What is a Personal Service Corporation?
A Personal Service Corporation (PSC) is a type of corporation that provides personal services in fields such as health, law, engineering, accounting, and consulting. The main characteristic of a PSC is that the majority of its activities involve the performance of services by its employee-owners.
Unlike regular corporations, which are subject to a flat corporate tax rate, PSCs are subject to different tax rules. The IRS defines a PSC as a corporation where at least 95% of its activities involve the performance of personal services, and at least one of its employee-owners owns at least 10% of the corporation’s outstanding stock.
One of the main reasons for the creation of the PSC classification is to prevent high-income individuals from incorporating themselves to take advantage of lower corporate tax rates. By subjecting PSCs to different tax rules, the IRS aims to ensure that these corporations pay their fair share of taxes.
It is important for PSCs to properly classify themselves as such, as failing to do so can result in penalties and additional taxes. To be considered a PSC, the corporation must meet the IRS criteria mentioned earlier and file Form 1120, the U.S. Corporation Income Tax Return.
How Taxation Works for Personal Service Corporations
1. Flat Tax Rate
One key aspect of taxation for PSCs is the flat tax rate. Unlike regular corporations, which are subject to graduated corporate tax rates, PSCs are taxed at a flat rate of 21%. This means that regardless of the corporation’s income level, it will be taxed at the same rate.
2. Limitations on Deductions
For example, PSCs cannot deduct certain fringe benefits provided to employee-shareholders, such as personal use of a company car or meals and entertainment expenses. These expenses are considered taxable income for the employee-shareholders and are subject to individual income tax rates.
Additionally, PSCs are limited in their ability to deduct certain employee compensation expenses. The IRS imposes restrictions on the deductibility of excessive compensation paid to employee-shareholders, aiming to prevent the conversion of personal service income into corporate earnings.
3. Accumulated Earnings Tax
PSCs are also subject to the accumulated earnings tax (AET). This tax is designed to discourage the accumulation of earnings within a corporation without a legitimate business purpose.
If a PSC accumulates earnings beyond the reasonable needs of the business, it may be subject to the AET. The tax rate for the AET is currently set at 20% and is in addition to the regular corporate tax rate of 21%.
To avoid the AET, PSCs must demonstrate that the accumulation of earnings is necessary for the conduct of the corporation’s business or for a specific business purpose, such as expansion or investment in new equipment.
4. Shareholder Taxation
Emily Bibb simplifies finance through bestselling books and articles, bridging complex concepts for everyday understanding. Engaging audiences via social media, she shares insights for financial success. Active in seminars and philanthropy, Bibb aims to create a more financially informed society, driven by her passion for empowering others.