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CHOOSING A PROFESSIONAL
LEGAL ENTITY FOR YOUR PRACTICE

PART I Nov 2000 - By Eden Rose Brown J.D. Attorney and Counsellor at Law

Whether starting a new medical practice or reorganizing an existing practice, one of the first things you’ll need to do is choose a legal entity through which the practice will be conducted. Attorneys refer to this as a “choice of entity.”

Generally, state laws permit the use of the “professional corporation,” “general partnership,” “limited liability company,” and “limited liability partnership” for the operation of a medical practice. Professional corporations may be Subchapter “C” or Subchapter “S” corporations for federal and state income tax purposes. The choices, therefore, are plentiful. Choosing the best legal form for a practice requires consideration of three important factors: liability insulation, tax treatment, and ease and convenience of formation and administration.

The ideal entity would shield the physicians personally from practice liability, be nontaxable and be free of requirements, restrictions and limitations in co-ownership arrangements, formation and administration. Unfortunately, this is an imperfect world! Nonetheless, the law has evolved to the point where most of the foregoing objectives can be achieved in whole or in part.

A brief review of this evolution is beneficial to understanding the comparative benefits and disadvantages of the choice entities. So, go get another cup of coffee, put your feet up, and here goes.

1970s and Sole Proprietors

Until the early 1970s, medical practices were incorporated entities. That is, sole practitioners were “sole proprietors.” One or more sole proprietorships, by law, constituted a general partnership. There were no alternatives. Corporations existed but were unavailable for use by doctors, lawyers, accountants and other professionals. State law prohibited incorporation of professional practices so that practitioners could not circumvent personal liability resulting from malpractice. The professions lobbied. Hard. It was understandable, perhaps, that professionals couldn’t shield themselves from malpractice. It didn’t make sense, however, that owners of nonprofessional businesses could shield themselves personally from the general debts and obligations of their businesses while professionals could not. Legislation was ultimately enacted allowing for the incorporation of professional practices under the classification, “professional corporations.” The “professional corporation” for all intents and purposes is the same as “business corporations,” except that shareholders are not personally protected from the general debts and obligations of their practice as well as from the acts and omissions of their colleagues. Thus, with the advent of the professional corporation, medical practitioners at long last were able to protect themselves generally from liability.

One disadvantage of the corporation, professional or otherwise, is that the tax law treats it as a distinct taxable entity. Therefore, the incorporated medical practice was required to pay state and federal tax on net income and was subject, for state purposes, to capital stock and franchise taxes as well. The unincorporated practice was not so subjected. Many, if not most, medical practitioners incorporated their practices anyway. Franchise and capital stock taxes of a few hundred dollars per year were generally viewed as the annual cost for acquiring the liability insulation they had sought. And taxes on net income were generally minimal or nonexistent as net income was passed through as tax deductible compensation to the physicians. Hence, professional corporations reported little, if any, corporate net income on a yearly basis. Still, the potential for “double tax” on net income was passed through as tax deductible compensation to the physicians. Hence, professional corporations reported little, if any, corporate net income on a yearly basis. Still, the potential for “double tax” on net income (i.e., taxed once at the corporate level and again on the individual level upon distribution) did exist.

Of far greater potential, however, was the double tax which could occur with respect to proceeds resulting from a sale of a practice’s assets. It would be far more difficult to pass proceeds through to the practice owners in a deductible fashion if the proceeds represented gain from the sale of practice assets rather than compensation for the services rendered by the practice owners.

1980s and the Subchapter S Corporation

The government passed legislation in the early 1980s that offered relief to small incorporated business owners, permitting them via election to be treated like partnerships for tax purposes. Hence, the advent of the Subchapter S corporation. As a “flow-through” entity, the S corporation, like its counterpart, the partnership, would not be taxed for income tax purposes. The S corporation would still pay annual franchise and capital stock taxes, but being relieved of the potential for double taxation was a significant benefit.

Seemingly, there was little, if any, reason not to be incorporated as either a C or an S professional corporation. Hence, during the 1980s, the sole proprietorship and general partnership became largely, although not totally, obsolete. Notwithstanding the favorable tax treatment, many doctors continued forming their medical practices as C corporations, rather than S corporations.

There were a few reasons. Unfamiliarity was one factor. Another was that certain tax benefits which were available to the C corporation were not available to the S corporation. For example, owners of C corporations were able to receive their health insurance benefits on a fully deductible basis, while the S corporation’s owner was only able to deduct a portion of these benefits. Furthermore, S corporations were subject to certain restrictions as to classes of tock, number and type of shareholders, and the like. Consequently, they would not be nearly as flexible as C corporations for purposes of structuring co-ownership arrangements. Also, many medical practices’ owners really were not concerned with the potential for double taxation. Practice sales were not a real consideration for many doctors. Therefore, C corporations reigned in the late 1980s.

1990s and beyond

Fast forward to the 1990s (where hindsight, of course, is 20/20). The 1990s have seen many medical practice asset sales. Generally, S corporation practice owners have retained a far greater percentage of their sales proceeds than the owners of the C corporation practices. Thus, the favorable “flow-through” feature of a non-taxable entity has proven to be significant.

Continue to Part II: The superiority of the Limited Liability Company.

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