1976, January, Pg. 1. Incorporating the Professional.

• Author: by John DeBruyn

5 Colo.Law. 1

Colorado Lawyer

1976.

1976, January, Pg. 1.

Incorporating the Professional

1Incorporating the Professionalby John DeBruynThe yellow pages of the Denver telephone directory list only a few law firms and individual lawyers who have appended "P.C." to their names. If professional corporations have so much to offer, why have not more lawyers incorporated their practice---especially since, in contrast, so many doctors, dentists, and other professionals have incorporated their practice? Without citing studies concerning the economics of the practice of law or the practice of medicine, I think it is fair to take "judicial" notice of the fact that doctors of medicine, generally, find themselves in higher tax brackets than lawyers. Consequently, they are able to obtain greater tax advantages from a retirement plan and other fringe benefits associated with a professional corporation.

Although incorporation of a professional practice is usually related to income level, it is impossible to settle on an arbitrary dollar figure as the point dictating incorporation for the professional. If our tax laws were simple and taxation were the only factor to be considered in incorporation, then we might be able to develop a precise formula that would pinpoint when incorporation is desirable. Unhappily this is not the case. The tax laws are too complex and the non-tax considerations too intangible and numerous to make an arbitrary answer feasible. For example, a recent development and frequently over-simplified factor to be considered in incorporating (or, for that matter, liquidating the professional practice) is the Pension Reform Act of 1974.(fn1) Essentially, the Act improves the tax-qualified retirement programs available to an unincorporated professional and other self-employed persons while placing some limitations on the tax-qualified retirement program available to the incorporated professional and other employees of a corporation. This recent enactment should cause us to rethink our approach to the professional corporation question.

RETIREMENT PLAN FACTORS

A professional corporation is usually established to permit the adoption of corporate type qualified retirement plans. (As used in this article, "retirement plans" refers to both pension plans and profit-sharing plans.) The initial decision on whether to incorporate should involve a careful study of the advantages of tax-qualified retirement plans over other savings and investment programs. The main attraction of a professional corporation is the tax deduction allowed for contributions to the retirement plan and the tax-free growth of the retirement plan trust fund.

2 Self-Employed Plan Limitation

Prior to the adoption of H.R.-10 (the Keogh Act), a sole proprietor or a partner could not establish a qualified pension or profit-sharing plan for himself. Even with the adoption of H.R.-10, the professional with substantial income from his practice could not shelter much of his income in a qualified pension or profit-sharing plan. The initial deduction, in 1962, for a contribution to such a plan on behalf of a self-employed person or partner was limited to $1,250. Subsequently, in 1966, the limitation was raised to $2,500 and most recently, under ERISA, the dollar limitation was raised to $7,500 and the percentage limitation, which had been 10 percent since 1962, was raised to 15 percent.(fn2) With these higher ceilings on contributions, the self-employed plan competes more vigorously with professional corporation retirement plans.

The percentage limitations on corporate plans are, on the surface, misleading. The limitation applicable to a pension plan or profit-sharing plan or a combination of such plans adopted by a corporation is the lesser of 25 percent of compensation or $25,000.(fn3) A greater amount may sometimes be set aside where older professionals are involved by using a defined or fixed-benefit pension plan.(fn4) However, comparing the 15 percent H.R.-10 limitation with the 25 percent limitation applicable to corporate plans is like comparing apples and oranges. A few minutes at the calculator will show that 25 percent of compensation paid to the professional by the corporation is, in reality, equivalent to only 20 percent.

For example, a sole proprietor having $50,000 after payment of all expenses in connection with his practice would be entitled to contribute 15 percent or $7,500 to his H.R.-10 plan. After incorporation and assuming he had the same $50,000 remaining after payment of all expenses other than his own compensation---including any contribution on his behalf to the corporation's retirement plan---this same individual would be able to make a $10,000 contribution to his plan. The $10,000 would have to be subtracted, as a corporate expense, from the $50,000---leaving $40,000 to be paid as compensation to the professional. Since the $10,000 is 25 percent of the $40,000 compensation figure, $10,000 is the maximum amount which the professional may set aside under the 25 percent limitation. This example points out that the $10,000 figure represents only 20 percent of the $50,000 net income from the practice.

The advantage of a corporate retirement plan comes when the professional gets closer to the $25,000 limitation. A professional with net income from his practice in excess of $50,000 will find that the difference between the H.R.-10 plan and a corporate plan is more than the five percentage points difference illustrated in the above example. If the net income from his practice were $80,000 then, under H.R.-10, he would be limited to a $7,500 contribution on his own behalf; with a corporate plan, he could contribute up to $16,000 on his own behalf.

Corporate plans have certain other advantages which are not available in self-employed plans. For instance, under a corporate plan the highly compensated professional can obtain relatively more benefits than his lower-paid, non-professional employees through social security integration and delayed vesting. These distinctions and a few others favoring corporate plans are discussed below.

Delayed Vesting and ParticipationOne of the primary drags on the establishment of a retirement plan by a professional person is that he must, with certain exceptions, cover himself and his employees on a non-discriminatory basis. He is, however, permitted to make contributions in proportion to compensation.(fn5) Therefore, with his own higher compensation he will be, in most cases, contributing substantially more for himself than his lower-paid, non-professional employees. In some practices, the coverage of non-professional employees on a pro rata basis can represent a substantial expenditure.

Under an H.R.-10 or self-employed

3plan, employees with less than three years of service can be excluded from coverage assuming the practice has been in existence for three years.(fn6) When the employee completes three years of service, all of the contributions made thereafter to his account will be 100 percent "vested," or owned by the employee.(fn7)

A professional corporation plan must include employees at an earlier date (shortly after one year of service is completed.)(fn8) A professional corporation plan may, however, exclude employees from participation in pension or profit-sharing plans on the basis of minimum age requirement---25 years, or some lesser number of years.(fn9) Using a minimum age requirement, the professional corporation may, in some cases, be able to exclude all of its employees other than the professional.

While a professional corporation must allow participation by otherwise qualified employees after a year of service has been completed, it may delay full vesting or ownership of an employee's account over a substantial number of years.(fn10) The Congressional Conference Committee statement on the Pension Reform Act might lead us to believe that an employee's ownership or vesting of his account may be denied in full until he has completed at least four years of service with the employer.(fn11) Thereafter, vesting would be granted to the employee in percentage installments based on the number of years of service. The employee would receive 40 percent after four years, with an additional 5 percent for the fifth and sixth years of service and an additional 10 percent for each year of service thereafter until the eleventh year of service when the employee would have 100 percent vesting of his account.

The benefit to the professional under the corporation plan is that he will continue indefinitely as an employee and will obtain 100 percent vesting of his account. Most of the other employees of the corporation, however, will not be around as long and when an employee leaves, he is entitled only to the vested percentage of his account. The non-vested balance of his account is then reallocated, either to reduce current employer contributions to a pension or a profit-sharing plan or, under a profit-sharing plan, as a "bonus" in addition to the current employer's contribution to the remaining employees' accounts.(fn12) With substantial turnover among lower-paid, non-professional employees, this can result in almost all of the contributions ending up in the account of the professional. However, if none of the lower-paid employees ever receive any benefits under the plan, or receive only token benefits, the Internal Revenue Service (notwithstanding the Congressional Conference Committee statement referred to above) may...