Should Your “General Corporation” Be a “Professional Corporation” Instead ?
The scenario is familiar: you’re a hard-working professional, you’ve saved your cash, done your homework, and are now ready to set up your corporation or limited liability company (“LLC”) with or without a trusted associate. But there’s a catch – many types of professionals in the state of California are not permitted to incorporate as a “general corporation” (either a “C” corporation or an “S” corporation) or as an LLC. Instead, they are required to set up what is called a “professional corporation” – a different type of corporation that is regulated by three different sets of California statutes AND by state agency regulations.** Aside from the usual suspects including lawyers, physicians, and accountant, other professionals such as clinical social workers, speech language pathologists, and several others are also subject to these requirements.
Characteristics of Professional Corporations
Generally speaking, a professional corporation may only perform services in one, single profession. Shareholders, and under certain circumstances, directors and certain officers must be licensed to practice the professional services that the corporation will perform. One exception to this general rule is that sometimes persons licensed in “allied professions” may also be shareholders, officers, directors, or professional employees of such a professional corporation (subject to limitations). For example, audiology is considered an “allied profession” of speech pathology. Therefore, a professional corporation authorized to practice speech pathology may also hire an audiologist professional to perform audiology services.
The benefits of incorporating as a professional corporation include: (1) insulation from liability for nonprofessional acts or omissions; (2) free transferability of interests (subject to statutory and regulatory restrictions), centralized management, continuity of existence; and (3) tax benefits. One example of a tax benefit is the deductibility of payments to fringe benefit plans, such as group term insurance.
A professional corporation is also subject to restrictions and additional registration requirements placed on it by the applicable regulating agency (such as the State Bar of California for lawyers), but often these restrictions are similar to those placed on sole practitioners.
What Happens When a Professional Incorrectly Sets Up a General Corporation
Any professional who incorrectly sets as a general corporation when they are instead required to set up a professional corporation runs a significant risk – namely relating to the legal principal that any contract made in violation of a regulatory statute is void.
In practical terms, this means that a professional runs the risk that any contracts it enters into could be considered legally void, i.e. illegitimate and unenforceable from the moment it was created. You can imagine the potential impact of scenarios relating to contracts with clients (think noncollectable receivables) and contracts among shareholders that can be terminated at a dissatisfied shareholder’s option.
Other risks include sanctions by the applicable regulatory agency, loss of professional license, and criminal penalties.
The Cautionary Tale
In one recent scenario, a medical doctor and a non-medical practitioner investor set up a general corporation that operated medical spas, providing such treatments as Botox, laser removal, and other cosmetic procedures as part of its services. The medical doctor was the individual actually responsible for providing the procedures. The doctor and the investor were the only two shareholders and were incorrectly advised by each of their individual legal counsel – who apparently both (!) ignored the California Business and Professions Code, not to mention the unambiguous wording on the California Board of Medicine website – that a general corporation was an appropriate structure for their business. However, not only is a general corporation not qualified to perform such services, but to do so constitutes a violation of the California Penal Code!
Lo and behold, after several years, the business failed, and the investor filed suit seeking a rescission of the contract underlying the entire deal, demanding a refund in excess of $300,000.00 on the basis that that (wait for it) any contract made in violation of a regulatory statute is void. While exceptions to this rule exist, after several years of litigation and tens of thousands of dollars in legal fees this case is yet to be resolved.
The Bottom Line
If you practice one of the many professions in California that does not qualify to incorporate a general corporation, due diligence is required. Caution should also be used if you provide (or intend to provide) services that may soon require a professional corporation instead of a general corporation. For example, it is likely that applied behavior analysis (“ABA”) will soon become an included profession, requiring ABA professionals to incorporate as a professional corporation.
While the corporate form provides significant benefits to practicing professionals, the failure to property incorporate as a professional corporation can lead to adverse consequences, including an inability to collect on contracts with clients, unnecessary litigation between shareholders, regulatory sanctions, and loss of professional licensing.
**On a side note, in certain circumstances, a limited liability partnership (“LLP”) is also permitted, but that is a topic for another post.