Personal Service Corporations

A qualified personal service corporation is not allowed to use the graduated tax rates for C corporations. The flat tax rate is the highest marginal rate (currently 35%). The definition for a qualified personal service corporation is the highest level of any of the personal service corporation definitions. At least 95% of the stock must be owned by employees performing the personal services.

• C Corporations (generally): Not subject to passive activity loss rules.

• Personal Service Corporations: Passive activity loss rules are the same for personal service corporations as they are for individuals. Passive activity losses cannot be offset against active income or portfolio income. 

• Closely-Held Corporations: If 50% of the value of outstanding stock is owned by 5 or fewer individuals, the corporation cannot offset passive activity losses against portfolio income. However passive losses can offset active income.

Businesses that provide personal services often incorporate to provide limited liability for the individual shareholders. The business may wish to remain a C corporation to take advantage of certain fringe benefits that are not available to S corporations or LLCs. However, because of the stiff 35% flat tax on personal service corporation taxable income, corporations will generally try to distribute all profits in the form of wages to the employee-shareholders performing the services. This in effect can eliminate the negative results caused by the flat 35% tax.

Personal Service Corporation Reasonable Compensation: IRS is challenging the amount paid as wages to employee-owners of personal service corporations. They try to reclassify wages as dividend distributions under the premise that the wage is not reasonable. If successful, the IRS reclassification can result in an increase in taxable income because dividend distributions are not deductible by the corporation. 

Professional athletes and other entertainers sometimes set up personal service corporations when the top individual tax rate is higher than the top corporate rate. As a corporation, the athlete can also set up and make contributions to a pension plan. When the IRS challenges the personal service corporation, it is usually trying to reclassify income as paid to the individual rather than the corporation.

Professionals in group practice are often concerned about liability exposure for the malpractice of their co-owners. Although a personal service corporation, LLC, or S corporation may shield a professional from claims against his/her personal assets, the assets inside the business are still at risk. For this and other reasons, professionals often form multiple personal service corporations when engaging in group practice.

Multiple Personal Service Corporations - How it Works: Each professional forms a separate personal service corporation in which the individual professional owns 100% of the stock in a personal service corporation. The overall group practice can then be organized as a firm under one of the following methods:

• Each personal service corporation owns a partnership interest in a firm organized as a partnership,
• Each personal service corporation is a member of a firm organized as an LLC, or
• Each professional owns stock in an S corporation. In turn, the S corporation contracts with the separate personal service corporations for professional services.

Personal Service Corporation Advantages:

• personal service corporations can provide fringe benefits to professionals that are not available under an S corporation, LLC, or partnership entity form. 
• Under the LLC or S corporation option, assets held in the individual personal service corporations are protected from claims against the firm which may result from the malpractice of other professionals in the firm.
• Ownership of assets, the hiring of employees, and the incurring of various expenses can be done either by the firm or by the individual personal service corporations. This means:
– Professionals have the ability to purchase needed equipment that would not be used by other professionals in the firm, avoiding controversy.
– Independent decision making is possible in a professional’s area of specialty.
– Discretionary expenses can be allocated to the professional, rather than having the expense imposed on the firm as a whole.
• Admitting a new member to the firm would be a tax-free event for the new member. 

Personal Service Corporation Risks: The IRS may try to disregard the solely-owned personal service corporations under IRC §482 or §269A, and allocate income of the personal service corporation to its sole employee/shareholder. To avoid this reclassification, the personal service corporations must be set up so that tax avoidance is not the primary reason for the organizational structure. In addition, the relationship between the individual professionals and the group practice as a firm should not have the appearance of an employment arrangement.