Many people incorporate their businesses to shelter themselves from liability attributable to litigation.  Likewise, one can enjoy graduated tax rates that are more favorable than those should one conduct their business as a sole proprietor.  But did you know that if you have a C-Corp and perform certain services, you may be deemed a Personal Service Corporation (PSC) and taxed at a flat 35% tax rate?

The IRS and Congress typically take the stance that the decision to incorporate when made by a personal services business is primarily for tax avoidance or to gain a tax advantage.  These include, but are not limited to, the graduated corporate tax rate, deducting business expenses that would otherwise be subject to the limitations on miscellaneous itemized deductions or the use of corporate retirement and fringe benefit plans.  Thus, Congress passed laws to limit the benefits received by incorporated personal service businesses, most of which are unfavorable to the corporation.

A corporation is a PSC if three conditions are met:

• The compensation test states that if more than 20% if the total compensation costs attributable to personal services are performed by employee owners, you pass the test.
• The ownership test states that at least 95% of the corporation’s stock, by value, must be owned directly or indirectly by employees performing the services.
• The function test states that the corporations is a PSC if “substantially” all of the corporations activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting.

If a corporation is deemed a PSC, there are three significant drawbacks:

• Graduated corporate tax rates often do not apply.  Normally, corporate income tax rates range from 15 % to 39%.  Unfortunately, PSCs pay a flat corporate rate of 35%.  The good news is that only the first $100,000 of corporate profits get to benefit from these more favorable rates.  Thus the maximum total tax “penalty” for being classified as a PSC is $12,750.
• 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.
• 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.

As mentioned above, the maximum penalty for being deemed a PSC is a mere $12,750.  Nonetheless, corporations that fall under PSC rules can take the following steps to prevent any possible re-characterization by the IRS:

• Consider electing S-corporation status.  The PSC rules do not apply here or to LLCs.   However, “reasonable compensation” requirements, odd health insurance rules, higher marginal rates, and stricter IRS scrutiny are the price you will pay.
• 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.
• Bring in an outside investor.  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.