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Service corporations: Survey the tax landscape

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in Small Business Tax,Small Business Tax Deduction Strategies

There’s talk about rising income tax rates for C corporations on the horizon. For now, it’s just that—talk. But certain company owners already have to deal with a higher tax rate.

Alert: If your firm is tagged as a “personal service corporation” (PSC), it must pay tax at a flat rate of 35% (the current highest average tax rate for C corps). You can’t benefit from the graduated rate structure like other corporations.

As a result, your company might have to fork over thousands of extra tax dollars each year. That’s what happened to a land surveying firm in a new case.

Here’s the whole story: Unfortunately, the tax law definition of a PSC isn’t clear. A corporation generally is treated as a PSC if it satisfies both a “function” 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 that 95% or more of time spent by employees is devoted to these services.

2. Ownership test: Substantially all of 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 has been vigilant in challenging companies that attempt to avoid the PSC label.

Latest example: A firm in Tennessee was engaged exclusively in the practice of land surveying. It didn’t employ any licensed engineers nor was it associated with any firm employing licensed engineers.

The firm acknowledged that it satisfied the ownership test for being a PSC. However, it argued it did not meet the function test because it was not engaged in any of the listed services.

The IRS pointed to regulations that treat land surveying and mapping as engineering services. (Regulation 1.448-1T(e)(4)(i)) But the firm contended that the regs were invalid. Alternatively, it said that services it provided could not be considered “engineering services” because they weren’t provided by licensed engineers, as required by Tennessee law.

However, the IRS disagreed with the firm. First, it upheld the regulations as being valid. Second, it ruled that state law did not control in this area. The determination of PSC status must be based on the relevant facts.

Bottom line: The firm was required to pay almost $10,000 more in income tax because it was treated as a PSC. (Kraatz & Craig Surveying, Inc., 134 TC No. 8)

Tip: The flat 35% PSC tax rate is levied on corporations when 95% or more of the stock is owned by employees who actually perform personal services.

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