Reasonable Compensation in Personal Service Corporations

A personal service corporation (“PSC”) is a C corporation, the principal activity of which is the performance of personal services, with such services being substantially performed by employee-owners. Generally, the term “personal services” includes the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. Although PSCs offer many benefits, including tax-efficient fringe benefits and perpetual existence, there is one disadvantage that often raises eyebrows – the flat income tax rate.

Unlike regular C corporations, PSCs cannot use graduated tax rates; all income is taxed at a flat 35% rate. Oftentimes, PSCs attempt to circumvent this hefty tax by paying out large year-end bonuses to their shareholders. Doing so creates a deduction at the corporate level, thereby eliminating substantially all of the corporate profits, and shifts the income to the shareholders’ individual tax returns. This technique, known as “income stripping,” also avoids the double tax that would apply if such income were, instead, paid out as a dividend. Corporations, however, are only allowed a deduction for compensation if the amount paid is reasonable for the services actually rendered. The determination as to the reasonableness of an individual’s compensation is based on the specific facts and circumstances surrounding the payments. The majority of the Tax Court circuits consider multiple factors, such as the following, when making this determination:

• The nature, extent, and scope of the employee’s work.
• The employee’s compensation as a percentage of gross and net income.
• The employee-shareholder’s compensation compared with distributions to shareholders.
• The employee-shareholder’s compensation compared with that of non-shareholder-employees.

If the employee-shareholder’s compensation is not deemed reasonable, it may be re-characterized as a nondeductible dividend payment. The PSC may also be imposed accuracy-related tax penalties that could be substantial. In Brinks Gilson, a 2016 Tax Court case, the imposition of such accuracy-related penalties amounted to more than $420,000 for a two-year period during which large year-end bonuses were paid.

With year-end tax planning at the forefront of this month’s priority list, it is important for PSCs to consider the reasonableness of year-end bonuses paid to employee-shareholders.

The tax professionals at Marcum can assist companies in ascertaining PSC status and planning for year end bonuses.