The Difference Between a C Corporation and a Personal Service Corporation

By Michelle Kaminsky, J.D.

The Difference Between a C Corporation and a Personal Service Corporation

By Michelle Kaminsky, J.D.

Both C corporations and personal service corporations are types of corporate business structures, and each has its own characteristics as defined by the Internal Revenue Service (IRS) for tax purposes. Most notably, personal service corporations must abide by specific, restrictive regulations regarding ownership and management whereas C corps do not.

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A corporation is a legal entity formed by filing articles of incorporation with the state agency that regulates business, usually the Secretary of State. The entity is taxed separately from its owners, called shareholders, who own shares, or stock, in the company. A corporation also provides limited liability for the debts and other liabilities of the company.

C Corporations

Most corporations are classified as C corporations by the IRS, which defines the way in which the entities pay federal income taxes. C corporations may take advantage of many favorable provisions in the tax code that bring their effective tax rate down considerably, though dividends are still taxed on shareholders' personal income tax returns.

This differs, for example, from an S corporation, through which all company profits pass through to shareholders to be taxed only on their individual returns.

Professional Service Corporations

A professional service corporation is a specialized type of corporation. The main difference between a C corporation and a professional service corporation is the way the IRS taxes them.

Personal service corporations are taxed at the highest corporate rate, and dividends distributed to shareholders are taxed on their individual returns as well. To avoid excessive double taxation, many personal service corporations distribute the vast majority of their income to employee-owners (shareholders) as wages. Personal service corporations may only carry net operating losses forward, not backward.

A professional service corporation may be registered as such under state law, but whether it qualifies as one for IRS purposes is a separate analysis based on the following criteria, discussed in IRS Publication 542.

1. Principal Activity

The corporation's principal activity during the “testing period," which is usually the previous tax year, must be in “accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, [or] the performing arts."

If the corporation was only recently formed, the testing period starts on the first day of its tax year and ends on either the last day of its tax year or the last day of the calendar year in which its tax year begins, whichever is earlier.

In contrast, a C corporation may operate in any business sector.

2. Owner Participation

Under IRS rules, the employee-owners must “substantially perform" the professional service defined above. The corporation can meet this requirement if the employee-owners perform more than 20 percent of the business's services.

This differs from a C corporation in that, although shareholders may participate in the company's daily operations, there is no IRS requirement that they do so.

3. Percentage of Ownership

The shareholders “must own more than 10 percent of the fair market value of its outstanding stock on the last day of the testing period." Outstanding stock includes all shares available to investors, including those held by the company's owners.

The shareholders in a C corporation may hold any percentage of stock of the business.

Professionals in the above-listed specialties may find that forming a professional service corporation offers tax benefits, but it is essential to follow the guidelines of the IRS closely or else risk losing personal service corporation status.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.