Key Takeaways

  • A personal service corporation (PSC) is a C corporation primarily engaged in qualified personal services, such as law, health, or consulting.
  • To qualify as a PSC, a corporation must meet strict IRS ownership and service tests.
  • PSCs are subject to a flat 21% federal tax rate (reduced from 35% under the Tax Cuts and Jobs Act).
  • Compensation paid to shareholder-employees must be reasonable to avoid reclassification as dividends, which could result in double taxation.
  • PSCs may have limited flexibility in choosing a fiscal year and must comply with IRS-approved methods if they seek a non-calendar year.

A Corporation

The Internal Revenue Service (IRS) offers a variety of tax options that business owners can choose based on their business types and circumstances. One of the most preferred tax statuses is the corporation. Business owners can also choose a personal service corporation if they meet the requirements.

What Is a Personal Service Corporation?

According to the IRS, a personal service corporation is an organization whose primary activity is to offer personal services delivered by its employee-owners. Personal services might include:

  • Architecture
  • Accounting
  • Actuarial science
  • Consulting
  • Engineering
  • Health, including veterinary services
  • Law
  • Performing arts

Based on the definition above, law firms, physician practices, vet clinics, and dance studios all qualify to file for personal service corporation status. However, employee-owners must have the necessary professional licenses from the state in which they operate. A corporation must meet certain requirements to be eligible for personal service corporation, including:

  1. Fifty-one percent of the corporation's service during a given tax year must be personal services.
  2. The corporation's employee-owners must have performed more than 20 percent of the value of the organization's provided services.
  3. On the last day of the tax year, the employee-owners must hold more than 10 percent of the corporation's outstanding stocks fair market value.

IRS Ownership and Service Tests

To qualify as a personal service corporation (PSC), the IRS requires that two criteria be met during the “testing period” (generally the prior tax year):

  • Substantially All Activities Must Be Personal Services: More than 20% of the corporation’s compensation cost must be for personal services in qualified fields such as health, law, engineering, or consulting.
  • Ownership Requirement: The services must be substantially performed by employee-owners, who must own more than 10% of the fair market value of the corporation’s stock on the last day of the testing year.

Failure to meet these criteria disqualifies a business from PSC status, even if the business primarily operates in a qualifying field.

Tax Treatment on Personal Service Corporations

Unlike the graduated tax rate structure applied to other corporations, personal service corporations are subject to a flat 35 percent tax rate. Also, the IRS allows personal service corporations to use the cash accounting system even if they earn more than $5 million a year. If a personal service corporation is using the cash method, the IRS lets it deduct interest and the business expenses it owes employee-owners. Personal service corporations can also deduct losses arising from the sale or transfer of property between the company and an employee-owner.

This arrangement is ideal for high net income personal service corporations because it restricts their tax rate to 35 percent. However, it might not be wise to operate as a personal service corporation if your net income qualifies you for lower tax rates.

Compensation vs. Dividend Risk

It is essential for personal service corporations to pay reasonable compensation to shareholder-employees. If compensation is found to be excessive, the IRS may reclassify part of it as a dividend. Unlike compensation, dividends are not deductible by the corporation and are taxable to the shareholder, resulting in double taxation.

To avoid reclassification:

  • Maintain documentation for salary decisions.
  • Benchmark salaries against similar roles in the industry.
  • Ensure duties performed align with compensation levels.

This is a critical compliance area for PSCs seeking to maintain favorable tax treatment.

Restrictions on a Personal Service Corporation

Personal service corporations can only use a calendar year as their fiscal year. However, they can choose a fiscal year by filing Form 1128 or Form 8716, which allows them to adapt, change, or retain a tax year or elect to have a different tax year, respectively. The IRS must approve the request formally after the company files any of these forms. However, the IRS can restrict deductions for a specific amount paid to employee-owners if a personal service corporation files Form 8716.

Fiscal Year Exceptions and IRS Requirements

While PSCs are generally required to use the calendar year for tax purposes, an alternative fiscal year may be adopted under specific IRS-approved circumstances:

  • Section 444 Election: Allows certain corporations to use a fiscal year if they make required payments (known as “required deposits”) and file Form 8716.
  • Business Purpose Justification: The IRS may approve a non-calendar year if the corporation can demonstrate a substantial business reason, typically via Form 1128.

However, even when granted, these exceptions impose administrative and financial compliance requirements that PSCs must carefully evaluate.

How to Form a Personal Corporation

To establish a personal corporation, you must:

  • Choose a state of incorporation. While many business owners choose their home state for incorporation, many incorporate their businesses in corporate havens such as Delaware, Nevada, and South Dakota.
  • Decide on a corporate name. Be sure to choose a name that has not been registered before in your state of incorporation.
  • Draft your articles of incorporation. An attorney or online legal form vendors can help you create this document.
  • Obtain an employee identification number (EIN) from the IRS. An EIN is the business equivalent of a Social Security number. You can apply online at IRS.gov.
  • File your articles of incorporation with your state of incorporation's business registration department, and pay the required fees.
  • Consult your attorney or CPA extensively during the incorporation period. These professionals usually have a lot of experience that can help you achieve the best business structure.

Fringe Benefits

Personal service corporations offer several fringe benefits. For instance, these corporations can:

  • Provide medical plans to cover their employees.
  • Provide employees with tax-sheltered pensions such as individual retirement accounts (IRAs).
  • Buy insurance to cover anything from their employees to equipment, life insurance, disability insurance, and more.
  • Ensure the continuity of the business even after the owner's death.

Other Tax Considerations and Limitations

In addition to fringe benefits, PSCs must be aware of other tax-related limitations:

  • Passive Activity Rules: Passive losses from PSCs may be subject to limitations under IRS passive activity rules.
  • AMT Considerations: While the corporate Alternative Minimum Tax (AMT) has been eliminated federally, some states may still impose it on PSCs.
  • State-Level Taxation: States may treat PSCs differently from regular corporations, which can affect overall tax liability.

Given the complexity of these rules, many corporations consult tax professionals to ensure full compliance and strategic planning.

Frequently Asked Questions

1. What is a personal service corporation under IRS rules? A personal service corporation is a C corporation primarily engaged in qualified personal service activities where employee-owners perform most of the work and hold significant stock ownership.

2. What industries qualify for personal service corporation status? Fields include health, law, engineering, accounting, consulting, performing arts, actuarial science, and architecture.

3. What is the tax rate for a personal service corporation? As of the Tax Cuts and Jobs Act of 2017, PSCs are subject to a flat 21% federal tax rate, reduced from the previous 35%.

4. Can a personal service corporation use a fiscal year other than the calendar year? Yes, but only with IRS approval via Form 1128 or through a Section 444 election with compliance obligations.

5. What happens if a PSC pays excessive compensation to shareholder-employees? The IRS may reclassify the excess as dividends, resulting in double taxation—once at the corporate level and again at the shareholder level.

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