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Strategies for sidestepping the higher rate for PSCs

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in Employee Benefits Program,Human Resources,Small Business Tax,Small Business Tax Deduction Strategies

Most C corporations benefit from a graduated federal income tax rate structure. But personal service corporations (PSCs) aren’t afforded that luxury. Their income is taxed at the highest corporate federal rate of 35 percent.

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 flat 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 IRS imposes a flat tax on PSCs only if 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 more than 5 percent of the firm is owned by a nonpracticing attorney or some other individual, 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 the employees who worked in the financial-services end. It also continued to provide employee benefits 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 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.

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