For firms whose main source of revenue is from the provision of professional services, many states allow the business to operate as a professional corporation rather than a C corporation or other pass-through entity, such as a limited liability company (LLC). The IRS treats professional corporations just like any other corporation; however, there are some tax advantages to using this structure instead of other corporate and pass-through entities.
The IRS treats all professional corporations as qualified personal service corporations for federal income tax purposes if substantially all of the corporation’s activities involve the provision of personal services, such as consulting, accounting, actuarial services, architecture, law and engineering. Moreover, this designation only applies if at least 95 percent of all outstanding stock of the professional corporation is owned by employees who provide the services, retired employees who provided the same services in prior years, or those who inherit the stock from current and retired employees.
The main tax advantage of using a professional corporation instead of a partnership or LLC is that the corporation is a taxpayer separate and distinct from its shareholders. In contrast, LLCs and partnerships use pass-through taxation principles, which require the individual members and partners to report their proportionate share of business income on their personal tax returns. As an owner or shareholder, this may not always save you more in actual tax dollars, but it significantly limits your personal liability for corporate taxes.
Cash Method Accounting
Pursuant to the Internal Revenue Code, corporations must use an accrual method of accounting for calculating taxable business income. However, a professional corporation the IRS designates as a qualified personal service corporation is eligible to choose the cash method of accounting instead. The cash method allows the professional corporation to defer the reporting of taxable income until the year it receives cash payment for its services. To illustrate, suppose your corporation provides legal services to a client on November 1, 2011, but doesn’t receive payment for the invoice until January 15, 2012. If you use a C corporation, the IRS requires the company to report the invoice amount on its 2011 tax return since this corresponds to the year it earns the income. In contrast, using the cash method of accounting as a professional corporation allows the company to defer reporting the taxable income to the 2012 tax year when it receives the payment, thereby allowing it to retain available cash for an additional year instead of using it to make a tax payment.
There is one significant tax disadvantage you must be aware of when choosing a professional corporation structure for your business. When your operations are subject to the IRS qualified personal service corporation rules, the agency imposes a 35-percent tax rate on all corporate earnings. A C corporation is also subject to a maximum tax rate of 35 percent, but its initial earnings up to $100,000 are subject to lower rates that progressively increase from 15 to 34 percent. Furthermore, LLC members and partners of partnerships calculate the income tax on business earnings using personal income tax rates, which also progressively increase from 10 to 35 percent.
References & Resources
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