense of operating a professional practice as a California Professional Corporation, resulting in the licensed professional shareholder keeping more of the net income earned after taxes.

The experienced corporate attorneys at San Diego Corporate Law are available to assist with the analysis of net income versus administrative expense budgeting when deciding whether or not a licensed professional should form a California Professional Corporation or choose another business structure for a professional practice.

Establishing a Business Structure for Anticipated Growth

Establishing a business structure conducive to anticipated growth involves selecting a formation that not only accommodates current operations but also facilitates future expansion.

For licensed professionals foreseeing growth of their professional practice, choosing to start as a California Professional Corporation is advantageous because it allows these professionals to establish their practice once, avoiding the establishment of a practice as a sole proprietorship or general partnership for a year or two before facing the need to establish the practice a second time to after net income grows and the self-employment tax burden becomes expensive.

Additionally, even when net income remains lower, the California Professional Corporation is still valuable to a licensed professional because it provides legal protection by separating personal assets from business liabilities, a critical consideration for risk management.

Finally, for medical and mental health professionals who accept insurance from patients, regional centers, the insurance paneling process will need to be repeated for a licensed professional first establishing a sole proprietorship or general partnership and later incorporating to take advantage of the liability protections and tax benefits of a California Professional Corporation.

If within the means of such a licensed professional, the recommendation is to establish the practice right the first time as a California Professional Corporation.

A Quick Note on LLCs and PLLCs

A licensed professional may not use a foreign or California limited liability company (LLC), nor may a foreign professional limited liability company (PLLC) be used to render professional services in California. Pursuant to California Corporations Code Section 17701.04(e):

“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 comes as a surprise to many licensed professionals, as professional limited liability companies (PLLCs) are commonly used to render professional services in other states.