Qualified Personal Service Corporations Avoid Flat Tax

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.

 

Conclusion

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.

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Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City. Read My Full Bio

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