Personal Service Shock

Today TaxMama hears from Mitchell in the Tax Parlor who just made a disturbing discovery. “I’m in the investigation process of setting up a corporation, S or LLC, for my one-man engineering business. Then I come across this category for Personal Service Corporation (PSC), whose definition includes engineering, but appears to be different than an S Corp. What is it, and would I still be able to be set up as an S Corp or LLC as far as the Feds are concerned? The IRS publication I was reading said that a PSC would be taxed at a flat rate of 35% as opposed to 15% for the first $50K of taxable earnings, although I intend to take out most of the earnings in salary or dividends. Why the higher tax rate?”

Dear Mitchell,

You’ve done quite a bit of investigating. But you haven’t learned the why of the higher rate? Who knows! Congress dreams these things up. Typically, because of abuse by some category of taxpayers – in this case, professionals. (I’ll provide a link to the explanation and code section, below,)

As long as you make sure to wipe out your profits within a C corporation, you won’t have any problem with the 35% rate, if you decide to use that entity. The advantage to a C corporation is that as an owner, you’re still eligible to take deductions for your own employee benefits. You can’t do that in an S corporation.

Naturally, if you decide to be an LLC filing as a S corporation or partnership, you won’t have that problem. Why naturally? S corps and partnerships pay no Federal taxes at all. Some state do tax these entities, or charge fees, like California. So don’t overlook researching your state’s entity costs.

You can find the state tax sites here

It’s precisely because there are so many variations on how to use entities that I urge you to consult with a good, local tax professional who understands how they work, and can take your long-term plans into consideration.

I know, it’s boring. I’ve said it before. But if you plan to have a lucrative business, getting it right in the first place will not only save you thousands of dollars a year; it will ensure that your business prospers and becomes marketable, when you’re ready to sell it.

And remember, you’ll find answers to lots of questions about business entities and other tax information, free. Where? At

In order to be considered a qualified personal service corporation under Section 448(d)(2) of the Internal Revenue Code, Section 1.448-1T(e)(3) of the temporary regulations provides that a taxpayer must meet two tests, the “function test” as set forth in paragraph (e)(4) of section 1.448-1T, and the “ownership test” of paragraph (e)(5) of section 1.448-1T. The function test under the statute provides that a corporation is a personal service corporation if substantially all of the corporation’s activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.

IRC 448(d)(2)

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  • IRC 448(d)(2) :: Personal Service Corporations (PSC)

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