It’s bad enough that corporate tax rates in the United States are among the highest in the world, but some companies have it even worse.
Strategy: If possible, avoid being tagged a personal service corporation (PSC). When this designation applies, your company is taxed at a flat federal rate of 35%, the top average tax rate for corporations.
In other words, you don’t benefit from the graduated corporate federal income tax rate structure. This could cost you thousands of tax dollars each year.
Here’s the whole story: Although the rules are somewhat vague, a corporation is generally treated as a PSC if it satisfies both a “function” and “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, either 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.
Tip: When it’s appropriate, some diversification of stock ownership might allow your company to squeeze under the 95% threshold.