Choosing the right business entity for your therapy practice could save you money on taxes, help protect you from legal and financial liability, and even lay the groundwork to expand your practice in the future.
That may seem overwhelming—but it doesn’t have to be. This article lays out all the basic info you need to know to start considering different business structures for your therapy practice, and make the choice that will benefit you the most in the long run.
Heads up: This article primarily covers business entity types at the federal level (e.g. those recognized by the IRS, better known as tax entities). Jump ahead to Why are state and federal (IRS) entities different? to learn how these may differ from the entities recognized by your state.
What are business entities?
Your therapy practice’s entity type (also referred to as its business structure) is the legal status of your business in the eyes of the IRS and state tax authorities.
The entity type you choose for your practice affects:
- How and when you file and pay taxes
- Whether other individuals are able to own parts of your business
- How you pay yourself
- To what degree you’re protected in the event of a lawsuit
- Which assets debtors are able to seize
- Which assets you lose in the event of bankruptcy
- Whether you can bring on investors
- What steps you need to take to sell your business
- Whether you’re able to pass your practice on to a family member or business partner in case you decide to leave it. (Or in case you die. But let’s not dwell on that.)
Why are state and federal (IRS) entities different?
Researching the topic, you may have noticed that the entity types your home state recognizes and the entity types the IRS recognizes are different.
The IRS recognizes four types of entity. We can call these tax entities:
- Sole proprietorships
- C corporations
- S corporations
However, the State of California (for example) lets you choose between five entity types. We can call these legal entities:
- Sole proprietorship
- Limited liability company (LLC)
- Limited partnership (LP)
- General partnership (GP)
- Limited liability partnership (LLP)
- Corporation (including a “professional corporation”)
Confused yet? That’s okay—looking at these lists, it seems like the IRS and the State of California are operating on totally different wavelengths. But the two systems work together. Here’s how.
(For now, don’t worry about what each entity type means—we’ll cover that below.)
If your business is based in California, no matter what entity you operate as on the state level (including LLC, LP, GP, etc.), you file your taxes as one of the four entities on the federal level (sole proprietorship, partnership, S corporation, C corporation).
For instance, an LLC in California (and in every other state) can elect to file its taxes with the IRS as either a C corporation or an S corporation.
And whether you form a limited partnership, a general partnership, or a limited liability partnership in the State of California, you’ll file your taxes as a partnership with the IRS.
The reason for the difference
Different states have different rules about which types of businesses can form different types of entities. For instance, in California, only attorneys, accountants, engineers, surveyors, and architects may form LLPs.
In most cases, this is due to the level of liability protection some professions need. And you may be required to register as a certain type of business entity in order to buy insurance in that state.
But at the end of the day, when it comes time to pay taxes, you’ll pay as one of the four entity types recognized by the IRS.
Before you choose an entity type for your therapy practice
Deciding on an entity type for your practice is a big move, and sets the groundwork for how you’ll track finances, file taxes, and make plans for the future. In some cases—such as filing articles of incorporation—a significant investment of time and money may be required.
With that in mind, make sure to do the following before you make a final decision:
- Research business entity requirements for therapists in your particular state. You may be legally required to register as a particular entity type, or prevented from registering as another type.
- Double check with a CPA or lawyer. They can alert you of any particular drawbacks or pitfalls to be aware of, depending on the business structure you’re considering.
Your therapy practice as a sole proprietorship
What is a sole proprietorship?
A sole proprietorship is the default business structure. As soon as you go into business for yourself and start making a profit, the IRS—and your state tax authority—consider you a sole proprietorship.
As a sole proprietor, for legal and tax purposes, your person and your business are one and the same. This is called a “pass through entity.”
How to form a sole proprietorship
You don’t need to go through any extra steps to become a sole proprietor—just start doing business.
That being said, many sole proprietors choose to obtain an employer insurance number (EIN) from the IRS, as a step towards preventing identity theft. If you don’t have an EIN, the IRS will identify your business according to your social security number (SSN).
At the state level, you may be required to register a “doing business as” name (DBA) if you plan to operate under a name other than your own (e.g. “Lisa’s Therapy Practice” as opposed to “Lisa Smith”).
And your local tax authority—your city or county—may require you to register with them.
How sole proprietorships are taxed
Your income and your sole proprietorship’s income are one and the same. Meaning, if you run your own therapy practice, but also work part time as an employee of someone else’s practice, you report income from both sources on your tax return, and it’s all taxed together.
Liability and sole proprietorships
Since you and your business are one and the same, you’re personally on the line for any business liability.
So, if a client trips on their way into your office and breaks their pinky finger, they are able to sue you personally. Likewise, if you can’t pay back your small business loan, the bank can put a lien on your personal assets. There’s no division between you and your business.
Since you and your business are one and the same, in the event you stop practicing, your business dissolves. There is no way to pass your business on to a family member or partner.
Your therapy practice as an LLC
What is an LLC?
An LLC is a separate business entity from your person. That means you carry less legal and financial liability than you would if you were operating as a sole proprietorship. An LLC can be either single member (just you) or multi-member (owned by multiple individuals).
In order to enjoy the benefits of an LLC—that is, reduced liability—you need to open a separate business checking account, and keep all your business transactions separated from your personal transactions. When your personal and business assets intermingle, you pierce the corporate veil, and risk sacrificing the protection of the LLC structure.
How to form an LLC
You form an LLC by filing for LLC status with your state tax authority. How you do so depends on which state you’re operating in. Check your Secretary of State’s website for details.
How LLCs are taxed
The IRS doesn’t have a separate tax category for LLCs. An LLC can file its taxes as either:
- A sole proprietorship (the default for single-member LLCs. In this case, the LLC is a “disregarded entity,” and your business is treated as a sole prop for tax purposes)
- A partnership (the default for multi-member LLCs)
- A C corporation (if elected by filing Form 8832)
- An S corporation (if elected by filing Form 2553)
Liability and LLCs
Since your LLC is a separate entity from your person, your liability is reduced. If someone decides to sue you, or lay claim to your assets because of outstanding debts, they are (theoretically) only able to access the assets owned by your LLC.
In practice, this means that you have an extra line of defense in case an individual or company tries to come after your assets. While you as an individual are never 100% protected from lawsuits or liens, your LLC makes it more complicated—and expensive, due to legal fees—for others to come after you. That means they’re less likely to try.
Your therapy practice as a partnership
What is a partnership?
A partnership is formed by two or more individuals who go into business together. They agree to take on equal shares of the company’s liability. The rules of the partnership are laid out in a partnership agreement signed by all members.
Your partnership is a pass through entity, meaning you report all income earned through it on your personal tax return. (The partnership must file its own tax return, but doesn’t pay taxes on any income reported there.)
How to form a partnership
In most states, you don’t need to formally register your new business with state tax authorities. Still, you will likely need to apply for a DBA (the name of your partnership).
How partnerships are taxed
You report your partnership’s income with Form 1065. The income you earn through the partnership is reported on Schedule K-1, and as income on your personal tax return. You pay personal income tax on it.
Liability and partnerships
In general partnerships, every member is liable for the debts and legal proceedings the other members incur or bring on as part of doing business as the partnership. In a limited partnership or a limited liability partnership, at least one member doesn’t carry this liability. Before deciding on a type of partnership, consult with an accountant or lawyer familiar with your state’s business entity laws.
Your therapy practice as a corporation
What is a corporation?
A corporation is owned by its shareholders. It can have thousands of shareholders, or just one. A corporation exists as its own, separate entity. It’s individually liable for all debts and legal proceedings. In the event of a bankruptcy, creditors can claim a corporation’s assets, but they can’t claim the assets of the owners.
There are two primary types of corporations: C corporations and S corporations. All corporations start out as C corporations, as C corporations are the traditional legal entity. “S corporation” is a tax status a C corporation (or, as you read earlier, an LLC) can elect. Because of this, we refer to an S corporation as a "tax entity", not a legal entity or definitive business structure.
A C corporation is taxed as an individual. It files its own tax return, and pays its own taxes. This is what’s referred to as “double taxation.” If you are an owner in a corporation, your corporation pays taxes on its income, and you’re taxed on any income you earn from the corporation as a salary or distribution.
When a C corporation elects S corporation status, it’s no longer taxed as an individual. Income and expenses are passed on to the corporation’s owners, much as they would be to members of an LLC or partners in a partnership. But the owners still enjoy the liability protection a corporation offers.
As well as liability protection, incorporating
- Gives you the option of bringing on investors
- May provide tax benefits
- May increase the legitimacy of your business in the eyes of clients, lenders, potential employees and partners, etc.
How to form a corporation
In order to incorporate your business, you must:
- File articles of incorporation in a state (not necessarily the one in which you do business)
- Authorize shares and distribute them to shareholders
- Elect a board of directors (the shareholders vote for the board of directors)
- Adopt bylaws governing how the corporation functions
- Appoint officers (CEO, CFO, etc.)
- File Form 2553 (if electing to be taxed as an S corporation)
- Maintain records of board meetings and decisions
This may sound like a lot. But, depending on your state, it’s possible to be the sole shareholder in your corporation, elect a board of three people (you and two colleagues), become appointed CEO, and file for S corporation status (so you don’t need to pay separate taxes for your corporation.)
Most companies hire lawyers to incorporate their companies, which can result in steep legal fees. Heard can help you understand the step to electing an S corporation, tailored for your therapy practice, when you sign up. Note: It is uncommon for therapists in private practice to become a C corporation due to the double levels of taxation.
How corporations are taxed
A C corporation is taxed as a separate entity. C corporations must file Form 1120.
If you elect to be taxed as an S corporation, shareholders pay taxes on the money they earn as distributions or salaries. But the corporation still has to file taxes, reporting its income and losses, using Form 1120S.
Liability and corporations
Of all entity types, both C corporations and S corporations offer the greatest level of protection for legal and financial liability.
What’s the best legal entity type for a therapy practice?
There’s no fast and easy answer to this question. The best entity type for your practice depends on your particular needs.
It will depend on your situation, and you’ll need to balance the pros and cons of each option. But, roughly speaking:
You may want to form a sole proprietorship if…
- You’re ready to start operating right away, without dealing with any extra paperwork
- You’re organized enough to distinguish between professional and personal finances, even if you don’t have a business checking account
- You’re interested in choosing a more complex entity type later, but don’t want to commit now
- You aren’t concerned with issues around financial and legal liability
You may want to form an LLC if…
- You want the convenience of a pass through entity (like a sole proprietorship), but with more liability protection
- You may want to bring on other therapists as members later, and want to have the flexibility to do so
- You may want to pass on your practice to another person in the future
You may want to form a partnership if…
- You want to work with another therapist, and share equally in the ownership of your company
- You’re open to incorporating later, but you’re not ready to commit the funds and time necessary to do so now
- You’re willing to take on the extra liability that comes from partnering with others (and have them accept liability for your actions in return)
You may want to incorporate if…
- You want the best liability protection possible
- You want to bring on investors or eventually sell your practice
- You can save on taxes by incorporating (ie. by avoiding Self Employment Tax)
- You can afford the time and money needed to incorporate
- You have the capacity to take on the extra documentation, reporting, and bookkeeping requirements a corporation demands
Before you head down any particular path, have a conversation with your accountant about which structure would benefit you the most.
Whatever entity type you choose, your business will benefit by hiring a bookkeeper, an accountant, or both. Learn about the difference between accountants and bookkeepers, and how they can help your practice.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post.
Bryce Warnes is a West Coast writer specializing in small business finances.