The current income tax laws afford taxpaying corporations (“sub chapter C corporations”) a graduated tax rate regime similar to that applicable to individual taxpayers, albeit with fewer “tax brackets”. The rate required on a corporations first $50,000 of taxable income is just 15%. The next $25,000 of taxable income is subject to tax at a rate of 25% and the next $25,000 is taxed at 34%. However, for taxable income above $100,000 through $335,000, the rate of tax applied is 39% which equates to a “give back” of the tax benefits afforded the corporation under the graduated rates on the first $100,000 of taxable income. As such, the lower rates on the first $100,000 of taxable income are most useful, and beneficial, to smaller corporations. Eventually, as corporation taxable income increases, all income is taxed at 35%.
A twist on this tax regime is that corporations that are found to be “personal service corporations”, or PSCs, do not get to realize the tax benefits of the graduated rates on the first $100,000 of taxable income. For corporations classified as PSCs under the Internal Revenue Code, the tax rate is simply a hefty 35%, even if the corporation’s taxable income is less than $100,000. Thus, it is beneficial to avoid such a classification if at all possible.
In addition to the direct tax implications of being classified as a PSC, there are other detrimental implications to consider beyond the scope of this posting.
Pursuant to the Internal Revenue Service website, a corporation is a personal service corporation if-
1. Its principal activity during the “testing period” is performing personal services (defined below). Generally, the testing period for any tax year is the prior tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of
a. The last day of its tax year, or
b. The last day of the calendar year in which its tax year begins
2. The employee-owners (shareholders) substantially perform the services noted in (1), above. The requirement is met if more than 20% of the corporation’s compensation costs for its activities of performing personal services during the testing period is for personal services performed by employee-owners (shareholders).
3. Its employee-owners (shareholders) own more than 10% of the fair market value of its outstanding stock on the last day of the testing period.
Personal services are defined to include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health, (including veterinary services), law and the performing arts. In reviewing the definitions, it is easy to identify that the purpose of the personal service corporation classification rules is to ensure that individuals providing personal services do not avoid the higher taxes imposed under the individual tax rate structure simply by incorporating their activities.
A recent Tax Court decision illustrates exactly how the Service looks at fact patterns supporting such a classification and should prove useful to anyone concerned about this issue.
In Reza Zia-Ahmadi, TC Summ. Op. 2017-39 (Tax Ct.), an ultrasound services company was found to be a Personal Service Corporation.
In this case, a husband and wife owned a C corporation that provided ultrasound services to medical offices and clinics throughout southern Colorado. For the years at issue, the corporation calculated its tax liabilities at the reduced graduated corporate tax rate of 15%. Upon audit, the Internal Revenue Service argued that the company was a Personal Service Corporation (PSC) and used a 35% tax rate to recalculate its liabilities.
The company claimed that it was not a PSC because its employees were not required to be licensed in Colorado, did not provide direct treatment services to patients, and did not make healthcare decisions.
The Tax Court disagreed, finding that the taxpayers attempted to “construe” the definition of healthcare services too narrowly, which was not the intent of the statute or the interpretive Treasury regulations. As such, the Court held for the Internal Revenue Service, and ruling that ultrasound services fall within the health profession. Therefore, the company was a PSC for tax purposes and subject to the flat 35% tax rate.
Planning for personal service corporations can be a complex undertaking to ensure the most tax efficient operation of the business. Should you have questions, please contact Bob Grossman or Don Johnston. Visit our blog for more Personal Service Corporation related articles.
