Advice: Beware of a potential tax trap if you divide your business into separate companies. If you devote one company entirely to a personal service, it could be socked with the 35 percent rate.
Fortunately, if you maintain sufficient control over the entire business, you may be able to avoid any dire tax consequences.
Here’s the drill: Tax law doesn’t explicitly define a PSC, but the list of personal services historically includes those performed in the fields of health, law, engineering, accounting, actuarial science, performing arts and consulting. If your business concentrates on one of those services, it might have to pay the flat 35 percent tax.
The flat tax is imposed on PSCs only if the employees performing the personal services own at least 95 percent of the stock.
Example: If two attorneys each own half of an incorporated law firm, the flat tax rate for PSCs applies. But, if a nonpracticing attorney or some other individual owns more than 5 percent of the firm, the corporation is subject to the regular corporate tax rates.
New case: A well-known Ohio firm split its accounting business from its financial-services business. The parent company continued to furnish the paychecks to employees who worked in the financial-services end. It also continued to provide their and to pay the employer’s share of Social Security tax on the wages.
The financial-services company reimbursed the parent company for the wages and claimed the resulting deductions.The IRS argued that the parent company, left with only the accounting-services part of the business, should be treated as a PSC.
But the Tax Court said that simply allocating costs of employees to the financial-services company doesn’t make them employees of the new company. It ruled that the employees in the financial-services business still effectively functioned as employees of the parent company.
Result: The company is not subject to the special tax. (Ron Lykins, Inc., TC Memo 2006-35)
Tip: If you own a PSC, distribute as much profit as possible in the form of deductible compensation paid to yourself and other owner/shareholders. That reduces the amount subject to the flat 35 percent rate.
Caveat: The compensation must be "reasonable" for services performed.