A personal service corporation (PSC) is a type of C corporation (C-corp) where the owners provide service personally to people or groups. A qualified PSC is where employees providing substantially all the professional services own at least 95% of the stock. These services can be in various professional business fields, like accounting, law, counseling, and other similar services.
Qualified Personal Service Corporation Requirements
A corporation is a qualified PSC if:
- It is a C-corp.
- Its principal activity is performing personal servicesTo be a qualified PSC, you must provide personal services, which can include a wide range of professional business activities, such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and other similar services. .
- The employee-owners substantially provide all the value of the services offered by the company.
- The employee-owners own more than 95%At least 95% of its stock, by value, should be owned directly or indirectly by:
1. Employees performing the services.
2. Retired employees who performed the services.
3. Any estate of an employee or retiree.
4. Any person who acquired the corporation's stock because of the death of an employee or retiree (but only for the 2 years beginning on the date of the employee's or retiree's death). of the stock on the last day of the tax year.
Tax Treatment of Qualified Personal Service Corporations
If you own and operate a qualified PSC or are planning to operate one in the coming year, you should be aware of a few tax consequences related to PSCs:
- You’ll pay a flat corporate income tax at a rate of 21%, which is the same as other C-corps.
- You must use the cash method of accounting.
- You must have a calendar year-end.
- While most C-corps are exempt from the passive loss rules, you’ll be subject to passive loss rules for any activities where you don’t materially participate.
- PSCs with accumulated earnings of more than $150,000 might be required to justify why they are not paying dividends to the IRS; most C-corps can accumulate $250,000 before having to justify not paying dividends
For guidance in these areas, see our articles on:
Tax Planning for Qualified Personal Service Corporations
When operating a PSC, you’ll have to employ some tax planning strategies. One of the main tax planning tips that you should use is to pay all your earnings as wages. While wages will expose you to payroll taxes, they will avoid the 21% corporate tax.
Additionally, you shouldn’t pay yourself so much wages that you create a loss. The loss will not generate a tax deduction in the current year because it is “trapped” in the PSC, but you can carry over the net operating loss (NOL) to future years.
How To Avoid Being a Personal Service Corporation
Since qualified PSCs are exposed to such high tax rates, you may want to avoid this designation. To avoid being a PSC, you can make an election to be treated as an S corporation (S-corp) instead.
S-corps are taxed by the IRS as pass-through entities. This means that the profits and losses pass to the shareholders and the S-corp itself does not pay federal taxes, such as a PSC would. Instead, the profits and losses appear on the owner’s personal income tax return, and it is taxed at the owner’s tax rate instead of the 21% flat tax for corporations.
PSC vs S-corp Comparison at a Glance
| PSC | S-corp |
|---|---|
| Earnings are subject to double taxation unless paid out in wages | Corporate earnings after wages can flow through to owners without paying employment tax |
| Losses do not pass through to the owners | Corporate losses flow through to owners and can create tax savings on the owner’s tax return |
| Earnings taxed at a flat rate of 21% | Compensation to owner-employees must be reasonable for services performed |
Frequently Asked Questions (FAQs)
PSCs do not enjoy any benefits over other C-corps. They must comply with some additional tax rules, as discussed in our article. However, PSCs do enjoy the benefits of having limited liability as do other corporations.
No, and PSC rules only apply to C-corps.
Yes, a PSC can choose to be treated as an S-corp, at which point they are no longer a PSC. Whether a company chooses S-corp status depends on its own goals and circumstances.
Bottom Line
If you have a qualified PSC or want to start one, you need to plan your taxes carefully. Qualified PSCs have to follow certain tax laws and rules, and most of the time, their income is taxed at the highest corporate tax rate of 21%. Qualified PSCs can convert to S-corps, though, and this way, the company doesn’t have to pay all of its earnings as wages to avoid double taxation.
