Beware the pitfalls of the personal service corporation

July 25, 2011

More and more physicians are choosing to incorporate their practices.

Key Points

Corporations are classified in several ways, each with its own legal and tax consequences. As a doctor, you need to know about the personal service corporation (PSC). That's because, under some circumstances, the Internal Revenue Service (IRS) has the right to designate your incorporated practice as a PSC-and possibly tax it at a higher rate than other forms of corporations.

THE ROOTS OF PSCs

Professional corporations began at a time when physicians, lawyers, accountants, and other licensed professionals operated almost exclusively as sole proprietorships or partnerships, and they were taxed at a higher rate than corporations.

To rectify that, Congress and the IRS began allowing professionals to incorporate and thereby enjoy the same tax advantages as corporations, although without the benefit of a corporation's limited liability.

The lines between the different forms of business organizations have blurred in recent years, however, as more tax advantages have become available to sole proprietorships and partnerships and more liability protection has been granted to professional corporations.

As greater numbers of professionals incorporated for the sole purpose of sheltering income, Congress subsequently reduced the incentive to incorporate as "qualified professional services corporations" and taxing them at a flat rate of 35%.

HOW THEY DIFFER

As noted previously, every PSC is a professional corporation, but not every professional corporation is a PSC.

According to the IRS's rules, for a business to be considered a PSC it must be organized under state law and then pass two federal tests: the function test and the ownership test. The function test requires that substantially all (95%) of the business activities of the corporation involve services within specific occupations in the fields of health, law, engineering, accounting, actuarial science, consulting, or performing arts.

The ownership test requires that substantially all the professional corporation's outstanding stock be held directly or indirectly by qualified people, defined as either (1) employees who are currently performing professional services for the corporation; (2) retired employees who did so prior to their retirement; (3) their heirs or estates.

Thus, for example, if a doctor has non-medical business activities under his or her practice's corporate umbrella, such that less than 95% of the corporation's activities are related to medicine, the corporation is not considered a PSC. A professional corporation organized under state law that does not qualify as a PSC is treated as a general partnership for federal tax purposes.

THE TAX CONSEQUENCES OF BEING A PSC

PSCs are taxed like regular "C" corporations but, as noted previously, at a flat 35% rate rather than at a graduated rate, depending on the level of income earned. The PSC files a corporate tax return and issues a form K-1 to all shareholder/employees to show their individual shares of the corporation's profit or loss. Any income retained in the PSC is subject to the corporate tax rate, whereas any salaries paid to employees are considered tax-deductible business expenses.

Like most small corporations, PSCs are likely to pay out all income earned by the business to shareholders in the form of salaries, bonuses, and fringe benefits, thus reducing corporate taxable income to $0. Of course, the shareholder/employees still must pay personal income taxes on the income they receive.