Introduction
When structuring a business, especially in industries involving professional services, understanding the tax classification of your entity is crucial. A common area of confusion is whether a Management Services Organization (MSO) qualifies as a Personal Service Corporation (PSC) under the Internal Revenue Code. Generally, an MSO is not considered a PSC; however, there are important exceptions to be aware of. This article explains why MSOs typically don’t fall under PSC rules and outlines the specific conditions under which they might.
What Is a Personal Service Corporation (PSC)?
A Personal Service Corporation (PSC) is a specific type of C corporation primarily involved in providing personal services in certain fields. To be classified as a PSC, a company must meet both of the following tests:
1. Principal Activity Test: The company’s main business activity must involve performing personal services in one or more of these fields:
– Health (e.g., doctors, dentists)
– Law (e.g., attorneys)
– Engineering
– Architecture
– Accounting (excluding bookkeeping)
– Actuarial Science
– Performing Arts
– Consulting
2. Ownership Test: More than 10% of the corporation’s stock (by value) must be owned by employee-owners who are actively providing those services.
Why MSOs Are Generally Not PSCs
- Do Not Provide Personal Services: MSOs offer administrative support, not direct personal services in the fields listed above.
2. Have Different Ownership Structures: MSOs are often owned by individuals who are not actively involved in delivering professional services.
3. Operate with a Clear Business Purpose: MSOs focus on management and operations, not providing professional services.
4. Arm’s Length Compensation Practices: MSOs typically implement reasonable compensation policies to ensure that salaries align with market standards, reducing the risk of misclassification as a PSC.
MSOs as Internal-Facing Corporations
MSOs are designed as internal-facing corporations that work exclusively with operating companies to provide vital support services. These services may include administrative functions, human resources, IT support, marketing, and accounting. In exchange for these services, the MSO charges a structured management fee outlined in a Management Services Agreement (MSA).
Unlike PSCs, MSOs typically do not engage directly with third-party corporations or external clients outside of the business enterprise they support. This structure helps limit the risk of being classified as a PSC because the MSO is not delivering professional services directly to the public or external clients.
Case Studies
Case Study 1: MSO Not Classified as a PSC
A healthcare MSO was created to manage the administrative operations of several medical clinics. The MSO handled payroll, HR, IT, and billing, while the clinics’ doctors remained separate and received no ownership interest in the MSO. Because the MSO did not engage in medical services and had no ownership by service providers, it did not qualify as a PSC.
Case Study 2: MSO Classified as a PSC
A consulting firm formed an MSO that also offered strategic advisory services directly to clients. Over 15% of the MSO’s shares were owned by consultants actively providing these services. Due to its direct engagement in consulting and the ownership structure, the IRS classified the MSO as a PSC, subjecting it to stricter tax rules.
Disclosure
Guardian Tax Consultants (GTC) does not offer legal or tax advice. We engage independent attorneys and tax professionals to provide objective legal and tax advisory services.
Sources
- IRS – Personal Service Corporation Definition: https://www.irs.gov/pub/notices/cp224_english.pdf
- Tax Foundation – 2017 Tax Cuts and Jobs Act Analysis: https://taxfoundation.org/research/all/federal/2017-tax-cuts-jobs-act-analysis/
- IRS – Business Activity Codes: https://www.irs.gov/pub/irs-soi/17pf_business_codes.pdf
- Investopedia – Personal Service Corporation: https://www.investopedia.com/terms/p/personal-service-corporation.asp
- IRS – Form 1120 Instructions: https://www.irs.gov/pub/irs-pdf/i1120.pdf
- Thomson Reuters – PSC Definition: https://www.thomsonreuters.com/en-us/help/ultratax-cs/1120/processing/definition-of-a-personal-service-corporation-psc.html
- IRS – Reasonable Compensation: https://www.irs.gov/pub/irs-news/fs-08-25.pdf
- Journal of Accountancy – PSC Classification: https://www.journalofaccountancy.com/issues/2010/jul/personalservicecorporations.html
- SuperMoney – Benefits of PSCs: https://www.supermoney.com/encyclopedia/personal-service-corporation
- Allen Barron – Tax Risks of PSCs: https://allenbarron.com/the-tax-danger-of-personal-service-corporations/
- H&R Block – TCJA Explained: https://www.hrblock.com/tax-center/irs/tax-reform/tax-cuts-and-jobs-act/
- Deloitte – Multistate Tax Considerations: https://www2.deloitte.com/content/dam/Deloitte/us/Documents/Tax/us-tax-tax-cuts-and-jobs-act-hr-1-multistate-tax-considerations.pdf
- Tax Policy Center – TCJA Business Taxes: https://taxpolicycenter.org/briefing-book/how-did-tax-cuts-and-jobs-act-change-business-taxes
- GovInfo – TCJA Comparison: https://www.govinfo.gov/content/pkg/GOVPUB-Y4_T19_4-PURL-gpo173848/pdf/GOVPUB-Y4_T19_4-PURL-gpo173848.pdf
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