Personal Service Corporations: An Iron Fist in a White Glove

Q: Tax Playa, I am the sole owner of a corporation.  Am I in danger of the IRS reconstituting it as a "personal service corporation?"
Bill, White Plains NY

A: You may be, but this is somewhat rare and doesn't come up much these days.  If your corporation is deemed a "personal service corporation" (PSC), you lose the advantage of the graduated corporate income tax rate structure, and you must normally use a calendar accounting year...

For more information on this topic, see IRS Publication 542, Corporations.

A corporation is a personal service corporation if three conditions are met:

1. The corporation's principal activity during the "testing period" (the prior tax year, or the last day of the current one if it is the first tax year) is one or more "personal services" (accounting, actuarial science, architecture, consulting, engineering, health, veterinary services, law, and performing arts);
2. The corporation's employee-owners (stockholders who perform personal services for the corporation) substantially perform (more than 20% of corporate compensation costs) these personal services;
3. The corporation's employee-owners have a more than 10% of the FMV of the outstanding stock.

If a corporation is a personal service corporation, there are three significant drawbacks:

1. Graduated corporate tax rates often do not apply.  Normally, corporate income tax rates range from 15 to 35 percent.  "Qualified" PSCs (those where 95% of the stock is owned by an employee, retired employee, estate of an employee, or heir of an employee doing the personal services) pay a flat corporate rate of 35%.  However, unlike personal income tax rates, corporate rates are not indexed to inflation.  As a result, this "penalty" goes down in real value every year.  Only the first $100,000 of corporate profits gets to benefit from these more favorable rates.  The maximum total subsidy for these rates is $12,750--the same as it has been for two decades and will be going forward.
2. The corporation cannot elect to have a fiscal year different from a calendar year without prior IRS approval.  As a result, the corporation usually cannot elect to play games with the shareholder's calendar tax year and its own (different) fiscal tax year.
3. The at-risk rules and passive loss rules apply.

The PSC rules are a relic of the pre-1986 era.  In those days, corporate rates were substantially-lower than personal income tax rates.  For instance, in 1980 the top personal rate was 70%, while the top corporate rate was only 46%.  Thus, a top-bracket taxpayer could reduce their taxes on the margin by over a third if they "incorporated themselves."  Congress wanted to disincentivize taxpayers from doing this, so the PSC restrictions were put into place. 

Today, though, the top personal and corporate tax rates are identical (35 percent), and have been in the same ballpark for over twenty years.  Furthermore, since the corporate graduated rate brackets are not indexed to inflation, the value of the graduated structure is less and less compelling every year.  As a result, I suspect that the IRS does not make reconstituting a corporation as a PSC a particularly-high priority in the area of corporate tax compliance.

Nonetheless, corporations that technically fall under the PSC rules should take steps to prevent any possible re-characterization by the IRS:

1. Consider electing S-corporation status.  The PSC rules do not apply here, and there is far less chance of triggering double-taxation.  However, "reasonable compensation" requirements, odd health insurance rules, higher marginal rates, and stricter IRS scrutiny are the price you will pay.
2. Diversify your corporation's business activities.  The rule is that 20% of your corporation's compensation costs cannot come from personal services.  So, ensure that at least 81% of your business's compensation costs come from something other than these personal services.  Another way of getting at this is to lower your compensation costs, and simply have the corporation perform pure business services.  Finally, have an unrelated person or persons purchase 6% or more of the corporate stock.  Diversification has the added benefit of getting around the idea of your corporation's "principal activity" being personal services.

The bottom line is that the downside risk to being reconstituted as a PSC is minimal.  If a C-corporation structure makes sense for your business, go ahead and do it.  In the unlikely event you get reconstituted as a PSC, pay your back taxes and elect S-status.  As the benefits of the graduated rate structure diminish, so should the IRS' zeal in pursuing this particularly-arcane tax matter.

Comments

[Mcgill]

I hate taxes. I get a few dollars as salary and the money at my disposal is nothing more than half of my total salary after tax reduction. It sickens me to pay such a large chunk when all you earn is nothing more than 3k.

[David E]

Just the article I was looking for, thanks! Really appreciate the definition, background, and how to avoid the dreaded PSC.

[Olga]

Great article, thanks a lot. Congrats on your high ranking in Google.