Key Takeaways

  • Professional corporations (PCs) are specialized entities for licensed professionals such as doctors, lawyers, accountants, and architects.
  • Federal tax treatment of PCs is strict: most are classified as Personal Service Corporations (PSCs) and subject to flat federal tax rates.
  • PCs can avoid double taxation by electing S corporation status if they meet IRS requirements.
  • Accumulated earnings tax and passive activity rules apply to PCs, limiting income sheltering.
  • Some states restrict entity options—certain professionals may be required to form a PC, while others may consider alternatives like PLLCs or LLPs.
  • PCs offer limited liability for business debts but do not shield professionals from malpractice liability.
  • Strategic tax planning, including reasonable salaries and profit distributions, is essential to maximize benefits under professional corporation tax laws.

Professional Corporation Tax is the tax levied on corporations offering professional services such as health clinics, dental offices, architectural practices, and others.

Professional Corporation

A professional corporation, also known as a personal service corporation, is a specialized business entity whose owners are professionals like doctors, attorneys, architects, and dentists who offer services for profit.

However, only licensed professionals may provide these services and be entitled to a proportion of the corporation's profits. If a group of professionals establishes a corporation, the liability of each professional is limited to their actions. A special form of taxation applies to professional corporations.

Tax Rate

A professional corporation is subject to a flat tax rate of 35 percent, meaning it pays $35,000 as a tax on revenue of $100,000. Conversely, a non-professional corporation is taxed based on its income. For example, a non-professional corporation pays $61,250 in taxes on revenue of $200,000 and the tax rate increases as earnings rise.

State-Level Variations in Professional Corporation Taxation

While federal professional corporation tax rates are standardized, state-level taxes can vary significantly. Some states impose corporate income taxes on PCs at rates that differ from the federal flat rate, while others levy franchise taxes, gross receipts taxes, or special fees. For example:

  • California requires professional corporations to pay a minimum franchise tax.
  • Texas assesses a franchise or margin tax, regardless of income level.
  • New York imposes both state corporate tax and metropolitan commuter taxes for PCs operating in NYC.

Professionals should confirm their state’s requirements, as state taxes often add complexity and may reduce the advantages of incorporation.

Accumulated Earnings

A corporation pays 15 percent of accumulated income as tax. The accumulated income tax applies to professional corporations whose income exceeds $150,000. However, it is possible to avoid this tax if your corporation can prove it has realistic and concrete plans for the unused revenue.

Limitations on Retained Earnings

Professional corporations must be cautious about retaining excess earnings within the company. The IRS closely reviews PCs to ensure income is not being stockpiled to avoid shareholder taxation. Generally, retaining more than $150,000 without a legitimate business reason—such as planned expansion, debt repayment, or equipment purchases—may trigger the accumulated earnings tax. Documented business plans and board resolutions are critical to justify retained earnings and avoid penalties.

Passive Activity Losses

Passive activity means businesses like a real estate asset, which the corporation is not directly involved in its management. It may not be possible for professional corporations to deduct losses from such business out of the earnings of their practice for the current year. These losses can only be deducted in the next year.

Professional Corporation Deduction Limits 

Unlike partnerships or sole proprietorships, PCs face more restrictions when claiming deductions. Expenses such as health insurance, retirement plan contributions, and fringe benefits may receive favorable tax treatment when properly structured. However, personal expenses disguised as corporate deductions often attract IRS scrutiny. PCs must also separate active business income from passive investment income, since excess passive income may disqualify S corporation status if elected.

Reallocating Income

If the Internal Revenue Service discovers that you created your professional corporation to dodge taxes, the agency can reallocate the corporation's earnings as personal income for tax purposes. In the event of an income reallocation, you may not be able to deduct your operating expenses from the practice's revenue.

Also, you may lose the privileges of a corporation if your client is only one person or company. For instance, the IRS will not treat your practice as a corporation if, as a doctor, you work for a single hospital.

C or S Corporation Taxation?

Like every other corporation, a professional corporation can choose to be taxed as a C or S corporation. The default designation of state-incorporated businesses is a C Corporation. Your company must satisfy specific requirements of small business before it can change to an S corporation.

As a professional corporation, the business must have only individual shareholders to become an S corporation. When you become an S corporation, you start enjoying the tax benefits that come with that status.

Avoiding Double Taxation Through S Corporation Status

Most professional corporations default to C corporation tax treatment, exposing earnings to double taxation—once at the corporate level and again at the shareholder level. Electing S corporation status allows pass-through taxation, where income flows directly to shareholders’ personal returns. However, strict eligibility requirements apply:

  • Only U.S. citizens or residents can be shareholders.
  • The number of shareholders is capped at 100.
  • Shareholders must be individuals (no corporations or partnerships).

S corporation status can reduce tax burdens, but the IRS requires that shareholder-employees receive reasonable salaries before profits are distributed, ensuring payroll taxes are not improperly avoided.

The Personal Service Corporation Issue

The reason many licensed professionals prefer S corporation status is to enjoy the pass-through tax treatment of the corporations' earnings and avoid the Personal Service Corporations (PSC) designation, which subjects the business' income to a 35 percent flat federal tax rate.

Liability and Malpractice Considerations

Professional corporations protect owners from liability for business debts and the malpractice of other owners, but they do not shield a professional from their own malpractice claims. For example, if one physician commits negligence, the other shareholders are not personally liable for that claim, but the negligent physician remains personally responsible. States may also require PCs to carry malpractice insurance to maintain this liability protection.

Requirements for Classification as a Professional Service Corporation

The main requirements for classifying a corporation as a PSC include:

  • Providing personal services in specialized fields such as architecture, health (including veterinary services), law, accounting, actuarial science, consulting, performing arts, and engineering.
  • The corporation makes over 20 percent of its income from the services.
  • Over 10 percent of the corporation's stock belongs to the employee-owners.

Tax Structure of a Professional Services Entity

Professionals such as physicians, dentists, and surgeons use the professional corporation entity because the business structure offers several benefits. Professionals in the same field can form a professional corporation with each individual's liability limited to his/her actions.

The default tax status of a professional corporation is a C corp. However, the entity can elect for S corporation status so that the IRS can treat it as a pass-through tax entity. However, the entity can elect for S corporation status so that the IRS can treat it as a pass-through tax entity.

It is essential to consider a wide range of factors before choosing between a C and S status. While an S corporation eliminates the 35 percent flat rate and double taxation, a C corporation provides employee-owners several employee benefits.

Additionally, S and C corporations treat payments made to employee-owners differently for tax purposes. C corps offer a favorable tax treatment for shareholders as it treats payments made to them as salary instead of dividends.

Alternatives to Professional Corporations

In some states, professionals can choose alternative entities with different tax implications:

  • PLLCs (Professional Limited Liability Companies): These combine liability protections with pass-through taxation and flexible management structures. However, they are not permitted in all states. For example, California does not allow PLLCs, requiring professionals to form PCs or LLPs instead.
  • LLPs (Limited Liability Partnerships): Often available to law and accounting firms, these provide liability protection with partnership taxation.

Professionals should weigh the administrative complexity, liability protection, and professional corporation tax implications before deciding on the entity type.

Frequently Asked Questions

  1. What is the federal professional corporation tax rate?
    Most professional corporations are classified as personal service corporations and taxed at a flat federal corporate tax rate (currently 21%).
  2. Can a professional corporation elect S corporation status?
    Yes, PCs can elect S corporation status if they meet IRS requirements, which can help avoid double taxation.
  3. Do professional corporations protect against malpractice liability?
    No. PCs protect against the malpractice of other owners but not your own malpractice; insurance is usually required.
  4. Are professional corporations required in every state?
    Not all states require PCs. Some allow professionals to form PLLCs or LLPs, but others (like California) mandate professional corporations for licensed professionals.
  5. What expenses can a professional corporation deduct?
    PCs can deduct legitimate business expenses such as salaries, retirement contributions, and health insurance. However, improperly claimed personal expenses may be disallowed.

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