Working With Personal Service Corporations.

Taxpayers incorporate their trade or business for various actual or perceived benefits; e.g., limited liability, continuity of life, fringe benefits, etc. However, when an accounting practice or other personal service business is incorporated, numerous tax provisions relating specifically to Personal Service Corporations are triggered. Eleven of these are discussed, below, nine of them distinctly unfavorable, such as flat tax rates, and limitation on deductions and taxable years. After an examination of these provisions, the impact of making an S election by personal service corporations is measured. While an S election reduces some of the adverse impact of being a personal service corporation, in most-cases it has no impact and, in at least one case, it exacerbates the problem!

A Calendar Year Requirement

Not unlike an S Corporation, personal service corporation must generally use a calendar year, absent a business purpose for using a fiscal year. [1] For this purpose, a personal service corporation is defined as:

"A corporation; the principal activity of which is the performance of personal services ... substantially performed by employee owners. [2]

In addition, employee-owners in the aggregate must own more than ten percent of the outstanding stock.

Such personal service corporations are also denied the automatic change in accounting period afforded most C Corporations. [3] An exception allows changing to a natural business year where less deferral of income to the owners result!

A Flat 35 Percent Tax

C Corporations are taxed at rates ranging from 15 to 39 percent until both the average and marginal tax rate reach a flat 35 percent at $18,333,333. [4] However, certain personal service corporations are taxed at a flat 35 percent from the first dollar without the benefit of lower rates; e.g., 15 percent of the first $50,000 of taxable income. [5] Corporations subject to the flat tax are "qualified

Personal service corporations" defined as follows:

"Any corporation...substantially all of the activities of which involve the performance of service in the fields of health, law, engineering, architecture accounting, actuarial science, performing arts, or consulting, and...substantially all of the stock...is held by...employees performing services..., ...retired employees who had performed such services for such corporation.

Exemption from the Accrual Method C Corporations, generally must use the accrual accounting method for tax purposes. [7] Corporations that do not exceed $5 million in gross receipts, based on a three year moving average, may use the cash method unless they keep inventories. [8] Qualified Personal Service Corporations may use the cash method of accounting, regardless of size. The definition of such corporations is the same as for the flat tax rate, [10] including the requirements that substantially all stock must be owned by employees performing services.

Matching of Income and Deductions: When a taxpayer makes a payment to a related party, no deduction is allowed until the payee reports the payment as gross income. [11] Related parties include a personal service corporation as defined under the calendar year, requirement and any employee-owner however small. [12] In the aggregate, employee-owners need merely own more than ten percent of the corporate stock.

Deduction Limitation on Amounts Paid to Employee-Owners

Personal Service Corporations with a Section 444 fiscal year election must defer deductions of front-ended payments to employee-owners. [13] This is done by requiring payments during the deferral period.

Example

John, a calendar year taxpayer, incorporates his accounting practice with a fiscal year ending August 31. If the pays himself $150,000 during the year ended August 31, he must pay himself at least $50,000 during the four month deferral peirod (September 1 - December 31). Or 4/12 of $150,000, to deduct $150,000 currently. If no payment is made during the deferral period, only 8/12 of $150,000, of $100,000 would be currently deductible.

The definition of a personal service corporation is the same as for matching income and deductions above. [14]

The Passive Loss Rules Apply

The passive loss rules apply to individuals, estates, trust, closely-held C Corporations and "any personal service corporation." [15] The definition of the latter is the same as for the calendar year requirement, including the overall ownership requirement of more than the percent. [16] Thus, passive losses may only offset passive income and not operating income that is generally allowed for C Corporations subject to the passive loss rules.

Reallocations in Tax Avoidance or Evasion Cases

Sometimes, all of the services of a personal service corporation are performed for another corporation partnership or entity. In such cases the IRS has broad powers to allocate, income, deductions, credits and other tax items between a personal service corporation and its employee-owners, but only to prevent fax avoidance or evasion of income tax or to clearly reflect the income" of the corporation or employee-owner. [17] A personal service corporation is defined as under the matching of income and dedutions and deduction limitation" rules with the employee owner needing to own more than ten percent of the outstanding stock. [18]

Exemption from the Uniform Capitalization Rules

Individuals and "certain corporations" do not have to capitalize "qualified creative expenses" paid or incurred in the trade or business of being a writer, photographer of artist. [19] For this purpose, "certain corporations" are those where

"Substantially all of the stock...is owned by a qualified employee-owner and members of this family...and the principal activity of such corporation is performance of personal services...of the qualified employee-owner"...[20]

The "qualified employee-owner" must be

Reduced Accumulated Earnings Credit

To enforce the "double taxation" of C Corporations, the IRS may impose a tax on accumulated earnings in excess of business needs. [21] However, the first $250,000 of accumulations are exempt-the "accumulated earnings credit." [22] For certain service corporation this credit is reduced to $150,000. [23] The definition of a service corporation for this purpose is "a corporation the principal function of which is the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting,..." There is no ownership requirement.

Service corporations, including personal service corporation, need to distribute earnings in excess of $150,000 and/or have acceptable business reasons for the accumulation.

Personal Service Income May Be Personal Holding Company Income

Like the accumulated earnings tax, the tax on "Undistributed Personal Holding Company Income" is designed to encourage dividend distributions by C Corporations. {24} In addition to portfolio income, Personal Holding Company Income includes corporate personal service income of someone outside the corporation; e.g., a specific actor. [25] Although the law was designed to prevent highly paid athletes and entertainers from sheltering income in a corporation, it is clear that all personal serivces are included--accounting, medicine and law. However, it is also clear that if the contract between the corporation and the client does not mention names, even a sole practitioner is not subject to the rule!

NO Qualified Small Business Stock

Noncorporate taxpayers must exclude 50 percent of gain from the sale or exchange of "qualified small business stock" held for over five years. [26] This favorable tax treatment is denied to

"Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or more of its employees." [27]

This is the broadest definition of a personal service corporation found in the Code. In addition, corporations in farming, natural services, hotels, motels and restaurants are also ineligible for the 50 percent exclusion. [28] There is no minimum employee-ownership requirement.

The impact of Making an S Ejection 

Making an Selection all but eliminates double taxation, even though Section 1244 is still available (ordinary loss for individuals on sale or worthlessness of the stock). In addition, a few of the eleven special rules regarding personal service corporations do not apply to S Corporations or become irrelevant as a practical matter:

1) Calendar Year. Whether an S Corporation is a personal service corporation or not, its "permitted year" is a calendar year, unless a business purpose is shown. [29]

2) Flat 35 Percent Tax. S Corporations are not generally taxed which solves the flat tax, or any tax, problem!

3) Accrual Method. Only C Corporations are subject to the accrual method requirement without regard to inventories. Personal service corporations are already exempt from this rule. [30]

4) Matching Income and Deductions. There is no exception for S Corporations. [31]

5) Deduction Limits on Payments to Employee-owner. There is no exception for S Corporations. [32]

6) Passive Loss Rules. Not only is there no exception for personal service corporations with S election, but the passive loss limitations also apply to S shareholders who are individuals, estates and trusts! [33]

7) Reallocations if Tax Avoidance or Evasion. There is no exception for S Corporations. [34]

8) Exemption from the "Unicap" Rules. There is no exception for S Corporations. [35]

9) Reduced Accumulated Earnings Credit. The accumulated earnings tax has no application to S Corporations, since there is no double taxation. However, S Corporations are not specifically excluded. [36]

10) Personal Holding Company Taxes. S Corporations are not specifically excluded. [37] However, the tax has no application due to the lack of double taxation.

11) Section 1202 Stock. Personal service corporations are excluded from the 50 percent exclusion benefit No exception exists for S Corporations. [38]

In summary, the S Corporation election eliminates the personal service corporation disadvantages in 2, 9 and 10 only. It makes no difference in 1,3,4,5,6,7,8 and 11! In fact, it makes matters worse in 6 (the passive activity rules).

Conclusions

Incorporating a business is never a decision to be taken lightly. Before a personal service business is incorporated, it is vital that the taxpayer be aware of the numerous adverse tax rules designed specifically to reduce possible abuse by such businesses. Thus, there are restrictions on the choice of taxable year, denied access to lower tax rates, limitations on timing of deductions, etc.

Making an S election removes only three of the ten unfavorable tax problems facing personal service corporations; i.e., the flat tax, the accumulated earnings tax and the personal holding company tax. Of the remaining seven, six are unaffected by the election and one is compounded by it! (The passive loss rules.)

Rolf Auster, Ph.D., LL.M., CPA is Professor of Taxation in the College of Business Administration at the Florida International University in Miami, FL.

Footnotes

(1.) Code Section 44l(i)(1).

(2.) Code Section 441(i)(2) and 269A(b).

(3.) Treas. Reg. 1.442-1(d).

(4.) Code Section 11(b)(1).

(5.) Code Section 11(b)(2).

(6.) Code Section 448(d)(2).

(7.) Code Section 448(a).

(8.) Code Section 448(b)(3).

(9.) Code Section 448(b)(2).

(10.) Code Section 448(d)(2).

(11.) Code Sections 267.

(12.) Code Section 267(a)(2)(B), 441(i)(2) and 269A(b).

(13.) Code Sections 280H.

(14.) Code Section 280H(f)(5), 441(i)(2) and 269A(b).

(15.) Code Sections 469(a)(2).

(16.) Code Sections 469(j)(2) and 269(b).

(17.) Code Sections 269A.

(18.) Code Section 269(b)(2).

(19.) Code Section 263A(h).

(20.) Code Section 263A(h)(3)(D),

(21.) Code Section 531.

(22.) Code Section 535(c)(2)(A).

(23.) Code Section 535(c)(2)(B).

(24.) Code Section 541.

(25.) Code Section 543(a)(7).

(26.) Code Section 1202(a).

(27.) Code Section 1202(e)(3)(A)..

(28.) Code Section 1202(e)(3)(C),(D) and (E).

(29.) Code Section 1378.

(30.) Code Section 448(a).

(31.) Code Sections 267(a)(2)(B).

(32.) Code Sections 280H(f)(5).

(33.) Code Sections 469(a)(2).

(34.) Code Sections 269A(h)(3)(d).

(35.) Code Section 263A(b)(1).

(36.) Code Section 532(b).

(37.) Code Section 542(c).

(38.) Code Sections 1202(e)(3)(A).