Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 10 MIN READ

The professional corporation, revisited: after the 35% surtax disappeared

TCJA repealed the §11(b)(2) personal-service-corporation penalty rate, and the cash-method doorway under §448 opened for most practices under $25 million

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. What TCJA actually did to §11(b)(2)
  2. Why the shareholder-compensation game still matters
  3. §199A and the SSTB problem for pass-through PCs
  4. §448 cash method, now reachable for most practices
  5. What stayed the same and still bites
  6. Sources

he federal tax code used to charge a professional corporation a flat 35% on the first dollar of taxable income. As of tax years beginning after December 31, 2017, it charges 21%, the same rate every other C-corp pays. The penalty that defined the form is gone.

Our December 2016 piece on the professional corporation opened with that 35% surtax and treated it as the central reason the PC had to be handled carefully. Eighteen months later the state licensing framework is unchanged, the malpractice carve-out is unchanged, and the buy-sell problem is unchanged. The tax spine has moved.

What TCJA actually did to §11(b)(2)

Section 13001 of Public Law 115-97, the Tax Cuts and Jobs Act signed December 22, 2017, struck the entire graduated rate table in IRC §11(b) and replaced it with a single sentence: "The amount of the tax imposed by subsection (a) shall be 21 percent of taxable income." The amendment applies to tax years beginning after December 31, 2017.

The old §11(b)(2), which imposed a flat 35% on the taxable income of a "qualified personal service corporation" as defined in §448(d)(2), was deleted in the same stroke. There is no longer a special rate for a PSC. A professional corporation that meets the §448(d)(2) definition, substantially all activities in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, with substantially all the stock held by employee-owners rendering those services, now pays the same 21% as a manufacturer of airplane parts.

This is the single largest change in the operating economics of the PC since the form was codified. A PC with $100,000 of taxable income that would have owed $35,000 in 2017 owes $21,000 in 2018, a $14,000 swing per $100,000 left at the corporate level. Under the 2017 graduated structure that applied to ordinary C-corps, the same $100,000 would have produced $22,250 of tax, so the PC has moved from paying a $12,750 surtax relative to a regular C-corp to paying roughly $1,250 less than a regular C-corp would have paid under the old law. The penalty rate inverted.

For fiscal-year PCs whose first affected tax year straddles January 1, 2018, IRC §15(a) requires a blended rate computation. A PC on a November fiscal year that ends November 30, 2018 applies the old §11(b) rates to the portion of the year falling in 2017 and 21% to the portion in 2018, weighted by days. Notice 2018-38 walked through the mechanics and confirmed §15 applies despite the flat replacement rate. Calendar-year PCs, which is most of them by operation of §441(i), feel the change cleanly on the 2018 Form 1120.

Why the shareholder-compensation game still matters

The old planning move was to zero out corporate taxable income by paying every dollar of profit to the physician, lawyer, or CPA shareholders as W-2 compensation, because the alternative was the 35% surtax on whatever stayed behind. At 21%, that move is less urgent but still the right default for most practices.

The reason is the second layer. Corporate income that is not paid as compensation and that is distributed as a dividend is taxed again at the shareholder level, at the qualified-dividend rates under §1(h)(11): 0%, 15%, or 20% depending on bracket, plus the 3.8% net investment income tax under §1411 at higher incomes. A top-bracket shareholder takes a dollar at the corporation, pays 21 cents in corporate tax, receives a 79-cent dividend, pays 23.8% on the dividend (19 cents), and keeps 60 cents. The same dollar paid as wages bears ordinary rates plus FICA, capped on the Social Security side at the 2018 wage base of $128,400 per employee, so the Medicare portion runs uncapped at 2.9% plus the 0.9% additional Medicare tax on high earners. The comparison still usually favors wages for working shareholders, especially above the Social Security cap where only the Medicare layers apply.

The S-election remains the standard workaround for a PC that wants single-layer taxation. Nothing in TCJA changed the mechanics of Subchapter S for a PC. A PC that has elected S status passes its income through to shareholders, who report it on Schedule K-1 and pay ordinary rates. What changed at the shareholder level is §199A, and for a PC that is where the new exposure lives.

§199A and the SSTB problem for pass-through PCs

Section 199A, added by TCJA §11011, grants individuals a 20% deduction against qualified business income from a qualified trade or business. For most pass-through owners, that converts a 37% top marginal rate into a 29.6% effective rate on QBI.

A PC that has elected S status is a pass-through. Its shareholders would in theory take the 20% deduction against their share of practice income. The statute does not let them, at least not past a threshold.

Section 199A(d)(2) defines a "specified service trade or business" by the same functional list §448(d)(2) uses, with two additions: services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and "any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners." Investing, investment management, and dealing in securities are also in. Engineering and architecture are not. An SSTB is disqualified from §199A treatment above an income threshold.

The phase-out is set out in §199A(d)(3) and the overall limitation in §199A(b)(3). For 2018 the threshold is taxable income of $157,500 for single filers and $315,000 for joint filers. Inside the threshold, an SSTB shareholder takes the full 20% deduction. Within a $50,000 (single) or $100,000 (joint) phase-in window above the threshold, the deduction is ratably reduced. Above $207,500 (single) or $415,000 (joint), an SSTB shareholder's income from the SSTB yields no §199A deduction.

Most practicing professionals in a mature S-elected PC are above the phase-out ceiling. A physician couple filing jointly with $500,000 of household income gets no §199A deduction on the medical-practice income. Engineering and architecture PCs escape the SSTB carve-out and take the deduction subject only to the wage and unadjusted-basis tests in §199A(b)(2). The same distinction flows through to a PLLC structured as an S-corp; §199A does not care about entity form, only about whether the trade or business is an SSTB.

The planning consequence is that a PC whose shareholders are below the threshold, younger associates, part-time specialists, solo practices with modest net income, still see material §199A benefit from the S-election. A PC whose shareholders are solidly above the ceiling sees none, and the S-election's only remaining benefit at the federal level is avoiding the second layer of tax on distributions. That is still worth something. It is worth less than it was before the C-corp rate fell to 21%.

The C-corp election, for a PC that wants to stay C, went from punishing to merely double-taxed. At $500,000 of corporate taxable income distributed in full, a C-corp PC pays $105,000 at the entity level and leaves $395,000 for dividend. A top-bracket shareholder pays $94,010 on the dividend (23.8%), for $210,010 total federal tax on $500,000 of practice profit. The same $500,000 run through an S-elected PC where the owners are above the SSTB ceiling yields $185,000 in federal income tax at 37%, plus FICA on whatever share is paid as reasonable compensation, plus 3.8% NIIT on any residual. The comparison has tightened dramatically, and for high-income SSTB practices it is no longer obvious that the S-election wins on a federal basis alone.

State tax still matters. California's 8.84% corporate rate (or 1.5% on S-corp net income) and New York's 6.5% corporate rate sit on top of whatever the federal result is, and a few states have responded to TCJA by adjusting their treatment of pass-through income.

§448 cash method, now reachable for most practices

The other TCJA change that mattered for PCs is quieter and, for a profitable closely held practice, nearly as useful as the rate cut.

Section §13102 of TCJA amended IRC §448(c) to raise the gross-receipts threshold under which a C-corporation (and a partnership with a C-corp partner) may use the cash method of accounting. The old threshold was $5 million, set in 1986 and never indexed. TCJA raised it to $25 million, indexed for inflation under §448(c)(4), and extended the same threshold to §263A (uniform capitalization), §460 (long-term contracts), and §471 (inventories) for small businesses through new §263A(i), §460(e)(1)(B), and §471(c).

For a PC, the cash method was already available without a dollar cap by operation of §448(b)(2), the "qualified personal service corporation" exception, which carved PSCs out of the accrual requirement entirely. A health, law, or accounting corporation could already report on cash. What changed is that the qualifying tests for that exception mattered less. A professional corporation that expanded into ancillary service lines, an ambulatory surgery center, a litigation-funding arm, a consulting subsidiary, could previously lose the §448(d)(2) "substantially all" posture and be forced onto accrual. Now the same entity, if under $25 million in three-year average gross receipts, qualifies for cash on the §448(c) small- business route regardless of the PSC composition test.

The operational win is timing. Cash-method accounting lets a practice defer income until it is collected and deduct expenses when they are paid, which for a service business with heavy receivables and year-end bonus discipline can move meaningful tax from one year to the next. Rev. Proc. 2018-40 is the automatic-change procedure for §448 and §263A method changes; the practice files a Form 3115 and takes any §481(a) adjustment on the terms set out there.

What stayed the same and still bites

The regulatory scaffold around the PC did not move. California Corp. Code §§ 13400–13410 still routes licensed professionals into the form, the licensing board still issues the certificate of registration §13404 requires, and §13406 still voids any share issuance to a non-licensee. New York BCL §1505 still makes each practitioner personally liable for her own malpractice. Illinois 805 ILCS 10/8 still does the same. The buy-sell problem on death or license loss is still the single most-overlooked document in a small-practice formation.

Section 441(i) still forces a PSC onto a calendar year unless it elects a fiscal year under §444 with the required minimum distribution, establishes a natural business year, or obtains §442 permission. TCJA did not touch this mechanism, and for a rate-matching C-corp PC the calendar-year default now costs less than it used to (because there is no surtax to defer) but the mechanical rule remains.

The people most affected by the rate change are the ones who already had the form figured out. A mid-career cardiology group that had been zeroing out corporate taxable income through compensation to avoid §11(b)(2) now has room to retain modest working capital at the C-corp level without triggering a 35% bill. A solo dermatology corporation that had elected S to escape the surtax might, in principle, now reconsider, but unless it plans to retain earnings or sell the practice as stock under §1202 (the qualified small business stock exclusion, which by its terms in §1202(e)(3) excludes most SSTB businesses), the S-election still usually wins on distribution math. A young engineering PC with shareholders under the §199A threshold is probably the biggest single winner in the new regime: 21% at the entity is now the C-corp alternative, 20% off QBI at the shareholder is the pass-through alternative, and engineering is not an SSTB. The form almost picks itself.

For most of the PC universe the redesign is less about switching election and more about recalibrating how much income to leave at the corporate level on the margin. The 35% ceiling that made that question simple is gone.

Sources

Keep reading

More from the journal.