Carefully evaluate your practice’s status as a personal service corporation
It can provide tax benefits and liability protection, but beware of IRS interpretation.
Mark E. Battersby
Many optometrists incorporate their practices for various actual or perceived benefits, such as limited liability, continuity of life or fringe benefits. However, an optometric practice where substantially all of the stock is held by employees performing services is taxed at a flat 35% tax rate, not the gradated rate generally afforded corporations.
Identifying certain professional practices as qualified professional services corporations and taxing them at a flat rate of 35% was our lawmakers way of reducing the incentive for professionals to shelter part of their income in a corporate form with a lower marginal rate.
However, personal service corporations (PSCs) remain popular because they afford optometrists and other professionals protection against many forms of liability and continue to provide tax benefits.
Incentive for incorporating
PSCs date back to a time when the top tax rate for individual income was much higher than the rate for corporations. This provided an incentive for many professionals to incorporate their practices to win the benefits available to employers or corporations. PSCs remain popular today because they afford professionals protection against various forms of vicarious liability.
There is no one definition of a PSC in the tax law. In general, however, PSCs are corporations whose principal activity is the performance of personal services, typically the performance of services by employee-owners. A certain amount of the stock of a corporation must be owned by the employee-shareholders for it to be considered a PSC, and the ownership test requires almost all of the stock to be held directly or indirectly by employees performing services for the corporation, retired employees, the estate of aforementioned individuals or individuals who acquired stock on the death of the aforementioned individuals.
A qualified PSC where at least 95% of the stock is owned by those performing the personal services cannot use the regular C corporations graduated tax rates. Instead, a flat tax rate at the highest marginal rate (currently 35%) must be used.
As mentioned, optometric practices providing personal services often incorporate to provide limited liability for the individual shareholders. The practice may wish to remain a regular corporation to take advantage of certain fringe benefits not available to S corporations or LLCs. However, because of the stiff 35% flat tax on PSC taxable income, incorporated practices will generally try to distribute all profits in the form of wages to the employee-shareholders performing the services. This, in effect, can eliminate the negative results caused by the flat 35% tax.
Remember, however, that the IRS frequently challenges the amount paid as wages to employee-owners of PSCs. The agency tries to reclassify wages as dividend distributions under the premise that the wages are not reasonable. If successful, the IRS reclassification can result in an increase in taxable income because dividend distributions are not deductible by the corporation.
Professionals in group practices are often concerned about liability exposure for the malpractice of their co-owners. Although a PSC, LLC or S corporation can shield a professional from claims against his or her personal assets, the assets inside the business are still at risk. For this and many other reasons, professionals often form multiple PSCs when in a group practice arrangement.
Generally, each professional forms a separate PSC in which the individual professional owns 100% of the stock. The overall group practice can then be organized as a firm under one of the methods outlined in the accompanying chart.
The tax rules are quite clear: If substantially all of the services of a practice are performed for, or on behalf of, another corporation, partnership or other entity, and the principal purpose for forming or using the incorporated practice is the avoidance or evasion of income tax by reducing income or securing the benefit of any expense, deduction, credit, exclusion or other allowance for any employee-owner that would not otherwise be available, then the IRS can allocate all income, credits, exclusions or other allowance between the PSC and its employee-owners in order to prevent tax evasion or avoidance or to clearly reflect the income of both.
A PSC is subject to special tax rules, including the ability to use the cash method of PSC. Also, if dividends are not paid regularly, and earnings are retained, it could become subject to the accumulated earnings tax.
Because they are separate entities, incorporated practices pay tax at the corporate level, with shareholders paying personal taxes on any profits distributed. To enforce the double taxation of regular C corporations, the IRS is permitted to impose a tax on any earnings accumulated in excess of business needs. Exempted from the accumulated earnings tax is the first $250,000 of accumulated earnings unless the earnings come from the performance of services in the field of health, law, engineering, architecture, accounting, actuarial services, performing arts or consulting. PSCs need to distribute earnings in excess of only $150,000 and/or have acceptable business reasons for the accumulated profits.
In addition, in some circumstances, the IRS is empowered to re-allocate income and deductions between the corporation and its shareholders. To avoid the reclassification, the PSC should be set up so that tax avoidance is not the primary reason for its formation. Other possible risks include a determination by the IRS that compensation to employee/shareholders is unreasonable, or the passive activity loss or the at-risk rules apply.
Although the definition of a PSC is fairly straightforward, Congress has taken this basic definition, modified certain aspects of it and applied it in a number of different settings. In spite of complex and intricate compliance requirements and greatly reduced tax benefits, the use of the PSC is still popular, but for non-tax reasons.
Professional athletes and entertainers as well as many optometrists and other professionals have long benefited from the PSC entity. Offsetting the risk of having the IRS unexpectedly and expensively re-label the optometric practice as a PSC, there are many benefits to operating as a PSC. However, avoiding the potential pitfalls that might result in higher taxes requires careful tax planning and, because the rules are highly technical, the services of an experienced professional are advisable.
Whether to avoid having the optometric practice labeled as a PSC by the IRS, whether to reap its many tax benefits or merely because it affords some protection against liability, the pros and cons of a PSC entity deserve careful consideration.
- Mark E. Battersby can be reached at P.O. Box 527, Ardmore, PA 19003-0527; (610) 789-2480; MEBatt12@earthlink.net.