One of the big changes under both the Trump tax plan and the GOP tax plan is regarding the taxation of distributions from flow through entities such as partnerships and S Corporation.
Although it hasn’t been clarified, these entities have been flow through for the net income and expense to owners, so it’s likely the tax will occur whether you take the money in a distribution or just leave it in the company.
The good news is that these distributions or net income amounts will be taxed at a maximum of 20% or 25% (depending on which version is eventually finalized). Currently, they are taxed as ordinary income up to 39.6%.
There is an exception to this tax break though. If you have a personal service company, you have to pay regular, ordinary tax rates. No tax breaks for you!
At this juncture, we don’t have a definition of what constitutes a personal service company (PSC). Most likely it will either the same as the definition for C Corporation personal service companies or something very close.
Let’s take a look at that and a strategy to avoid the PSC designation.
A corporation is a PSC if it meets all of the following requirements:
- Its principal activity during the testing period is performing personal services.
- Its employees/owners spend 20% or more of their compensated time providing personal services.
- Its employees/owners own more than 10% of the fair market value of the outstanding stock on the last date of the testing period.
Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.
Remember that simply performing some personal services does not mean your company is a PSC. It’s only if the other two tests, what you do with your time and ownership, are done as well.
The best way to plan for this is to look at the ownership you currently and how you spend your time in the company. It’s possible you don’t have a choice. You have a PSC. That is when it’s time to look at some dual entity strategies. More on that in next week’s blogs!