Personal Service Corporations
To save on taxes, many professionals form a C corporation where they perform their services as employee-owners. The IRS classifies this type of corporation as a personal service corporation (PSC), which is a type of C corporation where more than 10% of the stock by value is owned by professionals who provide personal services for the corporation in the fields of accounting, architecture, actuarial science, consulting, engineering, health, law, or the performing arts.
A corporation is defined by the state and in the late 1960s and early 1970s, some states started to allow licensed professionals to operate as a corporation. As a C corporation, the employee-owners could leave some of their earnings in the corporation, where it was taxed at lower corporate rates than at their marginal tax rates. Moreover, because a professional service corporation is a C corporation, the professionals could also enjoy tax-free fringe benefits that are only available to the C corporation as well as limited liability that was unavailable to partnerships at that time, and business expenses that are deductible on Schedule A and subject to a 2% AGI floor for employees under a pass-through business entity are not subject to the 2% floor for employees of a corporation.
Because the corporations offered little aside from the services of the professionals who owned the corporation, the IRS tried to negate the tax advantages of this organization under the assignment-of-income doctrine, where the professionals were merely assigning some of their income to the corporation so that it was taxed at the lower rates. However, the IRS lost several court cases regarding the PSC's in the early 1970s, so the IRS finally acquiesced to the existence of the personal service corporation.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, corporations, including personal service corporations, have received the best benefits, which includes the following changes:
- The top corporate tax rate is reduced from 35% to 21%.
- Business interest is no longer fully deductible. Instead, excluding depreciation, the deduction cannot exceed 30% of income.
- Eliminates the corporate alternative minimum tax and an AMT carryover credit can be used to offset regular income tax liability for any tax year, and can even be refunded.
- New investment purchases can be fully expensed in the 1st 5 years, but then it is phased out over 5 more years.
- The §179 deduction is increased to $1 million.
- The deduction of net operating losses is limited to 80% of taxable income.
- Previously, research and development expenses could be immediately deducted, but now they would need to be written off gradually.
The new law also changeS the taxation of C corporationS from a worldwide system, where all income earned by a corporation was taxed, regardless of where the income was earned, to one more like a territorial tax system, where income is taxed by the country in which it is earned. This is accomplished by providing a 100% deduction on dividends received by a US corporation from a foreign subsidiary, which includes any company that the C corporation owns at least 10% of the foreign corporation. However, the stock on which the dividend was received must have been held at least 366 days during a 731-day period, beginning 365 days before the dividend date.
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
Also, this new tax law lowers the tax rate on repatriated funds held overseas by corporations. Previously, corporations were taxed at the maximum rate of 35% on their worldwide income, including income earned in other countries, but this tax can be deferred on international earnings by keeping the funds overseas, which many corporations have done. To promote repatriation, a special tax rate will be applied to repatriated funds: 15.5% rate for funds held as cash and 8% for non-cash holdings.
Excess Employee Remuneration Not Deductible
For publicly traded corporations, this new law also eliminates the deduction for any compensation exceeding $1 million for a covered employee, which includes the principal executive officer, financial officer, and 3 of the other highest-paid officers. Although this is like previous law, the new law now extends the deductible limit for performance-based compensation.
Because a C corporation can offer many tax-advantages, many highly paid professionals organize as a C corporation to lower their taxes. To prevent this, certain tax rules that apply to qualified professional service corporations (QPSCs) reduces some of the tax advantages of a C corporation. The main drawbacks are that a QPSC cannot use the graduated income tax rates of the C corporation, but is taxed at a flat rate of 35%, any net operating losses (NOL) can only be carried forward, not backward, and strict rules will apply if the QPSC chooses a fiscal year.
The IRS uses 2 tests to determine if a personal service corporation is a qualified personal service corporation:
- Substantially all — more than 95% — of the activities of the corporation is to provide the services of the employee-owners in the qualified fields.
- 95% or more of the stock, by value, must be held directly or indirectly (through partnerships, S corporations, or other QPSCs) by one of the following:
- employees of the QPSC,
- retired employees who had performed such services in the past for the corporation,
- the estates of such individuals, or
- anyone who acquired such stock through inheritance, but only within 2 years of the testator's death.
If the QPSC also satisfies the compensation test, where more than 20% of the compensation paid by the corporation is to the employee-owners, then the QPSC must use a calendar tax year unless there is a business purpose for choosing a fiscal year or if the QPSC qualifies under IRC §444. If the QPSC does qualify for a fiscal year, then it will have to file IRS Form 1128, Application to Adopt, Change, or Retain a Tax Year.
PSCs do have 1 advantage over the C corporation in that it can use the cash method of accounting. A C corporation must use the accrual method of accounting if its average annual gross receipts exceed $5 million (IRC §448).
Generally, if the professionals must be licensed, then most licensed professionals within the applicable fields may be classified as a QPSC. So licensed members of the health profession, such as physicians, nurses, dentists, and veterinarians who formed a C corporation may be characterized as a QPSC, but not health club operators. Consulting includes those professions whose main service is selling advice, but does not cover those professions where the advice is incidental to the main service, as it is for salespeople.
The QPSC provides limited liability for the shareholders and can offer the tax advantaged fringe benefits that are only available to a C corporation. Although many states today offer limited liability partnerships (LLP) as an alternative business entity that limits the liability of each partner, the fringe benefits that can be offered by an LLP do not enjoy the tax advantages that can be offered by the QPSC.
However, to offer health and life insurance benefits tax-free requires that the QPSC establish a Voluntary Employees' Beneficiary Association (VEBA) that is usually administered by banks or insurance companies. However, the QPSC must have at least 3 shareholders. [IRC §501(c)(9)] Other benefits that can be offered without a VEBA include 401(k)s, disability insurance, dependent care and death benefits.
The QPSC is taxed as a separate entity at a flat rate of 35% of its net income. However, in most cases, the QPSC does not pay income taxes since the owners generally arrange that all the income be paid out as salary, bonuses, and fringe benefits, which, of course, is deductible by the QPSC, but it does remove the advantages of income splitting between the corporation and the employee-owners that would otherwise be possible with a C corporation. Because it is a corporation, states also charge an annual franchise tax that ranges from $50 – $800.
A QPSC can use either the cash or the accrual method of accounting. It can also adopt Section 1244 status, if it has not elected to be an S corporation. Section 1244 allows the shareholder to deduct any losses on §1244 stock from up to $100,000 ($50,000 if married filing separately) of other income in the 1st year of the loss and up to $3000 from other ordinary income for each year thereafter until the carried over losses are used up. However, losses on §1244 stock can be used to offset any amount of capital gains.
A disadvantage of QPSC stock is that it cannot be transferred to a nonprofessional, since this would probably violate state law that requires that most of the stock of a professional corporation must be held by the professionals performing the services. Generally, a QPSC carries life insurance on each of its shareholders, so that their share can be bought out if one dies.
A QPSC is dissolved by the majority vote of the shareholders, but it can also be dissolved by operation of law, such as would occur if the QPSC did not pay its franchise tax. When a QPSC is dissolved, then the shareholders will have a taxable gain or loss equal to the fair market value of the assets distributed to them minus the tax basis of their stock.
Because of the complexities of the tax treatment of QPSCs, many corporations that would otherwise be classified as QPSCs choose to become S corporations, which is a pass-through entity that simplifies tax accounting, but lacks the tax advantages of the C corporation.