In California, establishing a California Professional Corporation is a favored option for licensed professionals providing professional services in California. We recently published an article titled When Not to Use a California Professional Corporation outlining when this legal structure may not be suitable for a California professional practice. This article is intended to outline the strengths that most often make the California Professional Corporation the business entity of choice for California licensed professionals rendering professional services in California.

Liability Protection in California Professional Corporations

Licensed professionals often choose to practice in a California Professional Corporation to limit personal liability. Unlike sole proprietorships or partnerships, California Professional Corporations offer a liability protection and personal asset protection by separating the personal assets of the licensed professional shareholder from the business debts, liabilities, obligations, and legal judgments against the California Professional Corporation.

Limited liability protection is vital for licensed professionals who employ other licensed individuals as employees or independent contractors, especially when there is a significant risk of malpractice claims. By forming a California Professional Corporation, professionals can safeguard their personal assets and future earnings while adhering to state regulatory requirements and complying with agencies overseeing professional services in California.

Tax Benefits when Rendering Professional Service in a California Professional Corporation Taxed as an S-Corp

Selecting the ideal business structure to render professional service requires a deep understanding of tax implications. A California Professional Corporation that opts for S Corporation status can provide substantial tax benefits, especially in relation to self-employment and payroll taxes.

Self-employed professionals are responsible for covering the full Social Security and Medicare taxes, totaling 15.3% of net profit up to the statutory cap, which is $168,600 as of 2024. Beyond this cap, they must pay 2.9% on all net profit. Additionally, there is a 0.9% Medicare tax for single taxpayers earning $200,000 or more and for married taxpayers filing jointly with incomes of $250,000 or above, added to the 2.9%.

A California Professional Corporation taxed as an S-Corp offers a strategic way to minimize self-employment taxes. By providing a market-rate salary to licensed professional shareholders, the salary becomes subject to payroll taxes of 15.3% up to the statutory cap ($168,600 in 2024) and 2.9% for earnings above this limit. The remaining profits can then be distributed as shareholder distributions, which are not subject to payroll or self-employment taxes. This approach can result in significant tax savings for licensed professionals who balance their salary for professional services with the distributions on their shares of stock based upon ownership of their California Professional Corporation.

When do the California Professional Corporation Benefits Make Sense for a Licensed Professional?

Most licensed professionals would benefit from practicing with a California Professional Corporation in California, with the exceptions being very low revenue professional practices without employees that do not accept insurance and with no plans for future growth of the professional practice.

This article examines why forming a California Professional Corporation is advantageous for a licensed professional, whether practicing solo or with other licensed professionals. This article addresses relevant considerations to weigh when choosing the best business entity, namely, federal income taxes, California corporate taxes, self-employment taxes, personal income tax, liability protection, asset protection, and ownership issues.

The goal of this article is to equip licensed professionals with the information needed to make informed decisions. It is crucial to ensure that the chosen business entity aligns with the business goals of the licensed professional while adhering to California law, including the California Corporations Code, the California Business and Professions Code, and other relevant regulations, as well as the rules of government agencies overseeing professional practices, like the Governing Board for the profession.

Executive Summary: Putting the Conclusion First for Busy Professionals

A licensed professional should form a California Professional Corporation if they are either:

(i) concerned about liability protection or the separation of personal and business assets; or

(ii) anticipate an immediate or future tax benefit.

Some licensed professionals establish California Professional Corporations solely for liability protection, while many other licensed professionals do so exclusively for the tax benefits of practicing using a California Professional Corporation. When either liability protection or tax benefits justify the creation of a California Professional Corporation, a licensed professional should consider using a California Professional Corporation, even if only one of liability protection or tax benefits are sought by the licensed professional.

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.

Lower Net Income Practices without Employees or Independent Contractors

If a licensed professional works alone, has no employees or independent contractors, is fully insured, and runs a practice with an annual net income below $50,000 to $60,000 without the intention to grow the professional practice in the future, operating as a sole proprietorship in California may be suitable for that licensed professional.

Lower Net Income Practices with Employees or Independent Contractors

For licensed professionals earning less than $50,000 to $60,000 in net income annually without plans to grow their professional practice in the future, establishing a California Professional Corporation is still recommended if the licensed professional has or plans to have employees or independent contractors at any point in time, because California Professional Corporations offer protection to the licensed professional shareholder from liabilities related to their employees and independent contractors, including vicarious liability and malpractice liability claims.

Higher Net Income Practices Regardless of Liability Concerns

A licensed professional earning (or planning to earn) over $60,000 in net income annually should seriously consider practicing in a California Professional Corporation regardless of liability concerns because the tax savings of a California Professional Corporation can outweigh the additional administrative costs associated with practicing in a California Professional Corporation, and these tax savings can be significant.

Starting a New Practice Without Certainty of Future Performance

Licensed professionals planning to start small and grow their practice over time should carefully consider the administrative challenges of initially operating as a sole proprietor or general partnership with plans to later convert to a California Professional Corporation. It is best to schedule a consultation with an experienced corporate attorney for advice on the challenges for converting a thriving professional practice from a sole proprietorship or general partnership to a California Professional Corporation versus forming the California Professional Corporation as a part of starting their practice.

Special Considerations for Professionals Accepting Insurance, Working with a Regional Center, or Other Third-Party Payor Panels

A licensed professional whose practice accepts insurance (or plans to accept insurance), work with a regional center, or otherwise engage with third-party payor panels should weigh the administrative burden of undergoing a second round of paneling if they initially establish as a sole proprietorship or general partnership and later transition to a California Professional Corporation. Many licensed professionals opt to form a California Professional Corporation as a part of starting their practice to avoid the arduous task of paneling as a sole proprietorship or general partnership only to endure the process a second time one or two years later after forming a California Professional Corporation for the tax benefits or limited liability protection.

California Professionals are Prohibited from Practicing in a Limited Liability Company (LLC) or Professional Limited Liability Company (PLLC)

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

Choosing the right business structure for your practice can be a complex task. For tailored advice that considers your specific circumstances, schedule a consultation with the experienced attorneys at San Diego Corporate Law. Our team is committed to assisting licensed professionals in determining whether a California Professional Corporation or another business structure best suits their needs, maximizing tax benefits while minimizing liability risks.

Schedule a consultation today to ensure your practice is structured for success.

Liability Protection for Licensed Professionals

Licensed professionals often opt to operate under a California Professional Corporation to shield themselves from personal liability and to keep their personal assets separate and protected from business debts, liabilities, obligations, and legal judgments related to their practice. It is essential for licensed professionals to understand the liability protection differences between sole proprietorships and general partnerships compared to those offered by a California Professional Corporation when deciding on the ideal business structure for their practice.

General Liability

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

In this section, “general liability” refers to liabilities arising from contracts with vendors, claims of bodily injury, property damage, and other liabilities not related to employment relationships, malpractice, or professional errors and omissions.

For instance, consider scenarios such as a long-term lease of office space or specialized equipment, a bodily injury resulting from a visitor slipping and falling in the office of a licensed professional, property damage to leased premises or neighboring properties due to the professional practice, or claims of libel, slander, and other reputational harm stemming from professional advertising.

General Liability for Sole Proprietors and General Partnerships

Sole proprietors and general partners encounter substantial liability risks due to the absence of a distinction between personal and business assets. In a sole proprietorship, the owner is entirely accountable for all business debts, liabilities, obligations, and legal judgments related to general liability claims against the practice.

Similarly, in general partnerships, all general partners share joint and several liability. Each individual general partner is personally responsible for all business debts, liabilities, obligations, and legal judgments arising from general liability against the partnership. This means that each licensed professional acting as a general partner for a practice operating as a general partnership is personally liable for all liabilities of the practice.

If a visitor is injured on the premises or if the practice causes damage to property of a third-party property, the personal assets of a sole proprietor or each partner in a general partnership bear unlimited liability for these claims. This unlimited personal liability imposes a significant burden on a California sole proprietor or individual partners of a general partnership, especially if the practice lacks sufficient insurance or fails to effectively manage risks. It is essential for sole proprietors and general partners to be aware of these risks and consider protective measures, such as comprehensive insurance policies or restructuring the practice to limit personal liability exposure.

General Liability for California Professional Corporations

A California Professional Corporation offers significant protection against personal liability for licensed professionals. Unlike sole proprietors and general partners, who face unlimited personal liability for business debts, liabilities, obligations, and legal judgments, licensed professional shareholders of a California Professional Corporation generally enjoy protection from such business liabilities. This protection means their personal assets, such as homes and personal bank accounts, are typically shielded from claims related to the debts, liabilities, obligations, and legal judgments of the California Professional Corporation. As a distinct legal entity, the California Professional Corporation is accountable for its own debts, liabilities, obligations, and legal judgments, thereby insulating the personal financial exposure of its licensed professional shareholders.

It is important to recognize that the liability protection offered by a California Professional Corporation has its limitations. Licensed professional shareholders may still be personally liable for their own negligent or wrongful actions. Additionally, this protection does not cover liabilities backed by the personal guarantee of the licensed professional shareholder. To ensure limited liability protection for its licensed professional shareholders, the California Professional Corporation must be operated diligently and in compliance with California laws and regulations.

Despite the limitations mentioned above, the general liability protections afforded to licensed professional shareholders of California Professional Corporations are significant. These protections enable licensed professionals to manage their professional practices confidently with the maximum liability protection available under applicable law.

General Liability Conclusion

Some general liabilities for a California professional practice, whether it is structured as a sole proprietorship, general partnership, or California Professional Corporation, are insurable risks. However, if an incident occurs that is not covered by insurance, if the insurer denies coverage, or if the liability exceeds the insurance limits, the limited liability features of a California Professional Corporation may protect a licensed professional shareholder whereas a sole proprietor or general partner or a general partnership would be personally liable. The limited liability of a California Professional Corporation offers protection compared to the unlimited personal liability faced by a sole proprietor or a general partner.

Employment Liability

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

In this section, the term “employment liability” refers to both the responsibility owed to employees and independent contractors and the vicarious liability to third parties arising from the actions or inactions of employees and independent contractors.

Employment liability to employees encompasses issues such as wage and hour law, sexual harassment, hostile work environment claims, privacy and information privacy claims, discrimination, wrongful termination, and a host of other potential liabilities. In contrast, vicarious liability to third parties might involve a business being held accountable for an injury to a third party arising from an auto accident caused by an employee during company time or some similar claim.

Employment Liability for Sole Proprietors and General Partnerships

Much like general liability issues, professional sole proprietors and general partners are significantly exposed to liability due to the absence of a clear divide between personal and business assets. In a professional sole proprietorship, the licensed professional owner bears full responsibility and unlimited liability for employment-related claims made by employees or independent contractors, as well as for third-party claims concerning employee or independent contractor actions or inactions for which the professional practice is vicariously liable.

In general partnerships, professional general partners share joint and several liability. Each professional general partner has unlimited personal liability for all employee-related claims against the professional practice and for all third-party claims of vicarious liability resulting from employee or independent contractor actions or inactions.

If an employee or independent contractor files a claim for a meal break violation, wrongful termination, or other common workplace issues, the personal assets of a professional sole proprietor or each professional general partner in a general partnership is subject to unlimited liability. Similarly, if an employee or independent contractor assaults or injures a third party, or damages third-party property, the professional sole proprietor or each professional general partner faces unlimited liability for these claims under the legal principle of vicarious liability.

Unlimited personal liability places a heavy burden on professional sole proprietors and individual professional general partners of general partnerships, particularly when the practice is underinsured or poorly manages risks. It is crucial for professional sole proprietors and individual professional general partners to recognize these risks and explore protective measures. Options such as employment practices liability insurance can guard against employee claims, while comprehensive general liability insurance addresses vicarious liability from employee and independent contractor actions or inactions. Alternatively, restructuring the practice can help mitigate personal liability exposure.

Employment Liability for California Professional Corporations

A California Professional Corporation provides significant protection against personal liability for licensed professional shareholders, shielding them from employee-related claims. Unlike professional sole proprietors and professional general partners of general partnerships who face unlimited personal liability for employee and independent contractor claims and incidents caused by employees and independent contractors, licensed professional shareholders in a California Professional Corporation typically enjoy protection from both types of employment liability.

The liability protection provided by a California Professional Corporation ensures that the personal assets of licensed professional shareholders, such as their homes and bank accounts, are generally shielded from claims arising from employment liability related to the professional practice. As a separate legal entity, the California Professional Corporation assumes responsibility for employee and independent contractor claims and third-party claims based on employee and independent contractor actions or inactions under the legal theory of vicarious liability, thereby significantly reducing the personal financial exposure of licensed professional shareholders of a California Professional Corporation.

It is important to recognize that a California Professional Corporation holds liability for employee and independent contractor claims as well as third-party claims due to vicarious liability for the actions or inactions of employees and independent contractors. Although this is preferable to unlimited personal liability for licensed professionals, such liability can still significantly impact a professional practice, even as it protects the assets of the licensed professional shareholders.

Similar to general liability, a California Professional Corporation must operate diligently and comply with California laws and regulations to ensure its licensed professional shareholders receive limited liability protection. This protection extends to both employee claims and third-party vicarious liability claims.

Despite the previously mentioned limitations, licensed professional shareholders enjoy significant employment liability protections with California Professional Corporations, and the safeguards provided allow them to conduct their practices with confidence with the maximum liability protection available under applicable law.

Employment Liability Conclusion

Employment practices liability insurance can cover many, but not all, liabilities related to employee practices. Similarly, many general liabilities are insurable risks for a California practice whose employees may expose it to third-party claims under vicarious liability. Whether operating as a sole proprietorship, general partnership, or California Professional Corporation, having comprehensive insurance is crucial. However, if an incident is not covered, is denied by the insurer, or if liability exceeds the coverage, the limited liability status of a California Professional Corporation can protect a licensed professional from personal liability. This stands in contrast to a California sole proprietor or general partner of a general partner of a general partnership who would face unlimited personal liability for the same claim.

Malpractice Liability

Licensed professionals selecting a business structure for their practice should understand the variations in malpractice and errors and omissions liability protection offered by sole proprietorships, general partnerships, and California Professional Corporations.

In this section, “malpractice” is defined as the professional errors and omissions that occur when an individual professional fails to meet the accepted standards of practice for their profession, resulting in harm or damage. Malpractice liability pertains to the legal accountability professionals may encounter for not adhering to these standards, which can lead to claims and lawsuits.

For professionals selecting a business entity in which to practice in California, understanding the assignment of malpractice liability is vital. In a California professional practice, the consequences of malpractice can be significant. This section explores the intricacies of malpractice liability, focusing on the risks associated with professional errors and omissions, and examines the liability of professional practice owners in sole proprietorships, general partnerships, and California Professional Corporations.

Malpractice Liability for Sole Proprietors and General Partnerships

California professional sole proprietors and professional general partners of general partnerships bear unlimited liability for their own malpractice acts. Consequently, they are personally accountable for any malpractice claims filed against them by their clients or patients.

In a general partnership, each of the professional general partners not only bear unlimited liability for the malpractice and errors and omissions claims against them personally, but they also have unlimited liability for the malpractice and errors and omissions of all other professional general partners in the general partnership, giving each professional general partner unlimited personal liability for the malpractice and errors and omissions of each other professional general partner.

Furthermore, as previously mentioned regarding vicarious liability for employees and independent contractors, professional sole proprietors and professional general partners of general partnerships bear unlimited liability for malpractice claims of the professional employees and professional independent contractors who practice for the sole proprietorship or general partnership. This liability stems from the alleged malpractice or errors and omissions of their professional employees under the legal theory of vicarious liability.

The unlimited personal liability associated with malpractice claims for all other professional general partners, employees, and independent contractors makes sole proprietorships and general partnerships less appealing for professional practices because these business entities expose the personal assets of professional owners to unlimited liability for the alleged malpractice of other professionals.

Malpractice Liability for California Professional Corporations

Similar to professional sole proprietors and professional general partners in a general partnership, licensed professional shareholders of a California Professional Corporation face unlimited liability for their own malpractice and professional errors and omissions. This means that licensed professional shareholders remain personally liable for their own acts of malpractice and errors and omissions due to their own negligence.

However, licensed professional shareholders of a California Professional Corporation do enjoy protection from liability related to malpractice and errors and omissions allegedly made by employees, independent contractors, and other professional shareholders. A California Professional Corporations function as a legal entity separate and apart from its shareholders, safeguarding individual shareholders and their personal assets from malpractice liability, except for their own acts of malpractice and their own errors and omissions. In essence, while licensed professional shareholders of a California Professional Corporation are accountable for their own professional negligence, they are not held personally liable for the malpractice or errors and omissions of employees, independent contractors, or fellow professional shareholders within the California Professional Corporation.

This protection exists because the California Professional Corporation, not the individual licensed professional shareholder, is considered the employer of any employee, independent contractor, or other professional shareholder accused of malpractice. As a result, vicarious liability for malpractice falls on the California Professional Corporation rather than the individual professional shareholder. Consequently, while the professional alleged to have committed malpractice or an error or omission and a California Professional Corporation may face lawsuits for malpractice claims due to the actions of employees, independent contractors, or other professional shareholders, the personal assets of licensed professional shareholders not alleged to have personally committed an act of malpractice or an error or omission are typically protected.

As with general liability and employment liability, the limited liability framework for malpractice and errors and omissions relies upon the diligent operation of the California Professional Corporation in compliance with California laws and regulations.

Malpractice Liability Conclusion

Licensed professionals, regardless of their chosen business structure, are personally liable for their own acts of malpractice and their own errors and omissions. However, operating as a sole proprietorship or general partnership in California exposes licensed professionals to unlimited liability for malpractice and errors and omissions committed by employees, independent contractors, and professional co-owners. In contrast, forming a California Professional Corporation provides protection from personal liability for professional negligence committed by employees, independent contractors, or fellow professional shareholders. While malpractice insurance can cover errors and omissions, its limitations and the possibility of claim denial make malpractice liability a significant concern for licensed professionals and California Professional Corporations provide the maximum legal protection available under applicable law.

Conclusions About Liability Protections

Choosing the right business entity for a California professional practice requires careful consideration and consultation with legal experts, such as the experienced corporate attorneys at San Diego Corporate Law. It is crucial to have adequate insurance coverage, including general liability insurance, employment practices liability insurance, and malpractice liability insurance, to protect against claims regardless of the chosen professional business entity. However, insurance is limited in coverage and coverage amounts, and insurers deny claims when possible, so understanding professional liability and selecting the appropriate business structure can offer further peace of mind for professionals and safeguard both their personal and professional assets in ways even the best insurance policies cannot.

Tax Benefits for Licensed Professionals

The organizational structure of a California Professional Corporation offers significant liability protection for licensed professionals. However, it is essential to also consider its tax implications. Establishing a California Professional Corporation may also lead to favorable tax results. By understanding the tax benefits of California Professional Corporations compared to the taxation of sole proprietorships and general partnerships, licensed professionals can make more informed decisions when selecting a business entity for their practice.

The tax benefits of a professional business entity are influenced by several factors: the net income of the practice before distributing funds to owners, additional income earned by the owners, and their overall tax strategy.

Certain tax situations can diminish the usual benefits of forming a California Professional Corporation from a tax perspective. This is especially true when the net income of the practice before compensation to the professional owner is relatively low or when other income of the professional owner already meets the FICA cap. In such cases, the tax advantages of a California Professional Corporation may be diminished.

California Professional Corporations are by default C Corporations (C-Corps) and typically face double taxation at personal service corporation rates (sometimes referred to as professional service corporation rates). However, California Professional Corporations have the option to elect S Corporation status, which is advantageous for most professional practices. This article will concentrate on the benefits of S Corporation taxation, omitting detailed discussions on professional C Corporation (C Corp) taxation and the issue of double taxation generally.

This section examines tax concerns for licensed professionals, helping them assess whether establishing a California Professional Corporation aligns with their financial objectives 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.

The FICA tax is directly deducted from the wages or salaries of employees at a rate of 6.2% of their gross income. Employers must match this contribution with an additional 6.2%, resulting in a total contribution of 12.4% per employee.

For self-employed individuals, such as professional sole proprietors and professional general partners in general partnerships, the FICA tax is calculated differently. Instead of being based on wages or salaries, it is assessed at 12.4% of the net income attributed to the self-employed person (whether a sole proprietor or general partner) from their business.

The FICA tax is applied solely to income or net income up to a specified limit, which is annually adjusted for inflation. As of 2024, this cap is set at the first $168,600 earned.

FICA Tax Liability for Sole Proprietors and General Partners

Licensed professional sole proprietors and licensed professional general partners in general partnerships shoulder the entire FICA tax burden on the net income of a professional practice, each up to their individual FICA cap. Unlike professional employees who split this tax with their employers, self-employed professionals must cover both the employer and employee portions, resulting in a total FICA rate of 12.4% for professional sole proprietors and professional general partners in general partnerships.

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 opts for S Corporation status for tax purposes, it modifies the approach to handling FICA tax liability 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 offer a potential reduction in FICA tax liability by distributing a portion of business profits as shareholder distributions rather than wages. However, licensed professional shareholders actively participating in the daily operations of the California Professional Corporation must still receive reasonable compensation which is subject to FICA taxes. This reasonable salary is taxed at the 12.4% FICA rate up to the annual wage base limit, with a 6.2% contribution deducted from the wages of the licensed professional shareholder as an employee and a matching 6.2% paid by the California Professional Corporation.

Licensed professional shareholders may receive distributions from any profits beyond their reasonable salary exempt from FICA taxes. This allows licensed professionals in California Professional Corporations electing S Corporation taxation to strategically organize their income to reduce FICA tax liabilities as long as they adhere to Internal Revenue Service guidelines for determining reasonable compensation.

Here is an example of FICA tax liability for a licensed professional earning a minimum fair market value salary as determined by Internal Revenue Service guidelines.

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

This applies regardless of whether the licensed professional shareholder also receives $100,000, $250,000, or any other amount as a distribution through shares of stock in the California Professional Corporation.

This approach requires planning and documentation, as non-compliance with reasonable compensation standards could lead to the reclassification of distributions as wages, incurring additional FICA tax liabilities and penalties. Nonetheless, a $50,000 salary can be considered reasonable according to Internal Revenue Service standards, regardless of the total net income of the California Professional Corporation.

FICA Tax Liability Conclusion

When comparing FICA tax liability, professional sole proprietors and professional general partners of general partnerships are taxed on the total net income of their professional practice. In contrast, a California Professional Corporation that elects S Corporation taxation can divide its income into that which is paid to a licensed professional shareholder as salary subject to the FICA tax and distributions paid to the licensed professional shareholder through the shares of the stock of the California Professional Corporation, which distributions are 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 that same net income being paid to a professional sole proprietor or professional general partner.

Medicare Tax Liability

The Medicare tax is a mandatory payroll tax in the United States, supporting the federal Medicare insurance program. Responsibility for paying these taxes is shared between employees and employers.

For employees, the Medicare tax is deducted directly from their wages or salaries at a rate of 1.45% of their gross income. Employers must also contribute an additional 1.45% on behalf of the employee, resulting in a total contribution of 2.9% per employee.

For self-employed individuals, including professional sole proprietors and professional general partners in general partnerships, the Medicare tax is calculated not on wages or salaries, but rather as 2.9% of the net income of the professional practice attributed to the licensed professional owner.

Unlike the FICA tax, which is imposed only on income up to a certain threshold, the Medicare tax has no cap on the amount owed by an employee, professional sole proprietor, or professional general partner.

Medicare Tax Liability for Sole Proprietors and General Partners

As professional sole proprietors or professional general partners of a general partnership, these licensed professionals shoulder the entire Medicare tax burden on their net income. Unlike employees who share this responsibility with their employers, self-employed professionals must cover both the employer and employee portions of the tax, resulting in a total Medicare tax rate of 2.9%.

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 opts for S Corporation status for tax purposes, it changes how Medicare tax obligations are managed for its licensed professional shareholders. Unlike professional sole proprietors or professional general partners of a general partnership who pay Medicare taxes on their entire net income, California Professional Corporations taxed as S Corporations offer a way to potentially reduce Medicare tax liability by classifying a portion of business profits as distributions on shares of stock instead of wages. Licensed professional shareholders actively engaged in the daily operations of the professional practice must still receive reasonable compensation, which is subject to Medicare taxes. The Medicare tax responsibility is split, with a 1.45% contribution from the wages of the licensed professional shareholder as an employee and a matching 1.45% paid by the California Professional Corporation.

Licensed professional shareholders must receive a reasonable salary, but any additional profits can be paid to the licensed professional shareholder as shareholder distributions not subject to Medicare taxes. This allows licensed professionals with California Professional Corporations taxed as S Corporations to strategically manage their income and reduce Medicare tax liabilities. It is essential, however, to adhere strictly to Internal Revenue Service guidelines when determining reasonable compensation.

Here is an example of Medicare tax liability for a licensed professional earning a minimum fair market value salary as determined by the Internal Revenue Service:

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

This applies regardless of whether the licensed professional shareholder receives $100,000, $250,000, or any other amount as shareholder distributions through shares of stock in the California Professional Corporation.

This approach requires planning and documentation, as non-compliance with reasonable compensation standards may lead to shareholder distributions being reclassified as wages, resulting in additional Medicare tax liabilities and penalties. Nonetheless, a $50,000 salary can be considered reasonable under Internal Revenue Service standards, regardless of the total net income of the California Professional Corporation.

Medicare Tax Liability Conclusion

When examining Medicare tax liability, professional sole proprietors and professional general partners of general partnerships are taxed on the entire net income of their professional practice. In contrast, a California Professional Corporation that chooses S Corporation taxation can bifurcate its income to pay a reasonable salary to a licensed professional shareholder as an employee, which is subject to the Medicare tax, while distributing the remaining income to the licensed professional shareholder through the shares of stock of the California Professional Corporation, which is 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 the Medicare tax liability for a professional sole proprietor or professional general partner of a general partnership.

Additional Medicare Liability

The Additional Medicare Tax, introduced under the Affordable Care Act, targets high-income earners with increased taxation. Unlike the standard Medicare tax, this additional levy applies only to individuals and couples who surpass specific income thresholds. Specifically, it imposes a 0.9% tax rate on wages and self-employment income exceeding these limits, affecting only the income that surpasses the threshold.

The threshold for the Additional Medicare Tax is $200,000 for single taxpayers, $250,000 for married couples filing jointly, and $125,000 for married individuals filing separately.

Additional Medicare Tax Liability for Sole Proprietors and General Partners

As professional sole proprietors and professional 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 for licensed professional shareholders is another consideration in tax planning when selecting a business entity for a professional practice in California. This section will detail the tax implications and advantages of providing health insurance and other fringe benefits to licensed professional shareholders and employees. By grasping these deductions, one can engage in more strategic financial planning, significantly affecting overall tax liabilities.

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

For professional sole proprietors and professional general partners of general partnerships, the ability to deduct health insurance premiums and other fringe benefits can offer a tax advantage. Sole proprietors can deduct the health insurance premiums they pay for themselves as an above-the-line deduction, thereby reducing their adjusted gross income.

This deduction is available even if the sole proprietorship does not show a profit, though it cannot surpass the net profit of the professional practice. It is important to remember that these deductions do not reduce Medicare or Social Security taxes. For professional general partners in general partnerships, similar provisions apply if the premiums are paid by the general partnership and classified as guaranteed payments.

These deductions not only reduce taxable income but also serve as incentives within the tax code, encouraging smaller business structures to offer health-related benefits.

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, understanding the deductibility of health insurance premiums and other fringe benefits for licensed professional shareholders is important to creating an effective tax strategy.

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 licensed professional 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

Grasping these deductions is crucial for selecting the right business structure and optimizing tax responsibilities. For sole proprietorships, general partnerships, and California Professional Corporations taxed as S Corporations, health insurance premiums can qualify as business expenses. However, licensed professional shareholders of California Professional Corporations must include these premiums and other fringe benefits in their income tax calculations, although they are exempt from FICA and Medicare tax liabilities.

Additional Costs to Operating as a California Professional Corporation

California Franchise Tax Board Minimum Annual Franchise Tax

California Professional Corporations, when taxed as S Corporations, must pay the minimum annual franchise tax mandated by the California Franchise Tax Board. The minimum franchise tax is the greater amount between an annual $800 or 1.5% of net income.

Sole proprietorships and general partnerships are exempt from franchise taxation in California, allowing them to bypass the annual minimum tax. This exemption provides a slight financial benefit; however, the tax efficiency of California Professional Corporations far exceeds the California minimum franchise tax requirement.

Other Administrative Costs to Operate a California Professional Corporation

Operating a California Professional Corporation involves additional 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 unregistered 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, but these costs are often outweighed by the tax benefits provided by a California Professional Corporation taxed as an S Corporation.

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 California professional sole proprietor or professional general partner of a general partnership 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 California professional sole proprietor or professional general partner of a general partnership 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 California professional sole proprietor or professional general partner of a general partnership 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 California 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 California 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 California 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 professional 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 professionals who accept insurance, work with a regional center, or otherwise engage with third-party payor panels, 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 start with a California Professional Corporation formed as a part of starting the practice.

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 practice 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.