Selecting and Forming the Right Private Practice Entity
By Bonnie R. Benitez, Attorney
Previously employed with CAMFT
One of the most important decisions a therapist can make, when forming a private practice, is choosing the right type of business entity to form. Most therapists wish to avoid personal liability for the obligations of their business and may also wish to personally deduct the losses, if any, of their practice and avoid double taxation of any income. There are four main choices for therapists wishing to form a private practice: sole proprietorship, general partnership, limited partnership, and professional corporation. Other entities, such as limited liability companiesi and limited liability partnerships are unavailable to therapists, or anyone who renders professional services that require a license.ii
I. Factors in Selecting a Business Entity
There are a number of factors to consider in selecting the most appropriate business entity. These factors include: ease and cost of formation, taxation, management and control, and personal liability.
A. Ease and Cost of Formation
The ease with which one can form a business and associated costs depend on both the chosen form of entity and the scope and complexity of the specific business. The simplest business organization is the sole proprietorship, because there are no filing fees or minimum annual taxes. In addition, a sole proprietorship is the only entity that can be formed by an individual therapist, without the assistance of counsel. A general partnership can be created by form or function. Its formation can be through a written agreement or by the mere actions of the parties involved. In other words, if you act like another therapist's business partner, you are that therapist's business partner. Forming a general partnership is simpler than forming a limited partnership or professional corporation because there are no state filing requirements, and generally, the agreement between the partners is less complicated than that of a limited partnership. Also, unlike limited partnerships and professional corporations, general partnerships are not required to pay a minimum $800 annual franchise or privilege tax to the State of California. Limited partnerships and professional corporations require the filing of a certificate or articles of incorporation, and must meet other federal and state requirements as well.
Sole proprietorships and partnerships have what is referred to as "flow-through" taxation. In other words, the entity itself is not taxed for its income; however, the owners of the entity must pay income tax on their earnings. Similarly, the owners or partners claim any deductions, credits, or losses. Certain corporations, know as "S corporations," function as flow-through entities for federal and California taxation. Professional corporations can make an S corporation election. In addition to income taxation, therapists should consult with their accountants regarding the tax implications of certain fringe benefits, such as the cost of health insurance.
C. Management and Control
Sole proprietorships are completely managed and controlled by the practitioner/proprietor him or herself. In a general partnership, unless there is an agreement to the contrary, all partners have equal rights with regard to the management and control of the practice.iii Only the general partners manage limited partnerships, which consist of general and limited partners. Limited partners enjoy limited liability, but must also give up the ability to manage or control the business. In a professional corporation, generally the shareholders also serve as the board of directors and manage all of the business and affairs of the corporation.
D. Personal Liability
Owners of sole proprietorships, and general partners of general partnerships and limited partnerships are personally liable for the wrongful acts or omissions of the business entity. All partners of a general partnership are liable jointly and severally for the obligations of the partnership unless otherwise agreed by the person bringing the claims against the partnership, or provided by law.iv The partners of a limited partnership, which is divided into general partners and limited partners, have different degrees of personal liability. General partners of a limited partnership are liable for partnership obligations to the same extent as the partners of a general partnership. However, limited partners are not normally liable for the debts and other obligations of the partnership. The liability of a limited partner is usually limited to his or her investment in the partnership. Typically limited partners only become personally liable if they participate in the management of the partnership business. Professional corporations provide limited liability for shareholders under certain circumstances, to be discussed later in this article.
II. Analysis of Each Entity
A. Sole Proprietorship
A sole proprietorship is the simplest form of business. Children, who sell lemonade are sole proprietors. A sole proprietorship is simply a business in which an individual engages in business personally, rather than by means of a separate entity such as a corporation. Being straightforward and economical are its advantages. There are no formalities in forming a sole proprietorship, and it can easily be done without the assistance of an attorney. To establish a practice as a sole proprietor, a therapist should check with his/her city or county government and obtain a business license or permit, and file a fictitious business name as applicable. A fictitious business name is required when a business uses a name other than that of the therapist. For example, "Sally Smith, LMFT" would not necessitate the filing of a fictitious business name, whereas "Yosemite Valley Counseling Center" would. Additionally, a sole proprietor who takes on an employee would be required to file payroll and other tax returns, obtain workers' compensation insurance, etc.v The primary disadvantage of a sole proprietorship is the owner's personal liability for the obligations of the business. In addition, a sole proprietor is subject to liability for any injuries caused by the negligence of employees. Under the doctrine of "respondeat superior," employers are liable for the actions of their employees when such actions are within the scope of their employment.
While the sole proprietorship allows the therapist to avoid many of the costs, formalities and reporting requirements associated with other forms of business, because the proprietor is personally liable for the obligations of the business, a limited liability entity, such as a professional corporation may be of interest. However, a malpractice insurance policy would mitigate some of these concerns.
B. General Partnership
A partnership is an association of two or more persons who operate as co-owners of the practice.vi In a partnership, each partner is considered an agent of the partnership and can bind the partnership in its ordinary course of business,vii and each partner is personally liable for the obligations of the partnership.viii In addition, the partnership can be dissolved by the express will of at least half of the partners.ix
All general partnerships are regulated under the Uniform Partnership Act of 1994 (RUPA).x RUPA provides the statutory basis for attorneys to draft general partnership agreements. Many RUPA provisions can be amended by the mutual agreement of the parties. Therapists entering into a partnership should enter into a written partnership agreement, rather than relying on oral agreement. Written agreements remove uncertainty regarding the legal relationship of the parties, help to avoid misunderstandings, avoid the default provisions of RUPA, and provide the parties with a guide to their relationship, duties and obligations within the partnership.
Absent any written agreement, parties who act as partners with respect to a business arrangement will likely be treated as partners for legal purposes. A therapist could subject him or herself to partnership liability as a result of any words or actions that suggest that such a partnership actually exists.xi
Under the concept of mutual agency, each partner is considered an agent of the partnership for the purpose of its business.xii Any partner's act, including the signing of a lease or other contract in the name of the partnership, binds the partnership unless that partner lacks the authority to do the act and the person with whom the partner was dealing knew the partner lacked such authority.xiii
Each partner has other obligations to the general partnership, including but not limited to, fiduciary duties, duty of loyalty, duty of care and an obligation of good faith and fair dealing, in addition, of course, to his or her duties as a therapist.
Therapists considering a general partnership should consult with an attorney with regard to the formation of the partnership agreement.
C. Limited Partnership
A limited partnership is a partnership formed by two or more persons and having one or more general partners and one or more limited partners.xiv In a limited partnership, the general partner(s) have control over the management of the partnership, while the limited partner(s) are typically passive investors who possess neither the right to participate in the management of the partnership, nor the authority to bind the partnership.xv In exchange for their limited control and authority, limited partners enjoy no personal liability for the debts and other obligations of the partnership.xvi
Therapists do not often form limited partnerships, absent an agreement with party seeking to invest in the therapist's practice. Therapists considering a limited partnership should consult with an attorney with regard to all of the requirements set forth under the California Revised Limited Partnership Act. xvii
D. Professional Corporation
A professional corporation is a corporation formed under California state law for the purpose of practicing a particular profession. Professional corporations are governed under the Moscone-Knox Professional Corporation Act.xviii All of the licensed mental health professions in California are included in this Act. By and large, the laws governing general corporations apply to professional corporations.
Therapists wishing to limit their personal liability most often form professional corporations. However, generally speaking, therapists who practice in professional corporations will limit their personal liability only for the malpractice of their associates. Therapists may not avoid personal malpractice liability simply by forming a professional corporation. The personal assets of a therapist would be subject to malpractice obligations arising from that therapist's performance of his or her duties as an employee of the professional corporation.xix Similarly, the personal assets of a supervisor would be subject to malpractice obligations arising from his or her supervision. This is not to say that all supervisors are personally liable for the acts of their supervisees. However, a supervisor who commits malpractice as a result of his or her negligent supervision, would have such liability.xx In addition to any possible personal liability, all assets of a professional corporation are subject to any corporate obligations. Shareholders of a professional corporation would, however, enjoy limited personal liability for any nonprofessional obligations of the professional corporation, for example, any contracts, leases, or loans entered into by the professional corporation, unless such obligations had been personally guaranteed.
There are both advantages and disadvantages with regard to the tax consequences of a professional corporation. Professionals who incorporate may enjoy certain fringe and retirement benefitsxxi unavailable to sole proprietors or partnership owners. However, professional corporations are also subject to a 35-percent flat tax rate on the taxable income of the corporation. Thus, both the corporation, and the therapist employed by the corporations are taxed on their income.xxii
Professional corporations, which make an S corporation election, would not be subject to taxation on the corporate level. However, because S corporations are treated as partnerships for tax purposes, they are also prohibited from taking advantage of the fringe benefits available to corporations that do not make such elections.xxiii In addition, professional corporations are subject to a minimum state tax of $800, whether the corporation has taxable income or not.xxiv
A marriage and family therapist professional corporation must contain one or more of the following words in its name: "marriage," "family," and "child" together with on or more of the words "counseling," "counselor," or "therapist," and wording or abbreviations denoting corporate existence. The corporate name must also include the surname of one or more of the present, past, or prospective shareholders, and the words "professional corporation," "corporation," "incorporated," or an abbreviated form of one of these terms (e.g. Menendez and Sons, a Marriage and Family Therapy Professional Corporation). Marriage and family therapist professional corporations may use fictitious business names, so long as such names are not false, misleading or deceptive.xxv A professional corporation is officially formed upon the date when the Secretary of State files its articles of incorporation.xxvi The corporation must also have bylaws, which serve as a reference for officers, directors, and counsel, and provide a set of standard rules for the corporation. In addition, the corporation must obtain a federal tax identification number and a California employer identification number.
Therapists who currently work together in a practice may want to consider formalizing their arrangement either as a partnership or a professional corporation in an effort to avoid both misunderstandings and personal liability. In either case, contacting an attorney in one's area through a local bar association or other referral service is encouraged. Therapists interested in forming a professional corporation should look for an attorney who has experience in forming MFT professional corporations or other medical/mental health corporations.
This article is intended to provide guidelines for addressing difficult legal dilemmas. It is not intended to address every situation that could potentially arise, nor is it intended to be a substitute for independent legal advice or consultation. When using such information as a guide, be aware that laws, regulations and technical standards change over time, and thus one should verify and update any references or information contained herein.
i Corporations Code §17375.
ii See Corporations Code §16101(6), (12), (17).
iii Corporations Code §16401(f).
iv Corporations Code §16306(a).
v For more information on this subject, please read "Checklist for Therapists Who Become First Time Employers" published in the January/February 2002 issue of The California Therapist.
vi Corporations Code §16101(7).
vii Corporations Code §16301(1).
viii Corporations Code §16306.
ix Corporations Code §16801(1).
x See Corporations Code §16100 to 16962.
xi Corporations Code §16308.
xii Corporations Code §16301.
xiii Corporations Code §§16102 and 16301(1).
xiv Corporations Code §15611(r).
xv Corporations Code §15632.
xvii Corporations Code §§15611 to 15723.
xviiiCorporations Code §§13400-13410.
xix Civil Code §2343(3).
xxi A corporation can take an income tax deduction for the cost of health insurance premiums for its employees. Such benefits are not treated as income to the employee.
xxii Internal Revenue Code §11(b)(2).
xxiii Internal Revenue Code §1372(a)(2).
xxiv Revenue and Taxation Code §23152(d). Note: The minimum tax is waived for the first year of incorporation.
xxv Business and Professions Code §4987.7.
xxvi Corporations Code §110.
This article appeared in the March/April 2002 issue of The California Therapist, the publication of the California Association of Marriage and Family Therapists, headquartered in San Diego, California. This article is intended to provide guidelines for addressing difficult legal dilemmas. It is not intended to address every situation that could potentially arise, nor is it intended to be a substitute for independent legal advice or consultation. When using such information as a guide, be aware that laws, regulations and technical standards change over time, and thus one should verify and update any references or information contained herein.