An interview with Doug Bend by Nikole Mackenzie, a CPA and the owner of the owner of Momentum Accounting, on whether a California professional corporation should elect to be taxed as an S-corporation.
Nikole: It’s a pleasure having you! I’ve been following your articles on your blog, so I’m excited to finally have a chance to speak with you one-on-one.
Doug: Absolutely. It’s nice to be here, Nikole.
N: So, today I was hoping we could go over your thoughts on what professional service providers should do about incorporating their new ventures. What does someone need to know if they’ve just started out on their own?
D: Well, first of all, in California, certain professions that require a state license are prohibited from forming a limited liability company or a traditional corporation. Most of the companies affected by this are in the financial, legal and medical fields.
N: What would you recommend then for companies in those industries?
D: In most cases, I would tell them to incorporate as a professional corporation and elect to be taxed as an S-Corporation.
N: What are the advantages to being taxed as an S-Corp?
D: If you do not elect to have your California professional corporation taxed as an S corporation, the default is for it to be taxed as a C-Corporation.
N: And what exactly does that mean?
D: Well, as a C-Corporation, your professional corporation would pay federal taxes on its profits and you would also pay individual taxes if you receive salary, bonuses, or dividends from the corporation.
N: How would being an S-Corp differ?
D: By electing to be taxed as an S-Corporation, your professional corporation would instead be a pass-through tax entity, like an LLC or a partnership. Electing to be taxed as an S-Corporation may also allow you to pass losses from the business to your personal income tax return, where you can use the losses to offset income that you may have from other sources.
N: Ok. And can you talk about how the owner might take out a “reasonable salary?”
D: If the corporation pays you a “reasonable salary,” you may not be required to pay self-employment taxes on any additional corporate profits that are paid to you as dividends as a shareholder in addition to your reasonable salary.
N: That does sounds very advantageous—especially for those just starting out.
D: It is. It’s a great way to help small business owners who are sole proprietors get some financial breathing room.
N: Now, what would the disadvantages be?
D: The main drawback of electing to have your professional corporation taxed as an S-Corporation rather than a C-Corporation is that, in a C-Corporation, the cost of the premiums for shareholder benefits, such as insurance coverage, are deductible as a business expense. In addition, the shareholders may not be taxed on the value of the benefits.
N: Are there any restrictions on who can be a shareholder of an S-Corp?
D: Yes. The Internal Revenue Code limits the number of S corporation shareholders to 100 or less. Also, S corporation shareholders can only be individuals, estates and certain types of tax-exempt entities and trusts, and the individuals must also be U.S. citizens or permanent residents.
N: And what about stock?
D: S-Corporations may only issue one class of stock, whereas C-Corporations can have different classes of stock that have different rights and liquidation priorities.
N: What would you recommend to someone who is just starting their professional corporation?
D: I would tell them to consult with their CPA or tax professional to make sure being taxed as an S-Corporation is the best fit for them. That being said, for most California professional corporations, electing to being taxed as an S-Corporation rather than a C-Corporation is likely to provide the most tax savings.
N: Thank you so much, Doug! I think that just about answers everything we were hoping to cover.
Doug Bend is the founder of Bend Law Group, PC, a law firm focused on advising small businesses and startups. To find out more, please contact Doug at doug@bendlawoffice.com.