11 Feb Qualified Personal Service Corporations Avoid Flat Tax
A few months ago the U.S. Tax Court ruled on a case involving the treatment of qualified personal
service corporations when those corporations are part of an affiliated group. The ruling has
important, and beneficial, tax implications for qualified personal service corporations in these types
What is a Qualified Personal Service Corporation?
Under §448 of the Tax Code, a qualified personal service corporation is any corporation:
1. That is substantially involved in the fields of health, law, engineering, architecture,
accounting, actuarial science, performing arts, or consulting; and
2. That has substantially all (95%) of its stock, measured by value, held by employees, former
employees, or the estate of employees or former employees.
The tax imposed on the income of corporations is set out in §11 of the Tax Code. The rates are
graduated dependent upon the amount of taxable income the corporation makes. The rates may be
15, 25, 34, or 35 percent. However, for qualified personal service corporations, the tax rate is a flat
35% regardless of the amount of taxable income.
The Tax Court Ruling
The case involved an affiliated group consisting of a qualified personal service corporation, a parent
corporation, and another corporation that was not a qualified personal service corporation. The
group filed consolidated federal income tax returns, with all of the taxable income attributable to
the qualified personal service corporation. The taxpayer paid under the graduated rates because
the group, as a single entity, was not a qualified personal service corporation.
The IRS agreed that, when treated as a single entity, the group was not a qualified personal service
corporation. But, the IRS argued that each entity should be examined separately, and that, because a
qualified personal service corporation was part of the group, the taxpayer should pay the flat 35%.
The Tax Court disagreed with this interpretation and refused to break the group’s consolidated
income up into “separate baskets.” As a result, the court held that the graduated rates apply to
“affiliated groups consisting of a qualified personal service corporation and an entity that is not a
qualified personal service corporation where the group, as a single entity, is not a personal service
corporation.” See Applied Research Associates, Inc. v. Commissioner.
One possible effect of this ruling is that it appears to open the door for qualified personal service
corporations to file federal income tax returns with an entity that is not a qualified personal service
corporation in order to become eligible for lower tax rates. In other words, the ruling allows for the
circumvention of the Tax Codes’ desire for qualified personal service corporations to be taxed at
35%. Of course, if it so desires, the IRS can modify the regulations to eliminate this scenario from
taking place. It will be important and interesting to see what the reaction of the IRS is to the
outcome of this case.
If you have tax-related questions, please contact the Royse Law Firm at any of our offices.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.