In the face of the 2018 tax reform, many small business owners in the professional services sector have an array of new business tax benefits. For most small business owners who operate under a pass-through business entity like an S corporation or limited liability partnership, the massive overhaul to personal tax provisions also needs to be factored in for business decisions made in 2018.
When it comes to professional services like doctors and attorneys, these major changes to the tax code make it worth examining whether you should reorganize your practice under a different entity type. Personal services corporations (PSCs) are something to consider if you are not already mandated to operate as one.
What is a PSC and How Does It Differ From Regular Corporations?
PSCs are for professionals in health, law, architecture, accounting, actuarial science, engineering, consulting, and the performing arts and intended for owner-operators who are considered employee-owners. It’s a type of C corporation where more than 10% of the voting stock is held by professionals in any of the above fields who are providing these services. 95% of the stock must be held by the corporation’s employees (including employee-owners), retired employees, estates of both current and retired employees, or inheritors of the stock (within two years of the original stockholder’s death.) If you plan to wind down your current practice and reincorporate, your new practice would likely be classified as a PSC opposed to a normal C corporation if the conditions above apply.
What makes a PSC more attractive than pass-through entities is that it gets most of the same benefits as normal C corporations do in that the owners get tax-free fringe benefits which are deductible to the corporation. Salaries and bonuses are also deductible and any cash that hasn’t been paid out in owner salaries can sit on the books to be reinvested (unlike operating as a pass-through where the owner’s entire share of profit is taxed regardless of actual cash distributions.)
To make up for the loss in personal income tax revenue resultant of these major benefits, the IRS eliminated the graduated tax brackets for corporations so PSCs are always taxed at the maximum corporate rate. It was 35% until the tax reform bill passed. With the highest corporate tax rate at 21% now, and the top three personal income rates now 32%, 35%, and 37%, it’s certainly worth weighing the costs and benefits of converting your practice to a PSC if you were operating as a pass-through business.
The Pass-Through Entity Deduction
This new deduction for owner-operators of pass-through businesses primarily intends to reward new business owners and middle-income professionals. For professional services that are just starting out or operating on a small scale, operating as a pass-through business like a sole proprietorship or S corporation hasn’t completely lost its attractiveness in the face of the drastically-reduced maximum corporate tax rate.
To qualify for the pass-through deduction which is worth up to 20% of the profits, your total taxable income must be under $157,500 ($315,000 if married filing jointly) to have no additional requirements for the full benefit. If your income is between $157,500 and $207,500 (between $315,000 and $365,000 if married filing jointly), the amount of the deduction has a phaseout range and there are two additional limitations. One of them automatically disqualifies a majority of professional practices with the exception of engineers, in that the chief product or service can’t be your skills and/or reputation. The other limitation is based on a required investment formula based on 25% of W-2 wages paid to your employees and 2.5% of qualified business property. Qualified business property would be any assets in the 10-year class or higher such as furniture and fixtures and commercial real estate. If you have no or few employees and qualified business property, the deduction is also nullified. Once your income is above $207,500 ($365,000 if married filing jointly), there is no deduction.
While the pass-through deduction will reduce income taxes, the full profit or share of profit is still subject to self-employment tax for partnerships and sole proprietorships. S corporation profits are still exempt from self-employment tax.
Is Reorganizing As a PSC Worth It?
Using the figures from the pass-through deduction’s eligibility guidelines, PSCs are presenting colossal tax savings that they might not have in the past. Under the new tax rates, a single professional with a taxable income of $250,000 would be taxed at the 35% bracket and a married couple with the same income would be taxed at 24%, but only pay 21% with a PSC. Additionally, for 2018 the 15% tax rate for dividend income begins at $38,600 for single taxpayers, $51,700 for heads of household, and $77,200 for married taxpayers filing jointly. The 20% dividend tax rate begins at $425,800 for single professionals, $452,400 for heads of household, and $479,000 for married couples filing jointly.
Many entrepreneurs and self-employed professionals opt for S corporations to save on self-employment tax as the profits are not subject to it unlike a sole proprietorship or a partnership. But unlike S corporations, PSCs are not subject to reasonable compensation rules. If your salary is considered unreasonably high to get a deduction however, the excess portion can be reclassified as a dividend (lower tax rate at the personal level but no deduction at the corporate level.) In spite of these limitations, the lower tax rates on dividends and corporate income are making PSCs a more attractive option. While there may be higher administrative burden in having a PSC since it’s still a C corporation that also has additional limitations in place for what makes it a qualifying PSC, it can be worth it to avoid both self-employment taxes operating as a sole proprietor and the reasonable compensation rules that apply to S corporations.
If your practice is new or on a small enough scale to the point that you will qualify for the pass-through benefit, it would be prudent to operate as an S corporation to save on self-employment tax and reap the benefit of this new deduction. If you’re looking to hold onto your earnings to reinvest in new equipment, training, or other major investments in your career, that’s also when you should consider moving to a PSC.
Ultimately, reincorporating as a PSC depends on both your personal and business financial needs and which types of taxes you are specifically trying to avoid. Operating as a PSC is certainly starting to look more attractive. This is especially so given the major reduction to the highest corporate tax rate. If your income falls into or above the phaseout range for the pass-through deduction and you don’t have enough personal tax benefits to offset your taxable income, reorganizing as a PSC would result in major tax savings especially if your income remains steady or increases through 2025.