Refining the definition of a personal service corporation.

In 1987 Congress amended the tax law to provide that a personal service corporation (PSC) is not eligible for graduated corporate tax rates. Pursuant to IRC section 11(b)(2), PSCs pay tax at the flat rate of 35% on their taxable income. Recently, the Tax Court had an opportunity to examine the definition of a PSC.

In 1980 Ronald Lykins formed Ron Lykins Inc., a subchapter C corporation that offered tax and accounting services as well as financial advice. The financial advisory business grew substantially, and Lykins' attorney advised him to separate the financial services division from tax and accounting services. In 2000 he formed Lykins Financial Group LLC to offer financial services while Ron Lykins Inc. continued to offer accounting and tax services.

There was no overall change in the structure of the businesses; they both used one address and had the same employees. But the Internal Revenue Service decided that, as a result of the split, Ron Lykins Inc. had become a PSC and thus would be subject to a flat 35% tax rate rather than a potentially lower graduated rate. The taxpayer appealed this decision.

Result. For the taxpayer. The Tax Court ruled that Ron Lykins Inc. had not become a PSC in the split. Section 448(d)(2) contains the requirements for a corporation to be classified as a PSC. Specifically, a corporation must meet an ownership test and an income test. The ownership test requires that substantially all the stock (determined by value) be owned by employees; the temporary regulations define substantially all as 95%.

Employees include current employees, retired employees, estates of former employees and certain beneficiaries of former employees. Since Lykins, an employee/owner, owned 100% of the stock, he met the ownership test.

The income test requires that employees spend at least 95% of their time performing qualified services, which are defined as those in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. Accounting and tax services are qualified services, but financial services are not. On the surface, the split would have meant that 100% of the services performed by employees of Lykins Inc. were qualified services and that the company was a PSC.

The Tax Court determined that the financial services, although performed under the umbrella of the LLC, were in fact being performed by employees of the corporation. It was possible for the employees to work for two firms at the same time, so the employees remained employees of the corporation even though they were working for the LLC for other purposes.

This case, which reduced the taxpayer's tax liability, raises more questions than it answers, none of which were resolved in this decision. Specifically, given that the employees were still considered employees of the corporation, does the revenue generated by the financial services division get taxed in the corporation or the LLC? Which entity is entitled to the deduction for employee compensation? The general question left to be answered is whether the LLC will be recognized as a separate entity for tax purposes.

* Ron Lykins, Inc. v Commissioner, TC Memo 2006-35.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.