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Professional Law CorporationThe 1968 enactment of the Moscone-

Knox Professional Corporation Act,Corporations Code section13400-13410,allows professionals to render servicesthrough a professional corporation.

LiabilityThere are various types of liabilities

involved in practicing law, including tort andcontract. Tortious liability includes negligence,such as malpractice, car accidents, and slipsand falls, as well as intentional torts.Contractual liability can include businessobligations, such as commercial leases andemployment contracts.

Sole ProprietorshipThe sole proprietor is personally liable

for the obligations of the business because heor she is the business. There is no limited lia-bility partnership or corporate veil to hidebehind. The sole proprietor may choose tocover his or her risks using various types ofinsurance policies, such as malpractice andgeneral liability. Even with insurance policies,the risk to the sole proprietor is that the insur-ance policies would not fully cover the liabili-t y, because of exemptions, exclusions, or poli-cy limits.

Limited Liability PartnershipA limited liability partnership (sometimes

referred to herein as a “partnership”) providesan attorney with much greater liability protec-tion than the sole proprietorship. A partner isnot liable for tortious liability, such as malprac-tice of the other partners, and contract liabilityof the partnership, if it has not been personallyguaranteed by the partner and if the partnerhas not agreed to pay the contract liability(Corporations Code §16306).

The following types of liability cannot belimited by practicing either through a partnershipor a professional corporation: (1) liability result-ing from the partner or shareholder’s own mal-practice, (2) liability resulting from the malprac-tice of the employees that he or she supervises(CEB p. 714-715, Corporations Code §16306(e),Civil Code §2343(3)), and (3) liability resultingfrom the attorney’s own contract liability.

In order to take advantage of the liabilityprotection, a limited liability partnership mustbe registered with the Secretary of State(Corporations Code §16101(8)(A)) and have acurrently effective certificate of registration

Would You Benefit From a Professional Law

Corporation?

by Carolyn M. Dillinger

Introduction

This article compares using a profes-sional law corporation with a sole pro-prietorship and a limited liability partner-ship. Specifically, it will focus on the

advantages and disadvantages regarding liabilityand taxation.

The author largely draws on the ContinuingEducation of the Bar’s Organizing Corporationsin California, 3r d Edition, chapters one( “ C onsiderations Before Incorporating”) andsix (“Professional Corporations”), M a r s h ’sCalifornia Corporation Law, 4th Edition, chap-ter two (“Whether and Where to Incorporate”)

and twenty-four (“Professional Entities”), andU.S. Master Tax Guide, 2008, CCH Editorial StaffPublication.

This article does not examine the limited lia-bility company because Corporations Code section17375 states that a limited liability company maynot be used to render professional services.

Basic Introduction to BusinessStructures

Sole Proprietorship A sole proprietorship exists when a person

does business as that person or with a fictitiousbusiness name. There is no separate businessentity, such as a corporation or partnership.

Limited Liability Partnership In 1995 the California legislature created

the Registered Limited Liability Partnership(Marsh’s p. 24-25). A limited liability partnershipis a general partnership that engages in the prac-tice of public accountancy or law, and that hasregistered with the Secretary of State. Limited lia-bility partnerships are governed by theCorporations Code §16951-16962 (CEB p.35).

Wo u l d Yo uBenefit From a Professional Law Corporation?

Wo u l d Yo uBenefit From a Professional Law Corporation?

This article first appeared in

Orange County Lawyer magazine in May 2009, (page 30).

© Copyright 2009 Orange County Bar Association.

The views expressed herein are those of the author(s).

They do not necessarily represent the views of the

Orange County Lawyer magazine, the Orange County

Bar Association or its staff. All legal and other issues

should be independently researched.

3 1M A Y 2 0 0 9

corporation, the sole proprietor is allowed todeduct half of his tax in figuring his adjustedgross income (taken from www.irs.gov obtainedMarch 18, 2009).

The sole proprietor has little control overhow much income is taxed as self-employmentincome because the income is whatever moneyremains after the proper deductions. On theother hand, the shareholder of a corporationhas the ability to distinguish between salary,which is subject to payroll taxes, and dividendsor distributions, which are not subject to payrolltaxes. (See the discussion on subchapter S cor-porations and subchapter C corporationsbelow.)

Similar to a corporation and partnership, asole proprietor is allowed to deduct a wide rangeof business expenses. There are certain fringeb e n e fits, discussed below under corporations,which a corporation can take advantage of,which a sole proprietor is not eligible to deduct.

A key advantage of a sole proprietor is thatit is not subject to double taxation. Because theindividual is the business, there is no separateentity to be taxed separately. Finally, a sole p r o-prietor has limited retirement planning options,which include the IRA, and the SEP-IRA.

In general, the sole proprietor vehicle doesnot provide your tax professional with the rangeof tax planning strategies available through theprofessional law corporation. These tax plan-ning strategies include the ability to allocatewages and distribution or dividends, to deductcertain fringe benefits, and to utilize certainretirement planning options.

Limited Liability PartnershipA limited liability partnership is a pass-

through entity, which means that the profit andlosses pass through the partnership and areallocated amongst the partners.

This pass-through status can be helpfulbecause the partnership avoids the double taxa-tion of a subchapter C corporation. UnderCalifornia law, the partnership or corporation isrequired to pay taxes to the California FranchiseTax Board. The minimum annual fee is $800 pery e a r.

The pass-through status can be a disad-vantage to a profitable business that reinvests asignificant portion of its profits back into thepartnership. This is because the partners aretaxed on their allocable share of the profits evenif the partners have not received a cash distrib-ution. This concept of having tax liability when

issued by the State Bar (Corporations Code§16306(f)).

In order to register with the Secretary of State,a partnership must provide security for m a l p r a c-tice claims against it and its partners ( M a r s hp. 24-34, Corporations Code §16956(a)(2)). Thepartnership shall provide security by satisfying anyof the following four options: (1) insurance, (2)collateral, (3) net worth, or (4) the alternativesecurity requirement.

The partnership can obtain malpracticeinsurance in the amount of $100,000 multipliedby the number of licensed persons performingservices on behalf of the partnership; but with aminimum requirement of $1 million and amaximum obligation of $7.5 million(Corporations Code §16956(a)(2)(A)).

In the alternative, the partnership candeposit money in a bank escrow, certificate ofdeposit, or other specified form of collateral, inthe amount of $100,000 times the number oflicensed persons performing services on behalf ofthe partnership; but with a minimum require-ment of $1 million and a maximum obliga-tion of $15 million (Corporations Code§16956(a)(2)(B).

Or, the partnership can confirm in pre-scribed form to the Secretary of State that “as ofthe most recently completed fiscal year of thepartnership, it had a net worth equal to orexceeding fifteen million dollars ($15,000,000).”(Corporations Code §16956(a)(2)(D).

As an additional alternative, the partnershipcan aggregate its malpractice insurance cover-age, collateral, and net worth, to satisfy the $15million alternative security requirement. If thereis a shortfall between the $15 million and thepartnership’s aggregate security, the partners areautomatically deemed to have personally guar-anteed the shortfall (Corporations Code§16956(a)(2)(C)). The partnership may indem-nify the partners for this guarantee. Further, theLLP may choose the other options to avoid thisoption altogether.

Professional Law CorporationAccording to my research, a professional

law corporation provides the same liability pro-tection as the limited liability partnership.

As explained above in connection withLimited Liability Partnerships, shareholders ofprofessional law corporations may not limit cer-tain types of liability by hiding behind the corpo-rate veil. However, the corporate veil can protectthe shareholders from the tort or contract liabil-

ities of the corporation or other shareholders. Shareholders in a professional law corpora-

tion must personally guarantee the malpracticeobligations of their corporations within pre-scribed limits (CEB p. 715, B & P Code §6171(b),Law Corp R IV (B)(3)). The personal guaranteeis a required part of the State Bar Application forIssuance of Registration as a Law Corporation.

The formula for calculating the amountthat shareholders must personally guarantee is(a) per claim, $50,000 multiplied by the numberof persons who practice law on behalf of the cor-poration, and (b) aggregate, $100,000 multi-plied by the number of persons who practice lawon behalf of the corporation. A person who prac-tices law on behalf of the corporation is d e f i n e das “persons with whom the law corporation hasestablished a law practice relationship of a con-tinuous nature or who are held out by the corpo-ration as being available to practice law on itsbehalf. This includes all attorneys practicing in apartnership…or association in which the corpo-ration practices; employees; of counsel; contractattorneys; part-time attorneys and persons whopractice law on behalf of the corporation in otherjurisdictions, even if such members are n o tadmitted to practice law in California.” (StateBar of California Law Corporation GuaranteeWorksheet.)

Because of this required guarantee, a pro-fessional law corporation is strongly recom-mended to have enough malpractice insuranceto cover the maximum liability that the share-holders have personally guaranteed (Marsh p.2 4 - 2 0 ) .

TaxationFor purposes of this article, I have chosen

to discuss four key taxation issues: (1) self-employment tax, (2) deductions/fringe bene-fits, (3) double taxation, and (4) retirementplanning.

Sole ProprietorshipA sole proprietor reports her income on

Schedule C of her personal tax return, Form1040. Instead of processing payroll and payingpayroll taxes on her income, the sole proprietortakes money from the business in the form of a“draw.” Since payroll taxes are not taken out ofthe draw, a sole proprietor is required to pay self-employment taxes of 15.3%. This tax is chargedon the net amount, after business expenses arededucted. While the self-employment tax is not abusiness expense, as it is for a professional law

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money was not tangibly received is sometimesreferred to as phantom tax.

Partners can be subject to self-employ-ment taxes depending upon how the partner-ship chooses to structure payments to the part-ners. A partner’s eligible share of income maybe treated in one of three ways: (1) as net earn-ings from self-employment, (2) as salary orwages, or (3) as distributable shares of partner-ship income. The key is that your tax profes-sional has options and can help you structureyour respective income in an advantageousmanner.

The partnership is not subject to the dou-ble taxation of a subchapter C corporation.Although the partnership is not required to payfederal income tax, the partnership must file aForm 1065 information return with theInternal Revenue Service.

There is a concept applicable to partner-ships called guaranteed payments. A guaranteedpayment is any fixed payment to partners forservices or for the use of capital made withoutregard to partnership income. An example of aguaranteed payment is if the partnership agree-ment states that each partner is guaranteed toreceive a base payment of $5,000 per monthregardless of how much income the partnershiphas earned for that particular month, quarter, ory e a r. Guaranteed payments are regarded as ordi-nary income to the recipient and can bedeductible by the partnership as long as the pay-ments qualify as ordinary and necessary busi-ness expenses. The value of fringe benefits pro-vided to a partner for service rendered in thecapacity as a partner is generally treated as aguaranteed payment.

This ability to make guaranteed paymentsis a key factor that sets partnerships apart fromother entities. The partnership is able to takeadvantage of some, but not all, of the deduc-tions and fringe benefits that are allowed by aprofessional law corporation. There are also dif-ferences in the retirement planning strategiesthat are available to partners rather than toshareholders in a professional law corporation.

Professional Law CorporationA professional law corporation can be

structured as a subchapter C corporation or asubchapter S corporation. A corporation isautomatically a C corporation unless the share-holders file a Form 2553 to elect subchapter Sstatus. There are certain requirements for elect-ing subchapter S status which include that a

corporation have only one class of shares, haveno more than 100 shareholders, have no non-resident alien shareholders, and each sharehold-er consent to electing subchapter S status.

The shareholders of a corporation, regard-less of C or S status, are employees of the cor-poration. Because they pay payroll taxes on theirsalary, the shareholders are not subject to self-employment taxes. The benefit of paying payrolltaxes is that the employer’s half of the taxes, 7.65percent, is a deductible business expense. This ismore beneficial than the sole proprietorshipwhere the sole proprietor is allowed to adjust hisor her adjusted gross income by half.

The C corporation is subject to double tax-ation. First, a federal corporate income tax isimposed on the net earnings; then, after theearnings are distributed to shareholders as divi-dends, each shareholder pays taxes on his or hershare of the dividends. There is some relief avail-able for the shareholders. With the help of yourtax professional, a C corporation can reduce, oreven eliminate, its federal income tax liability bydistributing its income as salary to shareholders.This can reduce taxation at the corporate leveland minimize the negative impact of the doubletaxation.

The S corporation is not subject to doubletaxation. Instead, similar to the partnership, theshareholders are taxed on their share of the enti-ty’s earnings.

The C corporation provides the maximumtax benefit with fringe benefits. A full analysis isbeyond the scope of this article; however, some ofthe fringe benefits that are allowed under a Ccorporation include the full deductibility ofhealth insurance premiums, the deductibility ofparking expenses, and some qualified retirementplan advantages (CEB 714). It is important thatyou discuss your specific goals with your tax pro-fessional so that he or she can walk you throughthe details of these benefits.

The S corporation provides more tax benefitwith fringe benefits than a sole proprietorship, butless than the C corporation. It is noteworthy thattax treatment of fringe benefits paid to employeesof an S corporation is different for shareholdersthan for other employees. Fringe benefits paid to Scorporation employees who are not shareholders,or to shareholders who own two percent or less ofthe outstanding S corporation stock, can beexcluded from the employees’ taxable wages andare deductible as fringe benefits by the corpora-tion. However, shareholders who own more than

two percent of the S corporation stock are nottreated as employees for fringe benefit purposes,and their fringe benefits may not be tax free. Thisis an important distinction because many share-holders of small law firms will own more than twopercent of the stock and this will affect thedeductibility of fringe benefits. Shareholders withmore than two percent ownership are treated inthe same manner as partners in a partnership.

A shareholder employee who owns morethan two percent of the S corporation stock candeduct 100 percent of the amount paid for medicalinsurance for herself, her spouse and dependents.

ScenariosOne attorney firmA one attorney firm can be structured as a

sole proprietor or as a professional law corpora-tion. Depending upon the gross revenue of thefirm, and other factors, it may be beneficial forthe firm to be structured as a corporation. Theprofessional law corporation can take advantageof structuring salary and dividends or distribu-tion, deducting certain fringe benefits, and uti-lizing certain vehicles for retirement planning.

Two to nine attorney firmA two attorney firm can be structured as a

limited liability partnership or as a professionallaw corporation. The partnership and corpora-tion provide the same liability protection fromthe vicarious liability of the other partners andthe debts of the partnership. However, the part-nership must satisfy the security requirement byobtaining the minimum amount of malpracticeinsurance, providing the appropriate collateral,or verifying that it has a net worth of at least fif-teen million dollars. Otherwise, the partners willbe deemed to automatically personally guaran-tee the shortfall between the fifteen million secu-rity requirement and the partnership’s aggregatetotal of malpractice insurance, collateral, and networth. The partnership can indemnify the partnerfor this personal guarantee, but it would be betterto not have to provide this guarantee. Compare the difference between the guaranteerequirement of the shareholders in the corporationwith that requirement in a limited liability part-nership. A professional law corporation with twoshareholder attorneys is required to guarantee$100,000 per claim ($50,000 times 2) and$200,000 aggregate ($100,000 times 2). However,if those same two attorneys were structured as alimited liability partnership and chose to satisfy thesecurity requirement via insurance, the partner-

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ship would be required to obtain the minimum $1million insurance coverage. The professional lawcorporation would not have to meet $1 million incoverage to cover the personal guarantee of itsshareholders, unless the corporation had tenlicensed attorneys working on its behalf ($100,000times 10). You should speak with your insuranceagent to price the difference in malpractice insur-ance coverage. If the difference is significant, basedupon this calculation, in addition to other tax dif-ferences, it may be beneficial for the smaller firm toform a professional law corporation instead of alimited liability partnership.

Ten or more attorney firmFor the firm with at least ten attorneys, the

decision of whether to form a limited liability part-nership or a professional law corporation willprobably come down to a detailed discussion withyour tax professional. In order to be prepared forthat discussion, it is important for the attorneys tounderstand their financial goals, along with thebasics on salary allocation, fringe benefits, andretirement planning,

__________________Carolyn M. Dillinger is the president and soleshareholder of The Dillinger Law Firm, a pro-fessional corporation. She practices businesstransactional law from her office in AlisoViejo, California and forms professional lawcorporations for her attorney colleagues.Carolyn is the immediate past chair of theSolo/Small Firm Section of the Orange CountyBar Association. The opinions expressed hereindo not necessarily reflect the opinion of theSection. She can be reached at her office by e-mail at Carolyn@dillingerlawfirm.com or bytelephone at (949) 830-4717. Carolyn thanksc e r t i fied public accountant Ken Bright ofBright Accounting Services, which is a profes-sional accountancy corporation, for his inputon the taxation sections of this article.