WA Veterinarian Magazine
My typical veterinary client owns a piece of real estate with a clinic building located on that property. The client operates the veterinary practice out of the clinic. The Doctor wants to know how to structure this arrangement to maximize tax advantages and minimize liability. The answer is to incorporate the business side of the practice and form a limited liability company to hold the land and building. The limited liability company will then lease the property to the corporation. This article provides a brief overview of the specific reasons for this structure. Do you know why your business is structured the way it is? Let’s explore what options are available.
First, eliminate entities that don’t need to be used. A sole proprietorship is a single person engaged in business. We eliminate sole proprietorships because they provide no benefits other than the low startup cost. General and limited partnerships are anachronisms that are no longer used. They have been eliminated by limited liability companies. So that leaves the two entities that we normally use for structuring the professional practice: corporations to operate the business and limited liability companies to hold the land and buildings. First, some explanation about corporations.
Corporations are commonly created by an individual or a group of individuals (shareholders) who desire to enter into a business but desire to limit their liability to the amount of invested capital. Historically there has been a balancing act between protecting the shareholders from liability and protecting the public from the acts (sometimes abuses) of corporation shareholders. Corporations are granted corporate status by the state in which they are incorporated. All corporations must also conform to federal tax laws and regulations.
All Washington state corporations are incorporated under the Washington Business Corporations Act, Revised Code of Washington Section 23(B). For federal tax purposes, Corporations can be taxed under either subchapter C of the Internal Revenue Code or subchapter S of the Internal Revenue Code. Corporations that do not, or cannot elect to be taxed under Subchapter S are, by default, taxed under Subchapter C. Subchapter S passes income tax through to the shareholders. Subchapter C corporations are separate tax paying entities. Think Boeing.
Historically, professionals could not use corporations as a means of doing business because of the notion that the professional would be shielded from malpractice liability thus leaving the consumer without recourse in the event of an injury. Professionals wanted to incorporate due to the desire to take advantage of tax favored retirement plans. Corporations could use defined benefit plans, defined contribution plans and profit sharing plans. Sole proprietorships and partnerships were limited to HR 11 or Keogh plans which were fairly restrictive in the benefits allowed. As is usually the case, creative attorneys and accountants worked around the corporate retirement plan restrictions by reclassifying their partnerships into corporations for federal income tax purposes.
Under the Internal Revenue Code it was possible to create a state law partnership that would be classified as a corporation for tax purposes. The problem was that there was no real certainty whether the Internal Revenue Service would agree to the classification. This went on until Washington, together with many other states, decided to bring certainty to businesses owners.
In 1969 the Washington State Legislature adopted the Professional Service Corporation Act, RCW 18.100. With the adoption of the Professional Service Corporation Act, professionals could incorporate under RCW 23B. However, when the corporation formed under RCW 23B is in the business of providing professional services, the Professional Service Corporation Act, RCW 18.100 applies. These statutes are an overlay of additional rules that only apply to Professional Service Corporations. The most important provision of the Professional Service Corporation Act from a consumer standpoint is that it does not protect the professional from her liability for malpractice. This is a big difference from most corporations where all shareholders and employees are generally protected from liability. A corporation is not, however, an appropriate entity for land and buildings. For that we need a different entity.
In the old days real estate was held in corporations or partnerships. The advantage of holding real estate in a corporation was limited liability. The ability to hold real estate in a corporation was effectively eliminated when the Internal Revenue Code was amended to impose potentially onerous tax consequences when property was distributed out of a corporation. That left the partnership as the entity of choice to own real estate. Problems still exist with partnerships.
There are two types of partnerships –general and limited. A general partnership is a collection of individuals. All of the individuals are liable for the debts of the partnership. The second type of partnership is the limited partnership. The limited partners are not liable for the debts of the partnership because the thought is that their participation is limited to investing in the venture similar to shareholders investing in a corporation. As investors, the limited partners may not actively participate in partnership management. The limited partnership requires that there be at least one general partner who is fully liable for the debts of the partnership. One way of setting up a general partnership was to use a corporate general partner thereby limiting all partner liability. This scheme, however, sometimes backfired because if the court determined that the general partner was undercapitalized, which was often the case when a partnership failed, the courts could convert the limited partnership into a general partnership. One advantage of a partnership was the ability to specially allocate tax benefits such as tax credits and accelerated depreciation. This ability to specially allocate tax benefits was the essence of the tax shelter limited partnership of the 1980s. The abuses that arose out of tax shelter limited partnerships was later curtailed by federal tax legislation. Once again, state legislatures sought a solution to this problem by seeking a mechanism to allow limited liability thereby encouraging investment of capital and allow tax flexibility.
Legislation allowing limited liability companies was enacted in Washington in 1995. A limited liability company can hold real property and the real property can generally be transferred into and out of the limited liability company without state or federal tax consequences. All of the members of the limited liability company are protected from liability. As such, the limited liability company combines the best attributes of corporations by limiting liability and partnerships by providing tax flexibility. The members have limited liability and the members are able to make special tax allocations. Real estate may be transferred into and out of the limited liability company without unfavorable tax consequences.
This overview should give you a better sense of how and why the dual structure of limited liability companies and corporations are used when structuring a professional practice. This is only a brief overview. This is not a substitute for engaging the services of an experienced attorney and/or accountant to determine what works best for you.
David Carson is the founder of Carson Law Group, P.S. located in Everett, Washington. He has worked for veterinary practices for 30 years. Carson Law Group, P.S. represents veterinary practices throughout western Washington. He can be reached at