Groups of certain professionals can form corporations known as professional corporations or professional service corporations (“PC”). The list of professionals covered by professional corporation status differs from state to state; though it typically covers accountants, engineers, physicians and other health care professionals, lawyers, psychologists, social workers, and veterinarians. Typically, these professionals must be organized for the sole purpose of providing a professional service (for example, a law corporation must be made up of licensed attorneys).
In certain states, this is the only incorporation option available for certain professionals, whereas in others, they are given the choice of being either a professional corporation or S or C corporation.
Professional corporations can shield owners from liability. While it can’t protect a professional from his/her own malpractice liability, it can protect against liability from negligence of an associate.
The Professional Corporation or Traditional Corporation?
Commonly used by doctors, dentists and attorneys and formed under special state laws that specifically define which types of professionals are required to incorporate under this status, many professionals can only incorporate as a Professional Corporation. However, the benefits with respect to the protection of assets and against liability are very much the same as they are with a traditional corporation.
Historically, the primary motivations for selecting a professional corporation over a proprietorship or a partnership have been the tax benefits and personal liability limitation. With relatively recent changes in federal income tax laws, many, if not most, of the tax benefits of a PC may have diminished. For example, beginning in 1988, Sec. 11(b)(2) denies the graduated tax rates to PCs, resulting in a flat tax rate of 34%. Since any individual’s tax rate currently cannot exceed 33%, a PC becomes unattractive from a strictly tax perspective.
From a non-tax perspective, the issue of limiting liability and the protection of personal assets remains of interest to professionals, especially in light of the massive amounts of professional liability law suits that seem to abound these days.
Many states have enacted PC statutes that will allow licensed professionals to take advantage of the tax benefits of practicing as a corporation. The states in this category, however, continue to make shareholders jointly and severally liable for all acts and omissions committed by the PC’s employees. Consequently, from a liability standpoint, there is no difference between professional corporations and partnerships in these states. The following Oregon PC statute Sec. 58.185(2)(c) is a good example:
“Shareholders shall be jointly and severally liable with all of the other shareholders of the corporation for the negligent or wrongful acts or misconduct of any shareholder, or by a person under the direct supervision and control of any shareholder.”
This statute makes it clear that joint and several liability exists for all PC shareholders similar to partnership rules.
Supervising and Controlling Liability
Many states allow limited liability to the extent of the general operating and business obligations of the PC and the acts and omissions of other shareholders. However, these states do not diminish the liability attaching to the professional-shareholder due to his or her negligent acts or the acts of others he or she supervises or controls, regardless of whether the supervision is negligent. It is sufficient that the professional had the responsibility to supervise the negligent employee. The following Washington PC statute (Sec. 18.100.070) is an example:
“Any shareholder of a corporation shall remain personally and fully liable and accountable for any negligent or wrongful acts or misconduct committed by him or by any person under his direct supervision and control, while rendering professional services on behalf of a corporation.”
While the shareholder is not personally liable for acts by other shareholders, the PC itself is jointly and severally liable for employee acts under the legal doctrine of a respondent superior. Many times this can translate into direct liability for the shareholders or the professional corporation based on the conduct of an “empowered” employee. A good example would be a nurse under the direct supervision of a doctor who commits or is accused of a negligent act and the ensuing lawsuit that would name both the nurse, her supervising doctor, and him or her as a professional corporation.
Professional Liability Insurance is a Must
Maintaining the normal business umbrella policies, including solid Professional Liability insurance, is a sound best-practices stand. Aside from the obvious benefit of indemnifying against professional liability lawsuits, many states look favorably upon the maintenance of such insurance. The following statute from Colorado (Sec. 12-2- 131) is an example:
“All shareholders of the PC shall be jointly and severally liable for all acts, errors, and omissions of the employees of the corporation except during periods of time when the corporation maintains in good standing professional liability insurance….”
This PC category clearly removes joint and several liability at the shareholder level because all vicarious liability is negated by the statute when proper insurance, or in some states, capital, is present.
Corporation Rules Category and Case Law
The most liberal states decided that professional should be shielded from all vicarious liability–namely, the negligent acts of other professionals- shareholders and employees whether supervised or unsupervised. Of course, shareholders remain personally liable for their own negligent acts. These states merely incorporate the liability rules for regular corporations to obtain this result. For example, the following Arizona statute (Sec. 10-905) provides:
“… no shareholder of a professional corporation organized under this chapter is individually liable for the debts of or the claims against the corporation unless the debt or claim arises as a result of a wrongful act or omission of the shareholder.”
This statute follows the common law of tort liability as illustrated in Alabama Music Co. v. Nelson: where a tort of negligence is committed by an employee of a corporation, that employee is liable individually to the injured person whether or not the employee was acting within the scope of his or her employment. If the negligence is committed by the employee within the scope of employment, the corporation is also liable- -vicariously or secondarily under the doctrine of respondent superior. The employee, of course, remains primarily liable, and might enjoy a right to indemnification from the corporation. If the negligence is committed by the employee outside the scope of employment, the corporation is not liable; only the employee is liable. Finally, at common law, absent personal participation, an employee is usually not liable for the acts of negligence of other corporate personnel.
Judicial intervention might also occur in the following circumstances: Finding themselves in a professional partnership, some partners who want to limit their liability have individually incorporated themselves and allowed the PCs to become partners of the partnership in their place. Theoretically, the incorporating partner could shield personal assets against the joint and several liability for all partners’ negligence. This is true because only the PC’s assets, not the partner/shareholder assets, are available to satisfy claims, because the PC, not the partner/shareholder, is the partner in the professional partnership. However, there is a distinct possibility that a court might find this maneuver unconscionable or contrary to public policy, because clients dealing with a professional partnership would expect to satisfy claims against all the partners individually. Consequently, a court addressing the issue could allow the client aggrieved by the negligent act of one of the partners to satisfy his or her judgment not only against the personal assets of all the partners including the PC’s assets, but also against the shareholders of the PCs in the partnership–although worth of consideration, this would seem to be a rare case and would entail an “activist” judge successfully attacking the professional corporation.
The forming of an organization as a professional corporation also means that, just like with a traditional corporation, the corporate formalities must be observed. Corporate formalities are formal actions that must be performed by a corporation’s director, officers, or shareholders in order to maintain the protection afforded by the formation of the corporation. These are essential procedures that serve to protect the personal assets of a Corporation’s directors, officers, and shareholders.
The Formalities can be itemized as follows:
- Corporate Funds must be maintained separate and apart from Personal Funds.The corporate entity should have it’s own banking accounts (to include checking, lines of credit, etc.). Not keeping these funds separate, also known as “co-mingling,” can lead to increased scrutiny and potentially serious liability in the event of audit by the IRS and the endangerment of personal assets. It is a best practices procedure not to co-mingle funds.
- Meetings of the Board of Directors’ must be held at least annually, usually following closely behind Shareholder meetings (also known as “Special Meetings”). All 50 states mandate a meeting being held at least once a year.These annual meetings should be used to approve transactions entered into by the Corporation.
In lieu of attendance by any given Director, written consent must be provided by said Director (either in the form of a waiver in the absence of proper notice, or in the form of a proxy vote given proper notice) for any decisions made at these meetings.
Meetings of the Shareholders, also known as “Special Meetings” can be held at any time.
The Corporation’s Secretary is responsible for giving proper legal notice of these meetings, and for maintaining the necessary waivers, proxies, minutes, etc.
- Corporate Minutes, or “notes of the meetings of the Board of Director’s or Special Meetings” are essential and are the official, legal record of such meetings.The Corporate Minutes are to be maintained in date order in the Corporate Minute Book, and can be a valuable asset in the protection of the Corporation’s directors’, officers’ and shareholders’ assets. Proper, timely maintenance of these minutes is essential in defending against audits by IRS and alter ego claims.
Directors and Corporate Officers will at times seek legal counsel during annual meetings, and any discussions during these sessions are considered privileged conversations and protected by the legal doctrine of Attorney-Client Privilege. However, minutes taken of these conversations are considered part of the Corporate record and hence care must be taken, by the Corporate Secretary, to note when these communications occur by citing them in the Corporate Minutes as “Conversations by the members of the board of directors and legal counsel engaged in legally-privileged conversation at this point” instead of noting the actual conversation verbatim.
- Written Agreements for all transactions should be executed and maintained.
All transactions that involve real estate leases, loans (whether internal or external), employment agreements, benefit plans, etc. that are entered into by or on behalf of the Corporation must be in written agreement form.
Improper or untimely documentation of internal loans from a Shareholder to the Corporation, for example, may lead to IRS re-classification of repayment of the principal on said loan as a dividend, with the commensurate tax liabilities incurred by the Shareholder
It is imperative that executive compensation, capital asset acquisitions, etc. be timely and properly documented in these minutes. Failure t properly and timely documents these can potentially lead to tax liabilities on the part of the Directors, Officers, or Shareholders as a result of IRS “reclassification.” For example, the IRS may classify what they deem as “excessive, undocumented executive compensation” as a dividend by the corporation to the recipient, and hence not tax deductible by the corporation–this will lead to increased, unpaid tax liabilities.
We cannot stress highly enough that failure to observe and implement these formalities will serve to diminish and mitigate the protections offered by the formation of the Corporation and will allow outside entities (the IRS, creditors, claimants/plaintiffs, potential adverse litigants, etc.) to “pierce the corporate veil” and peer into the inner workings and assets of the Corporation, it’s Officers, Directors and Shareholders.
Should I Organize My Professional Practice as a Professional Corporation?
As is evident above, incorporating as a Professional Corporation provides for a substantial benefit to professionals and for the furtherance of their practice. First and foremost, of course, is the goal of achieving limited liability, or mitigating the impact of personal law suits, for if the idea of a lawsuit penetrating through the corporate veil to attack personal assets seems ominous, imagine what the consequences of a personal suit without the benefit of the corporate veil would be.