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Feb 1991

The many faces of a personal service corporation. (includes related case study)

by Young, James C.

    Abstract- Many of the tax planning advantages of personal service corporations (PSCs) have been eliminated to prevent them from being formed to take advantage of tax breaks that are peculiar to PSCs. However, PSCs remain popular because they afford professionals protection against various forms of vicarious liability. 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 a corporation 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, by retired employees, by the estate of aforementioned individuals, or by individuals who acquired stock on the death of the aforementioned individuals.

A personal service corporation (PSC) generally is a corporation whose principal activity is the performance of personal services, and such services are performed by employee-owners Sec. 269A(b)(1). Congress promulgated Sec. 269A to correct a specific abuse of tax law-- corporations formed to take advantage of retirement planning and other opportunities available only to that type of entity.

Although the above 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. The result is twofold: virtual elimination of the once available tax advantages, and practitioner confusion over the various definitions--for example, understanding when a specific definition applies and for what purpose.

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. For example, CPAs and other professionals may find protection for certain kinds of vicarious liability by operating in a professional corporation, which most likely would meet the definition of a PSC. And so, in spite of expanded Code sections that apply and the diminished benefits provided, today's tax practitioner must be familiar with the taxation of PSCs.



Several different Code sections use the term "PSC," each aimed at a perceived advantage of PSCs. The various definitions and related purposes of these provisions are summarized in Exhibit 1.

A quick walk-through of the exhibit and the IRC sections affecting PSCs is as follows: Sec. 269A relates to PSCs principally formed or availed of to avoid or evade income tax. Such a situation may exist if the corporation performs substantially all its services for one client. The corporation's services must be "substantially performed" by employee-owners. In such circumstances Sec. 269A allows the IRS to allocate income, deductions, and credits between the PSC and its employee-owner(s) to prevent the avoidance or evasion of federal income taxes.

Sec. 448(b)(2) allows qualified PSCs to use the cash rather than accrual method of tax accounting. Sec. 11(b)(2) subjects qualified PSCs to a flat 34% tax rate. Sec. 441(i) requires PSCs to (generally) use a calendar tax year. Sec. 444(a) allows certain PSCs to elect a tax year other than a calendar year. Sec. 280H requires PSCs to make minimum distributions to employee-owners if the corporation has a Sec. 444(a) election in effect.

Sec. 469(a)(2)(C) subjects PSCs to the passive activity rules. Exhibit 2 summarizes these rules for closely-held C corporations as well as PSCs.



To be deemed a PSC, a certain percentage of the corporate stock must be owned by the employee-shareholders. The percentage varies depending upon which PSC section is applicable.

For Sec. 269A the percentage is more than 10%. Thus, employee-owners are only those who own more than 10% of the stock.

For Secs. 11(b)(2) and 448(b)(2) the percentage is substantially all. Reg. Sec. 1.448-1T(e)(5)(i)(D) defines substantially all as 95% or more. Thus, any amount of stock owned by an employee is counted, but on a combined basis employee-shareholders must own at least 95%.

For Secs. 441(i), 444(a), and 469(a)(2), the percentage is any stock owned and more than 10% combined employee-shareholder ownership. Thus, any stock owned by an employee is counted, but on a combined basis employee-shareholders must own more than 10%.

Attribution Rules

Direct and indirect stock ownership is used to determine how much stock an employee-shareholder owns. The Sec. 318 related taxpayer rules are used for Secs. 269A, 280H, 441(i), 444(a), and 469.

Under Sec. 318(a)(2)(C) stock of a corporation (corporation 2) owned by another corporation (corporation 1) is not owned indirectly by corporation 1's shareholder unless the shareholder owns (directly or indirectly) 50% or more of corporation 1's stock. Sec. 269A also uses this approach, but replaces the 50% threshold with 5%.

Secs. 280H, 441(i), 444(a), and 469(a)(2)(C) use the Sec. 318(a)(2)(C) approach, but replace the 50% or more threshold with any stock ownership.

Note: Watch out for the dual use of indirect ownership. The taxpayer may have indirect ownership in entity 1 and then entity 1 may own an interest in entity 2. The taxpayer may have an indirect interest in entity 2 via the taxpayer's ownership (direct and/or indirect) in entity 1.

Example 1: Jones owns 3% directly and 20% indirectly of Entity 1. Jones owns 35% directly and Entity 1 owns 18% directly of Entity 2. Assume Entity 2 is a potential PSC. Jones is an employee of Entity 2 and performs personal services on behalf of it (see Exhibit 3).

* Under Sec. 318(a)(2)(C), Jones' ownership in Entity 2 is 35%, determined as follows:

Direct: 35%

Indirect: 0% via Entity 1. Jones' direct plus indirect ownership of Entity 1 is 50% or less. Therefore, Entity 1 is ignored in determining Jones' indirect ownership of Entity 2.

* Under Sec. 269A, Jones' ownership in Entity 2 is 39%, determined as follows:

Direct: 35%

Indirect: 4% via Entity 1. Because Jones' direct plus indirect ownership of Entity 1 is 5% or more, Entity 1 is used to determine indirect ownership. Therefore, Jones owns 4% (3% + 20%) X 18% of Entity 2 indirectly.

* For purposes of Secs. 280H, 441(i), 444(a), 448(b)(2), and 469(a)(2)(C) Jones' ownership in Entity 2 is also 39%, determined as follows:

Direct: 35%

Indirect: 4% via Entity 1. Because Jones has a direct or indirect interest in Entity 1 (i.e., any stock ownership), Entity 1 is used to determine indirect ownership. Therefore, Jones owns 4% (3% + 20%) X 18% of Entity 2 indirectly.

Secs. 11(b)(2) and 448(b)(2) do not use Sec. 318 to determine stock attribution. Instead, a potential PSC's stock is held indirectly by a person if, and to the extent, such person owns a proportionate interest in a partnership, S corporation, or qualified PSC that owns stock in the potential PSC Reg. Sec. 1.448-1T(e)(5)(iii). No other arrangement or type of ownership constitutes indirect ownership of the potential PSC's stock. There is no indirect ownership via a spouse, even in community property states.

Example 2: ConsultServ, Inc., is a potential PSC. Bob Ikawa is a 20% shareholder and the only employee of ConsultServ, Sue Ikawa (Bob's wife), is a 10% shareholder, and Investment Partnership is a 70% shareholder. Bob is a 35% partner in Investment Partnership. See Exhibit 4.

1. Bob owns directly 20% and indirectly 25% (70% X 35%) of ConsultServ. ConsultServ is not a PSC for Secs. 11(b)(2) and 448(b)(2) purposes because 95% or more of its stock is not owned by employee- shareholders.

2. Thus, ConsultServ would not be subject to the 34% flat tax but would check the PSC box (Line C) in the upper left hand corner of page one, Form 1120. Also, ConsultServ would not qualify to use cash basis accounting under the Sec. 448(b)(2) PSC exception. (However, it might be eligible for the Sec. 448(b)(3) $5 million or less gross receipts exception.)

Example 3: Assume the same facts as Example 2, except ConsultServ is a medical PC. Bob Ikawa would be the 100% shareholder because state professional corporation law would not allow his wife or Investment Partnership to be shareholders. In such a typical case, ConsultServ is subject to all of the PSC-related provisions.





Sec. 11(b)(2), added by RA 87, denies graduated corporate tax rates to qualified PSCs as defined in Sec. 448(d)(2). That definition requires corporations to meet two tests--a function test Sec. 448(d)(2) (A) and an ownership test Sec. 448(d)(2)(B).

Function Test

The function test requires substantially all activities of the corporation to involve performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting Sec. 448(d)(2)(A).

Reg. Sec. 1.448-1T(e)(4)(i) states that a corporation meets this test only if 95% or more of the time spent by its employees is devoted to the performance of services in one of the qualifying fields as noted above. For purposes of determining whether this 95% test is satisfieid, the performance of any activity incident to the actual performance of services in a qualifying field is considered the performance of services in that field. Activities incident to the performance of services in a qualifying field include the supervision of employees engaged in directly providing services to clients, and the performance of administrative and support services incident to those activities.

It is, therefore, possible to avoid the qualified PSC classification by restructuring the corporate activity, taking advantage of this "function test" under Sec. 448(d)(2)(A). The corporation will be a qualified PSC only if 95% or more of the time spent by employees of the corporation is devoted to service in qualifying fields.

Example 4: A medical corporation occupying one-third of a complex of professional offices decides to purchase the complex. If the result is that more than 5% of the total time of its employees thereafter was devoted to managing and maintaining the property, the corporation would fail the function test. The corporation would not be subject to the Sec. 11(b)(2) 34% flat tax and would not be eligible for the PSC cash basis accounting exception.

Ownership Test

The ownership test requires substantially all of the stock (by value) to be held directly (or indirectly through one or more partnerships, S corporations, or C corporation qualified PSCs) by the following:

1. Employees performing services for the corporation in a field detailed in the function test;

2. Retired employees who had performed such services for the corporation;

3. The estate of any individual described in (1) or (2); or

4. Any other person who acquired stock by reason of the death of an individual described

in (1) or (2), but only for the two-year period beginning on that individual's date of death.

Reg. Sec. 1.448-1T(e)(5)(i) defines the term "substantially all" as 95% or more. The regulations, therefore, require that 95% or more of the corporation's stock (in value) be owned by active corporation employees. In other words, it is also possible to retain the graduated rates (but lose the cash basis) by having just over 5% of the stock (in value) owned by non-employees.

Was it a Mistake?

Many practitioners are bothered by the idea that an organization that was clearly a PSC within the meaning of Sec. 441(i), which governs the taxable year, could so easily retain the graduated rates. Some feel that the reference to Sec. 448(d)(2) in Sec. 11(b)(2) was unintentional. They argue that Congress should retroactively change the law to cross- reference Sec. 441(i) instead.

The response to this "wrong Code reference" concern lies in understanding Congressional shaping of the various PSC provisions. In TRA 86, Congress defined two categories of PSCs. One category was allowed to retain the cash basis of accounting. It was narrowly drawn because Congress wanted to limit the availability of this method. The second category of PSCs was denied the right to use a fiscal year. It was broadly drawn, to force most PSCs onto a calendar year. In denying graduated rates, Congress had a choice of PSC definitions from which to choose. Congress purposely chose the narrow definition of a PSC. Also, many PSCs do not need to meet the narrow definition in order to retain the cash basis of accounting. They have less than $5 million in gross receipts and are, therefore, permitted the cash basis in any event.

Other practitioners point to Sec. 448(d)(8), added by TAMRA 88, which states that:

"...the secretary shall prescribe such regulations as may be necessary to prevent the use of related parties, pass-thru entities, or intermediaries to avoid the application of this secton."

This anti-abuse provision allows regulations to be promulgated to deal with devices aimed at "avoid(ing) application of this section." But application of Sec. 448 is to ban the use of the cash method, and the created devices authorized to be stopped by regulation would be those devised to allow the cash method when the 95% ownership test is not really met. The Senate explanation makes it clear that these are regulations to counter attempts "to avoid the application of the rules denying the use of the cash method of accounting."

Other commentators state that Sec. 269A could apply and allow the IRS to deny graduated rates when a corporation has consciously structured itself to fail the Sec. 448(d)(2) definition. However, Sec. 269A really has very limited applicability. It only comes into play when substantially all of the services of a PSC are "performed for (or on behalf of) one other corporation, partnership, or other entity."

The statutes and their legislative history clearly indicate it is possible for many PSCs to retain the graduated rate structure.



One of the most important PSC provisions is the Sec. 441(i) definition, because it controls the required tax year. As will be seen, the rules requiring the use of a calendar tax year are less stringent than those that require the use of the 34% flat tax and permit the use of the cash basis. Specifically, for purpose of Sec. 411(i), a corporation is a PSC for a taxable year if Reg. Sec. 1.441-4T(d)(1):

1. The taxpayer is a C corporation as defined in Sec. 1361(a)(2) for the taxable year;

2. The principal activity of the taxpayer during the testing period is the performance of personal services.

3. During the testing period for the taxable year, the personal services are substantially performed by employee-owners; and

4. Employee-owners own more than 10% of the fair market value of the outstanding stock in the taxpayer on the last day of the testing period.

If a corporation is a member of an affiliated group filing a consolidated return, all members of the group are taken into account in determining whether the corporation is a PSC.

Testing Period

The testing period is the taxable year preceding the current year Reg. Sec. 1.441-4T(d)(2).

Personal Services

The Sec. 441 regulations adopt the Sec. 448(d)(2)(A) definition of personal services. Therefore, C corporations affected are those whose principal activity is the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting Reg. Sec. 1.441-4T(e)(1). The regulations deal with three of the eight fields--health, performing arts, and consulting.

Health. According to the regulations, the performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and other similar health-care professionals. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.

For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers.

Performing Arts. The performance of services in the field of performing arts means the provision of services by actors, actresses, singers, musicians, entertainers, and similar artists in their capacity as such. The performance of services in the field of the performing arts does not include the provision of services by persons who themselves are not performing artists (e.g., persons who may manage or promote such artists, and other persons in a trade or business that relates to the performing arts). Similarly, the performance of services in the field of the performing art does not include the provision of services by persons who broadcast or otherwise disseminate the performances of such artists to members of the public (e.g., employees of a radio station that broadcasts the performances of musicians and singers). Finally, the performance of services in the field of the performing arts does not include services by athletes.

Consulting. Although each category has its own peculiartieis, the consulting category is the most difficult to pin down. What does consulting mean? It is defined as "the provision of advice and counsel." The Sec. 448 temporary regulations lay great stress on whether compensation "is contingent upon the consummation of the transaction that the services were intended to effect." Thus,

computer consulting would be consulting if compensation were fee-based, but would not be if compensation was a commission on hardware and software purchased by clients.

Legal and Accounting Services. What are legal and accounting services? Many law and accounting firms perform more than legal or accounting services. What if a CPA firm also renders business appraisal services? Are these accounting services? If not, are they consulting services? Given that most or all such services are performed by the CPA firm as such, nd the reports go out on the letterhead of the CPA firm, it seems likely that these will be deemed accounting services.

Yet, at the same time, an appraisal firm would certainly not be rendering accounting services--and might not be rendering consulting services, either, because it may be providing an expert opinion (that is, a valuation) for third party use and not advice and counsel to its client.

Similarly, some law firms engage in activities such as putting together real estate syndications or arranging business combinations, that are not strictly the practice of law, but are usually done under the umbrella of the law firm. While the activities themselves, in a separate organization, would not be the practice of law and probably not be consulting because of the compensation structure, again they are apt to be swept up into the legal services portion of what is being done. The regulations contain 10 examples to help define the term consulting. Four of those examples conclude that the taxpayer is in the business of consulting. The common thread that runs through these examples is that the taxpayer advises a client, and the taxpayer's compensation is not contingent on the consummation of the transactions the services are intended to effect.

Principal Activity

Principal activity occurs when the compensation cost attributable to the personal services exceeds 50% of total compensation cost for the testing period Reg. Sec. 1.441-4T(f). Note that this 50% test is a broader test than the 95% function test for qualified PSCs under Sec. 448(d)(2), and will force PSCs other than qualified PSCs onto a calendar year.

Compensation Cost

The compensation cost is equal to the sum of the following amounts-- whether allowable as a deduction, allocated to a long-term contract, or otherwise chargeable to a capital account by the corporation during the taxable year Reg. Sec. 1.441-4T(f)(2):

* Wages and salaries; and

* Any other amounts attributable to services performed for, or on behalf of, the corporation by a person who is an employee of the corporation (including an owner of the corporation) during the testing period.

Comment. According to the regulations, these other amounts include (but are not limited to) amounts attributable to deferred compensation, commissions, bonuses, compensation includable in income under Sec. 83, compensation for services based on a percentage of profits, and the cost of providing fringe benefits that are includable in income. Compensation cost does not include amounts attributable to a plan qualified under Sec. 401(a) or Sec. 403(a), or to a simplified employee pension plan as defined in Sec. 408(k).

Determination of Compensation

Cost When Employee is

Performing Both Personal Service

and Non-Personal Service


The compensation cost for any employee who is not exclusively performing personal service or non-personal service activities ("a mixed activity employee") must be allocated as follows Reg. Sec. 1.441- 4T(f)(3):

* Compensation Cost Attributable to Personal Service Activity. The personal service activity compensation cost for a mixed activity employee equals: the compensation cost for the employee, times the percentage of the total time worked during the year attributable to personal service activities.

Comment: The percentage of time related to personal service activities is determined in any reasonable and consistent manner. Time logs are not required unless maintained for other purposes.

* Compensation Cost Not Attributable to Personal Service Activity. The balance of the compensation cost for a mixed activity employee is deemed to be not attributable to the personal service activities of the corporation.

Substantially Performed

Just as principal activity is related to compensation, so, too, is substantially performed activity.

The Test. If more than 20% of the C corporation's compensation cost for the prior year attributable to personal service activities is attributable to personal services performed by the shareholders, then the substantially performed test is met Reg. Sec. 1.441-4T(g)(1). While 20% looks easy to escape, it often is not. If shareholders have average billing rates of $150, while staff billing rates average less than $75, for instance, a time-based test would be easier to avoid than one based on compensation.

Example 5. Engineering Concepts, Inc., has two shareholders (Bob and Susan), both of whom work full-time for the company. There are 15 other employees. Bob manages the engineering services portion of the company's operation. Susan manages the software development and sales portions of the company's operation. The software is not developed for or sold to engineering services clients of the company. The chart below summarizes the time and compensation cost for the company.

* 50% Principal Activity Test: $1,065,000 / $1,065,000 + $445,000 is greater than 50%

Personal services comprise more than 50% of the compensation cost of the company.

* 20% Substantially Performed Test:

Shareholder-Employee Personal Service Cost / Total Personal Service Compensation Cost = $215,000 / $1,065,000 is greater than 20%

Engineering Concepts, Inc., is a PSC for purposes of Sec. 441(i). However, Engineering Concepts is not a qualified PSC under Sec. 448(d)(2) because only 76.1% of time spent by employees 26,100/(26,100 + 8,200) were devoted to a qualifying field (engineering).

Note: If the 20% substantially performed test was based on hours, this test would be met 1,800 + 300)/26,100 = 8.05% and the taxable year restriction would not exist.

In the explanation released as part of the temporary regulations, the IRS comments that:

"In the process of drafting the temporary regulations, the Service received many informal comments relating to the appropriate percentage for determining 'substantially performed.' Most of the commentators suggested that the term 'substantially' should be interpreted as 'substantially all.' 'Substantially all' would imply a very high percentage of services performed by employee-owners whereas 'substantially' would imply a lower percentage. Given that the term 'substantially' is used in the Code rather than the term 'substantially all,' the temporary regulations use 20% as the threshold for determining whether services are substantially performed by employee-owners."

The Sec. 448 regulations use 95% as the level for ownership of substantially all of the corporation's stock. There is much discussion about the 1982 history of Sec. 269A, which is where "substantially performed" first appeared. The 20% level chosen by the IRS seems to be grossly inappropriate in the context of Sec. 269A's history and purpose in using the phrase "substantially performed." In the conference report on TEFRA (p. 633), the corporations to be affected by Sec. 269A were described as those "the principal activity of which is the performance of personal services substantially all of which are performed by employee-owners for or on behalf of another corporation, partnership, or entity."

Sec. 441(i) is not concerned with whether substantially all of the services are being performed for one other entity, but is concerned with whether substantially all the services are being performed by owner- employees. The prime purpose of Sec. 269A, as stated in the conference report itself, was to "overturn the result reached in cases like Keller v. Commr., 77 TC 1014 (1981)," where one-person professional corporations were obtaining tax benefits for their sole stockholders. Given that purpose, an explanation of the meaning of "substantially performed" hardly seems justified.

It seems that the IRS may be wrong on this point and is still equating "substantially performed" with "a substantial portion of which is performed," which is not meaningful in the context of Sec. 269A. Many commentators say something like 70% would better fit the idea of what would be consistent with Sec. 269A.

The following case problem serves as a vehicle for exploring many of the PSC issues raised in this article.


Although originally intended to correct a specific abuse of tax law, Congress has used modified versions of the original personal service corporation definition to combat other perceived abuses by these entities. Practitioners must be prepared to deal with each of the definitions, and, given a specific situation, know which definition applies.

Steven C. Dilley, PhD, CPA, is Professor at Michigan State University where he teaches tax accounting. He is a member of the Wisconsin Bar Association, American Bar Association, AICPA, AAA Wisconsin Institute of CPAs, Michigan Association of CPAs, Hawaii Association of Public Accountants, and American Taxation Association. Dr. Dilley is also President of the Federal Tax Workshops, Inc., which prepares continuing education materials and presents continuing education programs for accountants and attorneys. He has published numerous articles on those topics.

James C. Young, PhD, CPA, is Associate Professor of Accounting and Director of the Graduate Tax Program at Grand Valley State University. He is a member of the AICPA, AAA, Michigan Association of CPAs, and American Taxation Association; and he serves as a director for several small closely-held corporations. Dr. Young is Director of Research for Federal Tax Workshops, Inc., where he oversees the development of course materials. Formerly on the tax staff of Price Waterhouse, he has written articles appearing in The National Tax Journal, Tax Notes, The CPA Journal, and Taxation for Accountants, and continuing proessional education programs in the field of taxation.

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