Tuesday, April 13, 2010

Professional Corp: just a piece of the Plan

I had an interesting discussion about Professional corporations today. It appeared to me that a young professional had been steered into a PC without much thought or planning. This assumption, which I hope is unfair, is partly from experience. Tell your lawyer you’re starting a business and he will pull out an LLC filing form. You’re a professional, it will be a PC form. That’s it. You have your company, The lawyer, accountant or adviser act like they have blinders on. Were you asked or advised on the following:

· Where will your income come from, just professional services or will you be selling anything else, such as books, guides, gear, tools, any specialized non-professional reports?
o The IRS function test requires that substantially all (95 percent) of the business activities involve services within specific occupations
· Where will you put business assets for the best tax results?
o You don’t have to keep it in the PC
· Which type of organization costs the less to form and operate?
o Must it even be a PC in this state
· Will you have multi-state operations?
o The other state may be better
· How will you get the most tax deductions?
o You are not in a box do not limit thinking to the PC
· Who else will you employ and how?
o All owners must be professionals, retired professionals or heirs
o Address avoiding often overlooked potential employee claims
· Will your personal and family assets be safe?
o Don’t have any yet? What’s the plan for when you do?
· Will you buy or rent your office? From whom?

And those are just a handful of the things that should be thoroughly thought through.
Sadly, the typical answer is often NO and not just in the creation of legal entities. Back in 1983, a house builder acquaintance of mine ran out of money. He went to one of the most respected lawyers in town. He heard the tale and pulled out a bankruptcy questionnaire. No real advice. No assessment of other options. Maybe lawyers are held in such disrepute because they just fill out the forms, sometimes doing no more than the client asks, as though the client already knows all his legal options.
That client went to another lawyer got refinanced and went on to create a multi-million dollar home building company, got greedy then lost everything in the economic downturn of 1989. If the first lawyer had made a personal instead of legal assessment of the client he was prescient. Most likely, and all too common, he just didn’t do his job.

Back to the young lady professional I met and what I think should have been done (and mostly still can be). I’ll keep it generic because I have not examined her situation.

Back in the olden days professionals could not incorporate at all. Their services were special and personal. They were expected to stand behind their work and remain personally liable. When Professional Corporations, PCs, were introduced they retained this personal liability component but allowed the benefits of continuity and a few tax and accounting benefits.

In a PC, Individual liability may be somewhat less than Partnerships and may protect against personal liability for purely business, not professional, claims but, as a practical matter, there is very little liability protection. Like a sole member LLC, the PC will be sued, the professional who did the wrong will be sued and most everybody else will be sued on such theories as failure to supervise, failure to train, wrongful hiring (he did the same thing at the last five companies where he worked, Oh Yes, and He’s a felon), etc., and that’s not even addressing the many ways your employees could sue you.

The PC offers very little liability protection. Was this explained? Maybe, but then were her assets discussed? What kinds of assets are held in the PC or in her own equally vulnerable name? It better be NONE.

If there are few liability benefits, what about tax deductions of business expenses in a PC? Unlike a sole proprietorship or S-Corp or most LLCs, PC income is not passed through to the professional and can be double taxed. Most PCs , like many C-Corps pay everything “left over” as salary or bonuses. Most C-Corporate deductions and medical, retirement and other advantages are also available except for retained earnings. A C-Corp (2009) tax on the first $50,000 net profit is just 15% and the next $25,000 is just 25%. Over time, significant money can be put aside at these lower tax rates. You can then fund many things, training junkets, Insurance, retirement benefits such as a 419e plan, etc. The PC is taxed at a flat 35% from the first Dollar so don’t keep money there. Legitimately move income to your C-Corp by leases or other service agreements and pay much less tax than a PC (35%) or the individual rate (39%).

You want a PC or already have one, what do you as a young professional do? Fully review your options. When you fully understand your situation and options, Go ahead, create the PC, if it is better than a partnership or sole proprietorship for you, then:

1. Have as little money as possible in the PC. Move as much income as possible into your C-Corp where you can retain earnings, gain more and better audit proof deductibility. Buy Insurance and Protect business assets from suits by moving them to the C-Corp then lease them back to the PC achieving a lower tax rate AND asset protection..

2. Set up a family limited partnership (FLP) to hold all your safe assets and some mildly “dangerous” assets like a real estate trust for your house. This is where your closely held C-Corp stock goes too. Never keep the C-Corp stock in your name, a claimant can take it from you as easily as they could raid your bank account.
3. Don’t EVER own the building in a PC. Real estate owned by a PC are particularly vulnerable to suit. Worse, when you are ready to retire and sell the depreciated Real Estate from the PC it may be taxed as regular income not capital gain, AND likely be double taxed to the PC and then to you as a dividend. Never, Never, Never waste an appreciating asset like realty on taxes. Put it in an LLC under the C-Corp and let the PC lease it back adding corporate income and taking it out of the tax inflexible PC.

4. Never get caught in bad legal advice. You are a professional, yes you may be restricted in what you can do with your business entity, but do not let your advisor box you in because he has a form to fill out. You are also a person, you have a family, you can have other businesses, you can create family holding companies, FLPs, LLCs, special purpose Trusts, retirement plans (401(k), 419(e), etc.). You can isolate liabilities, firewall assets, shift income, use tax code advantages. Review your whole situation and PLAN.

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