Benefits of personal services corporations

Because a large number of incorporated veterinary practices involve the services of the practice's principal(s), the ever-vigilant Internal Revenue Service frequently labels them personal service corporations, a designation that a surprising number of veterinarians have not found to be a deterrent.

Identifying certain personal services corporations (PSCs) as "qualified" and taxing them at a flat rate of 35 percent was our lawmaker's way of reducing incentives for professionals to shelter part of their income in a corporate form with a lower marginal rate. However, PSCs remain popular because they afford veterinarians protection against many forms of liability, and they continue to provide tax benefits.

Admittedly, there is the all-too-real possibility that the IRS will use the PSC rules to combat perceived abuses by incorporated veterinary practices. In fact, a recent decision by the U.S. Tax Court should serve as a warning to any veterinarian considering or operating his or her own personal service corporation.

A PSC for every practice

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 professionals to incorporate their practices to win the benefits available to employers or corporations.

Today, this obstacle is easily overcome as the personal service corporation pays the salary of its employee/shareholder. As employees of a corporation, professionals can avail themselves of benefits, such as group term-life insurance, medical reimbursement plans, death benefits and a more generous retirement plan than if they remained self-employed.

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As a regular corporation, the PSC files Form 1120 and pays tax on profits at the entity level. Despite the fact that there is no one definition of a personal service corporation in the tax law, in general, a personal services corporation is a regular or "C" corporation where the veterinary practice's services are performed by proprietors. Personal services are services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting. And, yes, veterinarians are considered healthcare professionals under these rules.

An incorporated veterinary practice with at least 95 percent of the stock owned by those performing the personal services cannot use the regular C-corporation graduated tax rates. Instead, a flat-tax rate at the highest marginal rate (currently 35 percent) is used.

Compensatory issues

As mentioned, veterinary practices that provide personal services often incorporate to provide limited liability for the individual shareholders. The veterinary practice may wish to remain a regular corporation to take advantage of certain fringe benefits that are not available to S-corporations or limited liability companies or partnerships (LLC/LLP). However, because of the stiff 35-percent flat tax on a PSC's taxable income, corporations generally will 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-percent tax.

But remember, the IRS often challenges the amount paid as wages to employee-owners of PSCs. They try to reclassify wages as dividend distributions under the premise that the wage is not reasonable. If successful, the IRS reclassification can result in an increase in taxable income because dividend distributions are not deductible by the corporation.

Group practice

Professionals in group practices are also concerned about liability exposure for the malpractice of their co-owners. Although a PSC, LLC and S-corporation can shield a veterinarian/professional from claims against his or her personal assets, the assets inside the practice are still at risk. For this and other reasons, professionals often form multiple personal service corporations when engaging in group practice.

Generally, each professional forms a separate PSC in which the individual professional owns 100 percent of the stock. Consequently, the overall group practice can be organized as a firm under one of the following methods:

• Each personal service corporation owns a partnership interest in a firm organized as a partnership.

• Each personal service corporation is a member of a firm organized as an LLC.

• Each professional owns stock in an S-corporation. In turn, the S-corporation contracts with the separate personal service corporations for professional services.

PSCs also can provide fringe benefits to veterinarians and other professionals that are not available under an S-corporation, LLC or partnership entities. As with LLCs or S-corporations, assets held in the individual PSC are protected from claims against the firm resulting from malpractice of other professionals in the firm.

Ownership of assets, the hiring of employees and the incurring of various expenses can be done either by the firm or by the individual personal service corporation. This means:

• Professionals have the ability to purchase needed equipment that would not be used by other professionals in the firm, avoiding controversy.

• Independent decision-making is possible in a professional's areas of specialty.

• Discretionary expenses can be allocated to the professional rather than having the expense imposed on the firm as a whole.

• Admitting a new member to the firm would be a tax-free event for the new member.

Legal ramble

In a ruling that applies to all professionals, the U.S. Tax Court recently answered the question of when is a firm not a qualified personal service corporation (QPSC). In this situation, the professional wanted to avoid being labeled a QPSC. The answer, according to the Tax Court, is when the firm's employees spend less than 95 percent of their time on, in this case, accounting and accounting related tasks, even if they are nominally the employees of a financial and investment services firm.

The case of the accountant, which we will refer to as John Jones, began when John Jones, sole owner of John Jones Inc., a well-established accounting and financial services firm, split off the financial advisory business into a new company, Jones Financial Group LLC. This left Jones Inc. selling accounting services exclusively.

The decision to split the firms left Jones in a challenging position, potentially increasing his tax liability if it was determined to be a QPSC. If the accounting firm were not determined to be a QPSC, the split would allow Jones to market his businesses to a wider variety of buyers when he retires.

After splitting its financial consulting services from the accounting business, employees who worked at Jones Financial continued to receive paychecks drawn on Jones Inc., the accounting firm, continued to receive benefits provided by Jones Inc. and continued to have their Social Security tax paid for by Jones Inc. They had worked at Jones Inc. at the start of the year, and those working on financial services during the year were told to do so by Jones Inc. Jones Financial even reimbursed Jones Inc. for their wages, taking a deduction while Jones Inc. reported those reimbursements as income.

The Tax Court noted that merely allocating the costs of Jones Inc. employees to Jones Financial does not make them Jones Financial employees. The taxpayer and the IRS stipulated to a breakdown of Jones Inc.'s employee hours into two categories: hours spent on accounting and consulting services and hours spent on investment services. Since the hours spent were less than the 95 percent requirement for a qualified personal service corporation, the Tax Court ruled the taxpayer was not subject to the special tax.

Remember, the tax rules are quite clear: "If substantially all of the services of a personal service corporation are performed for or on behalf of one other corporation, partnership or other entity, and the principal purpose for forming or using the personal service corporation 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 personal service corporation and its employee-owners in order to prevent tax evasion or avoidance or to clearly reflect the income of both."

The IRS may attempt to disregard the solely owned personal service corporation and allocate all income to its sole employee/shareholder. To avoid the reclassification, the PSC must be set up so that tax avoidance is not the primary reason for the organizational structure. Also, keep in mind that the relationship between the individual professionals and a group practicing as a firm should not have the appearance of an employment arrangement.

Professional athletes, entertainers and many veterinarians and other professionals have long benefited from the professional services corporation entity. Whether structured to benefit from its remaining tax benefits or merely because it affords some protection against liability, the PSC entity deserves careful consideration.

Mr. Battersby is a financial consultant and writer in Ardmore, Pa.