President Trump and Republican leaders in Congress have rightly complained that corporate tax rates in the U.S. are among the highest in the world. But some companies have it even worse than most.
Strategy: Watch out for the tax trap for “personal service corporations” (PSCs). If the PSC designation applies, your company is taxed at a flat rate of 35%, the top corporate tax rate.
In other words, your company can’t benefit from the graduated rate structure. This could cost a firm thousands of tax dollars, or even more, each year.
Here’s the whole story: Although the rules in this area are somewhat vague, a corporation is generally treated as a PSC if it satisfies both a “function” test and an “ownership” test.
1. Function test: Substantially all of the activities involve the performance of services in a field of law, accounting, health, engineering, architecture, actuarial sciences, performing arts or consulting. For this purpose, “substantially all” means 95% or more of time spent by employees is devoted to these services.
2. Ownership test: Substantially all the stock is held (directly or indirectly) by employees performing these services or retired employees who provided these services. Owning 95% or more of the stock is considered to be “substantially all.”
Naturally, business owners usually interpret the rules in their favor. On the other hand, the IRS is likely to challenge companies that are obviously trying to avoid the PSC label.
When appropriate, some diversification might allow your company to squeeze below the 95% threshold under the function test. Adding some employees who are not stockholders could avoid the 95% threshold under the ownership test.
Tip: Proposed tax reforms could affect the rules for PSCs. Stay tuned.