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Is Your Healthcare Entity a Personal Service Corporation?

A qualified personal service corporation (PSC) is a specific type of C Corporation, providing personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. Many entities currently classified as PSCs could see substantial tax savings if they elect to convert to a flow-through S Corporation. The IRS classifies a PSC as a C Corporation where 95 percent of the work performed is in personal services, and 95 percent or more of the stock by value is held directly by employees providing these services or by retired employees who provided these services during their tenure.

The PSC rules are a result of the tax structure prior to the Tax Reform Act of 1986, when individual tax rates were much higher than corporate rates. At that time, many individuals performing personal services formed corporations so that income was taxable to the corporation and therefore subject to the substantially lower corporate tax rate. To mitigate the tax savings by personal service professionals incorporating, PSC restrictions were put into place and a flat 35 percent tax imposed on PSC income. This flat PSC tax differs from the graduated tax rates normally levied on a C Corporation. In general a flat tax is seen as unfavorable however during the 1970s and 1980s, the 35 percent PSC flat rate was still very favorable versus the high individual income tax rates at the time.

This situation changed in the following decade, as the maximum individual income tax rate dropped from 70 percent in 1980 to 28 percent in 1990. The top rate has stayed level for the last eight years at 35 percent. As a result of this trend toward lower individual tax rates, the incentive for personal-service-provider owners to continue as a PSC in order to benefit from a material income tax rate differential has been eliminated. There are many tax implications that should be reviewed by the PSC owners and their advisers to ascertain if the PSC structure still makes financial sense or if an S election should be made to create a flow-through entity going forward.

In addition to the flat tax rate of 35 percent, PSCs have many tax disadvantages in comparison with S Corporations. Dividends paid to the employee-owners are subject to double taxation; income is first taxed at 35 percent for the corporation, and then taxed again on the individual’s return as a dividend (currently 15 percent for qualified dividends). As a result, PSC owners want to decrease the potential pool of doubled-taxed income to close to zero, often by increasing the amount of salaries paid to the employee-owners. If there is a large amount of compensation with little or no dividends paid to employee-owners, the IRS may recast some of the compensation as taxable dividends, which would then be subject to double taxation. Interest and possibly penalties would also be added to this amount.

Conversion from a PSC to an S Corporation may provide considerable tax advantages while maintaining the limited liability advantages of incorporation. By electing to become a flow-through entity, the issue of double taxation is eliminated. Also, the personal-service-provider owners would be taxed using graduated individual income tax rates as opposed to the flat 35 percent PSC tax.

One of the most often overlooked tax-planning issues related to PSCs is the tax implications of selling the entity at a future date. In addition to the previously mentioned issue of double taxation, there is also not a favorable long-term capital gains rate for C Corporations as there is for individuals. If a C Corporation has an asset sale, any capital gain is taxed at 35 percent, and the remaining cash distributed out to the owners will be taxed again at dividend rates. Any capital gain for an S-Corporation asset sale would be taxable to the individual owners, allowing for a favorable (currently 15 percent) long-term capital gains rate.

When converting from a C Corporation to an S Corporation, the advantages are not all immediately available; judicious tax planning now can reap substantial benefits in the coming years. Corporations that convert to an S Corporation from a C Corporation are subject to a built-in gains tax, which is applicable for 10 years after conversion. Any gain on sale is taxed as though the Corporation were a C Corporation up to the value in place at conversion. Any residual value would then be taxed as an S Corporation that flows through to the owners. The built-in gain would be zero if the S election had been made at the time of incorporation. To start the clock on built-in gains, it is best to convert to an S Corporation earlier rather than later, and ideally to wait until the built-in gains tax is no longer applicable before the entity is sold.

There are many advantages to converting from a PSC to an S Corporation. Please consult your tax advisor to see if an S Corporation election is right for your PSC.

For further information, please contact Leslie Shoemaker at lshoemaker@BlackmanKallick.com or 312-980-3303, Gina Mastrangeli at gmastrangeli@BlackmanKallick.com or 312-980-3355, or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.