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Stuck with the personal service corporation label?

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in Small Business Tax

Rumors have been flying about reducing the tax rates for C corporations as a way to stimulate the economy. For now, it’s just that—talk. But things could be a lot worse if your business is in a service industry.

Advisory: If your firm is tagged as a “personal service corporation” (PSC), it must pay federal income tax at the flat rate of 35%. You don’t benefit from the graduated rate structure like other corporations, so your company might have to fork over thousands of extra tax dollars each year.

Unfortunately, the tax-law definition of a PSC isn’t completely clear. A corporation is generally 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, directly or indirectly, by employees performing these services or retired employees who provided these services. Owning 95% or more of the stock is considered “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. Example:  In a 2007 case decided by the Tax Court, a solely owned corporation that prepared tax returns and performed bookkeeping services was found to provide accounting services under the function test. Therefore, it had to pay the flat 35% rate on its corporate income. (Rainbow Tax Service, Inc.,128 TC 42)

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