# Understanding Personal Service Corporations and Their Taxation

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## What Is a Personal Service Corporation?

A personal service corporation (PSC) is a type of business entity recognized by the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) that's created to provide personal services directly to clients. These services typically include fields like accounting, health, law, consulting, engineering, and other specialized professions.

Under IRS rules, PSCs are taxed at a flat 21% corporate rate, and they must meet criteria such as having employee-owners who perform most of the company's services. Forming a PSC can offer tax advantages and organizational benefits, but it also comes with strict compliance requirements and potential drawbacks if IRS rules aren't followed.  

### Key Takeaways

*   Personal service corporations offer professionals in specified fields like accounting and health a corporate structure that combines a flat 21% tax rate with the benefits of limited liability and potential corporate tax deductions.
*   To qualify as a personal service corporation, at least 95% of work hours must be spent on qualified activities, and employee-owners must collectively perform at least 20% of these services themselves.
*   To comply with IRS regulations, employee-owners must also own more than 10% of the corporation's stock at the end of the initial one-year testing period and align their fiscal year with the calendar year.
*   While personal service corporations offer tax advantages, they are costly and complex to establish, demanding strict adherence to IRS guidelines to avoid audits and penalties.  
    

## Understanding the Functions of a Personal Service Corporation

The services provided by a personal service corporation may include any activity performed in the following fields: accounting, engineering, architecture, consulting, actuarial science, law, performing arts and health, including veterinary services. Financial services activities are not considered qualified services (which is why many financial advisers choose to organize as [S corporations](https://www.investopedia.com/terms/s/subchapters.asp)).

To qualify as a personal service corporation, employee-owners must directly perform 20% of the services. The IRS evaluates this based on the time employees work for the corporation compared to total service hours. For example, if a corporation’s total service hours for a year are 5,000 hours, then the employee-owners collectively need to have provided at least 1,000 of these service hours.

The employee-owners must also own more than 10% of the outstanding stock of the personal service corporation on the last day of the initial one-year testing period. This rule ensures active employees also invest in the corporation.

Employees must spend at least 95% of their work time on qualified services.

## Tax Implications for Personal Service Corporations

Personal service corporations are taxed by multiplying taxable income by 21%. Organizing as a C corporation offers tax benefits, attracting many high-earning professionals. A C corporation lets employee-owners keep earnings in the corporation, taxed at a lower rate than individual [marginal rates](https://www.investopedia.com/terms/m/marginaltaxrate.asp). Professionals may also take advantage of some tax-free fringe benefits, limited liability, and may receive favorable treatment of business deductions.

Such corporations have to comply with certain tax regulations, such as employing a fiscal year that is based on the calendar year and adhering to specific [passive activity](https://www.investopedia.com/terms/p/passiveactivity.asp) regulations. Personal service corporations are not to be confused with professional corporations, which are business entities made up of certain types of professionals under state law.

> **Important**
>
> It’s crucial to weigh the tax benefits against the administrative and compliance requirements of a personal service corporation. While a flat 21% tax rate and potential for corporate deductions may sound appealing, carefully consider the cost complexity of setting one up and maintaining compliance.

## Criteria to Qualify as a Personal Service Corporation

According to the IRS, a person may be considered an employee-owner of a personal service corporation if the following conditions are met:

1.  They are an employee of the corporation or perform personal services for, or on behalf of, the corporation (even if they are an independent contractor for other purposes) on any day of the testing period. (The testing period, generally, is the previous tax year.)
2.  They own any stock in the corporation at any time during the testing period.

If an individual functions as the owner/employee of a personal service corporation and their primary business is related to creative/fine arts or photography, any current expenses they incur pursuant to creative work are deductible for the corporation. However, either the owner/employee or their family members must hold all or nearly all of the corporation’s outstanding stock. This rule does not apply to other types of personal service corporations.  

## What Are the Benefits of a Personal Service Corporation?

The potential benefits of operating as a personal service corporation include tax savings, liability protection for employee-owners, and the ability to take advantage of corporate tax deductions, including business expenses, employee benefits, and capital expenditures.

## What Are the Drawbacks of a Personal Service Corporation?

Personal service corporations can be costly and complicated to set up, and they are generally less flexible in their structure than other types of corporations. Failure to comply with IRS guidelines and regulations may also increase the risk of an IRS audit, and can lead to significant tax penalties.

## What’s the Difference Between a Personal Service Corporation and an S Corporation?

Personal service corporations and S corporations differ in many ways, including how they are taxed, restrictions on the number and type of shareholders allowed, liability protection, and the nature of services provided.

## The Bottom Line

Personal service corporations can be attractive for professionals in fields like accounting, law, engineering, and consulting, offering a flat 21% corporate tax rate, possible deductions, limited liability, and access to tax-free fringe benefits. To qualify, employee-owners must meet IRS thresholds for both ownership and work performed, which makes eligibility stricter than for other corporate structures.

The tradeoff is that PSCs can be complex and costly to set up, with heavier compliance requirements under IRS rules. Because of this, business owners should carefully weigh the benefits against the drawbacks and consider whether the structure truly fits their company's needs. While PSCs can provide tax advantages, they aren't the right choice for everyone.

> **Article Sources**
>
> 1.  Internal Revenue Service. “[Publication 542, Corporations](https://www.irs.gov/publications/p542#en_US_202201_publink1000257743).”
>     
> 2.  Internal Revenue Service. “[Publication 542: Corporations](https://www.irs.gov/pub/irs-pdf/p542.pdf).”