Gold Medal Software 2/Gold Medal Software Volume 2 (Gold Medal) (1994).iso/accounts/sba93_4b.arj/F303.SBE

Text File | 1993-10-01 | 21KB | 558 lines

@Q01

           ┌───────────────────────────────────────────────┐
           │         PERSONAL SERVICE CORPORATIONS         │
           │  AND QUALIFIED PERSONAL SERVICE CORPORATIONS  │
           └───────────────────────────────────────────────┘

Tax laws can be terribly confusing.  A good example is the fact
that the tax code uses 3 very similar definitions of "PERSONAL
SERVICE CORPORATIONS" and "QUALIFIED PERSONAL SERVICE CORPORA-
TIONS" for varied purposes.  Even tax pros find the tiny differ-
ences between the 3 definitions maddeningly complex and obscure.

Definition #1 of "personal service corporations" has to do with
whether a corporation is subject to the limits on passive acti-
vity losses; #2 is a virtually identical definition of PSC's
that decides whether a corporation will be allowed to use cer-
tain fiscal years for tax purposes; #3 is a slightly different
definition ("qualified personal service corporations"), that de-
termines whether a corporation is subject to a flat 35% tax rate
and if it can use cash method accounting in certain cases.

QUESTION:  Which definition do you want to test your company for?
           1- "Personal Service Corporation" -- Subject to passive
               loss rules and unable to freely choose fiscal year.
           2- "Qualified P.S.C." -- Subject to flat 35% tax rate.
@MC\02
01\Q02
02\Q11

@Q02

LIMITATIONS ON CERTAIN "PERSONAL SERVICE CORPORATIONS."  Some
C corporations that fall under the definition of "personal ser-
vice corporation" are fully subject to the passive activity
loss restrictions that apply to all taxable entities other than
C corporations.  The tax law has a virtually identical defini-
tion of "personal service corporation" that is used to deter-
mine whether a corporation is restricted in its choice of fis-
cal year.  Being determined to be a personal service corpora-
tion ("PSC") under EITHER definition is almost always bad news.

The first type of PSC is fully subject to the limits on deduc-
ting losses from passive activities (such as real estate ren-
tals); they can't offset passive activity losses against either
"portfolio" or "net active" income.  The second type of PSC is
very limited in its choice of fiscal year, usually limited to
using the calendar year. These two definitions are so nearly
identical that we have lumped them together here for analysis.

  QUESTION:  Is your firm a C corporation?
@YN
01\Q04
02\Q03

@Q03

CONCLUSION:

Your company is not a "personal service corporation" ("PSC")
subject to the passive activity loss rules, since your form
of business is not a C corporation.

But don't break out the champagne yet.

This does not mean you are free from the passive loss limita-
tions.  To the contrary, ANY other kind of business organiza-
tion other than a C corporation (such as a partnership, sole
proprietorship or an S corporation) is AUTOMATICALLY subject
to the passive loss restrictions.

(Rules for business trusts, which may be treated as corpora-
tions, are somewhat more complex and are not considered here,
since few small businesses are set up as business trusts.)

Not being a C corporation also means that you are severely
limited in your choice of fiscal year, since only certain C
corporations (those which are not PSCs) may freely choose
any fiscal tax year they choose.  PSCs, partnerships, and S
corporations all must generally adopt either a calendar year
(December 31 year-end) or, in the case of partnerships, a
year-end that coincides with that of most of its owners.

It is also frequently possible for some such entities to se-
lect a year that ends in either September, October, or
November, but, if this is done, it will be necessary, in
the case of S corporations or partnerships, to make complex
tax prepayments each year that will undo any tax deferral
benefits that might otherwise result from having a tax year
other than a calendar year.  Similarly, a PSC that elects a
fiscal year may have to give up the right to deduct certain
expenses in order to make sure that it does not enjoy any
tax deferral benefits.

Of course, you can always apply to the IRS to let you choose
a fiscal year for some good business reason other than defer-
ring taxes, if you have one.

@STOP

@Q04

For a C corporation to be a "personal service corporation,"
the corporation's principal activity must consist of the per-
formance of personal services.  Personal services would cov-
er a wide range of activities, including professional ser-
vices such as law, medicine, dentistry, accounting, archi-
tectural and engineering services, actuarial sciences, and
the like.  It would also cover areas such as consulting ser-
vices, the incorporated professional athlete or entertainer,
and miscellaneous other service businesses, such as an incor-
porated salesperson.

  QUESTION:  Does your corporation perform personal services
             as its principal activity?

@YN
01\Q08
02\Q05

@Q05

CONCLUSION:  Your C corporation is not subject to the limi-
tations on choice of fiscal year.  Thus, if it is a new cor-
poration, you can choose whichever month of the year as its
year-end that you desire.  You may be able to gain some sig-
nificant tax deferral benefits, if, for example, you choose a
January 31 fiscal year, and pay yourself a major fiscal year-
end bonus each year in January.

CONCLUSION:  Your company is also not a "personal service
corporation" for purposes of the passive loss rules, and
thus is not fully subject to the passive activity loss lim-
itations.  However, your company may be a "closely held C
corporation" that is partially subject to the passive loss
rules, depending on its stock ownership.  (See below)

 QUESTION:  Did 5 or fewer individuals (directly or indirect-
       ly) own more than 50% (in value) of the stock of the
       corporation during the last half of the tax year?
@YN
01\Q06
02\Q07

@Q06

FURTHER CONCLUSION:  While your corporation is not considered
a "personal service corporation," and thus is not fully sub-
ject to the passive loss restrictions, it is considered to be
a "closely held C corporation," and thus is partially subject
to the passive loss rules.  That is, it may offset passive
activity losses against its "net active income" -- but NOT
against its "portfolio income."

@STOP

@Q07

FURTHER CONCLUSION:  Your C corporation is not a "personal
service corporation" (within the meaning of the passive loss
rules), and is also not considered a "closely held C corpora-
tion." This means, if the above conclusions are both correct,
that your corporation is not subject to ANY of the passive
loss restrictions.  Thus, losses incurred by your corporation
on passive activity investments should be fully available to
offset against either portfolio income or other income ("net
active income") of the corporation, without restriction.

@STOP

@Q08

SERVICES "SUBSTANTIALLY PERFORMED" BY SHAREHOLDER-EMPLOYEES:
To be deemed a "personal service corporation," the personal
services performed by the corporation must be "substantially
performed" by employees who own its stock.  To determine if
services to customers, clients, etc. are "substantially" per-
formed by employee-owners, IRS regulations say that more than
20% of the corporation's compensation expense attributable to
its service activities must be attributable to services per-
formed by its employee-owners.  If it is clear that over 20%
of the cost of performing services (of the types described in
the previous question) are attributable to services performed
by owners, answer "Y" ("YES") to the following question.  If
it is clear that LESS than 20% of such compensation costs are
attributable to services rendered by employee-owners, you
should answer "N" ("NO").

QUESTION:  Are the services rendered by the corporation "sub-
stantially" performed by employee-owners of the corporation?

@YN
01\Q09
02\Q05

@Q09

STOCK OWNERSHIP REQUIREMENT:  A corporation cannot be treat-
ed as a PSC for tax purposes unless employees own more than
10% of its stock (by value), directly or indirectly.

  QUESTION:  Do employee-owners own (directly or indirectly)
             more than 10% of the stock of your corporation,
             by value?

@YN
01\Q10
02\Q05

@Q10

CONCLUSION:  It appears from your responses that your C cor-
poration may be a "personal service corporation" under the
definitions used in the passive activity loss rules and for
determining whether a C corporation is restricted in its
choice of a fiscal tax year.

If so, this means that if your corporation has losses from
"passive activities," it may not generally offset those los-
ses against its "net active income" (business income, general-
ly) or against its "portfolio income" (income from dividends,
interest, annuities, certain royalties, etc.).

It also means that your C corporation, unlike other C corpor-
ations, may not be able to freely choose a fiscal tax year.
Instead, it will generally be required to use the calendar
year as its accounting period, unless you can convince the
nice folks at the IRS that you have a valid business purpose
for using another (fiscal) year.  In most cases, a PSC may
also make a Section 444 election (on Form 8716) to have a
fiscal year.  However, the Section 444 election is extremely
cumbersome and requires complex annual calculations that
effectively prevent you from obtaining any tax-deferral ben-
efits from having your PSC elect a fiscal year.

@STOP

@Q11

"QUALIFIED PERSONAL SERVICE CORPORATIONS:"  This tax defini-
tion is very similar to, but has subtle differences from the
two definitions of "personal service corporations."  The de-
termination that a C corporation is a "qualified personal
service corporation" ("QPSC") is a two-edged sword:  On the
one hand, it is a negative, since a QPSC is taxed at the
highest corporate tax rate (35%) on ALL of its taxable in-
come, without receiving the benefits of graduated rates on
the first $75,000 of income that other C corporations enjoy.

On the other hand, however, certain large C corporations (ov-
er $5 million annual sales) that would otherwise be forced to
use the accrual method of accounting are allowed to choose the
cash method (which is usually preferable for them) if they
are "qualified personal service corporations."  This is chief-
ly a benefit to large law firms, accounting firms and the
like, however, and not to the typical small service business.

          QUESTION:  Is your firm a C corporation?
@YN
01\Q13
02\Q12

@Q12

CONCLUSIONS:

Since your company is not a C corporation, it is not a "qual-
ified personal service corporation."  Hence, the 35% flat
tax rate that applies to certain C corporations engaged in
personal service businesses is not relevant.  S corporations
and unincorporated businesses are generally not taxable enti-
ties, since their income or losses are reported on the tax
returns of their owners.

Also, from the standpoint of determining whether your busi-
ness may use the cash method of accounting, it does not mat-
ter that it does not qualify as a QPSC, since unincorporated
businesses and S corporations are automatically permitted to
use the cash method (unless the production, purchase or sale
of merchandise is a material income-producing factor in the
business), except for certain partnerships that have one or
more C corporations as partners.

@STOP

@Q13

To be a "qualified personal services corporation," substanti-
ally all of a corporation's activities must involve the per-
formance of services in the fields of health, law, engineering
(including surveying and mapping), architecture, accounting,
actuarial science, performing arts, or consulting.  The "sub-
stantially all" test is met if 95% or more of the firm's em-
ployees' time is devoted to services in the particular field,
or to activities that are incident to performing such services
(e.g., administrative, supervisory and support services).

Services in the health field include services of physicians,
nurses and similar professionals, but not in indirectly rela-
ted fields, such as operation of health spas.  Services in
the performing arts field do not include services of mana-
gers, promoters, broadcasters, and athletes.

QUESTION:  Do "substantially all" the services performed by
    your corporation fall within one of the qualifying cate-
    gories described above (health, law, etc.)?
@YN
01\Q15
02\Q14

@Q14

CONCLUSION:  Your C corporation is apparently not a "quali-
fied personal service corporation" (QPSC).  Accordingly, it
should be entitled to enjoy the lower (graduated) federal
income tax rates of 15% on its first $50,000 of taxable in-
come and 25% on income over $50,000 and not over $75,000, be-
fore it reaches the 34% tax bracket (a 35% rate would apply
to ALL of its taxable income if it were a QPSC.)  This is a
significant tax advantage.

On the other hand, if your firm had over $5 million of aver-
age annual gross receipts for the preceding three years, it
is not allowed to use the cash method of accounting for tax
purposes, since all such large C corporations (OTHER than
QPSC's) are required to be on the accrual method, except for
certain farming corporations.  However, if your firm is that
large, you probably didn't need this computer program to tell
you that fact....If you did, you may need a new accountant....

@STOP

@Q15

Your C corporation must meet an ownership test before it is
treated as a "qualified personal service corporation" (QPSC).
At all times during the tax year, substantially all of the
value of the corporation's stock must be held directly or
indirectly by:
  . employees who perform services in one of the fields
    described in the previous question;

  . retired employees who performed such services;

  . the estate of an individual who was in either of the
    above categories; or

  . any other person who acquired the stock by reason of
    the death of someone in the first two categories above
    (inheritance, etc.) within the last two years.

 QUESTION:  Is substantially all of the stock of your cor-
 poration owned by persons in the categories listed above?
@YN
01\Q16
02\Q14

@Q16

CONCLUSION:  It appears that your corporation comes within
the definition of a qualified personal service corporation.
As such, all of its taxable income will be subject to tax at
the maximum federal corporation income tax rate of 35%, ra-
ther than at the much lower graduated tax rates that apply
to other C corporations.

That's the bad news.  The good news, such as it is, is that
your corporation will be eligible to use the cash method of
accounting for income tax purposes if we have correctly
determined that it is, in fact, a QPSC.

@STOP

@HELP

@H\01

Enter a number, 1 or 2, to let the prog-
ram know which  definition you need help
with.   This guidance to these technical
definitions is  provided mainly  to help
you  respond  correctly to  questions in
certain of the  other Q & A consultation
topics. For example, if you need to know
if your company is a "qualified personal
service corporation" (QPSC)  in order to
answer one of the questions in the Q & A
session on  whether to incorporate,  you
would select #2 above,  to determine  if
your corporation is  subject to the flat
35% tax rate on all of its income.

@H\02

A "C corporation" is  a technical term,
but, fortunately,  is a relatively easy
one to understand.  A C corporation is,
quite  simply,  any corporation  (other
than a  not-for-profit  one) OTHER THAN
an "S corporation" (formerly known as a
Subchapter S corporation). Thus, unless
your corporation  is one that  has made
an election to be taxed as an S corpor-
ation,  it is an C corporation.  There-
fore,  answer this  question "N" ("NO")
only if your  company is an  S corpora-
tion, or is not a corporation at all.

@H\03

Note that virtually  all forms  of busi-
ness organization are subject to passive
loss restrictions, as well as to the re-
strictions on choice of fiscal tax year,
EXCEPT for certain C corporations (other
than  those which  are  Personal Service
Corporations).   Since your  business is
not a C corporation, it is fully subject
to the  limitations on using passive ac-
tivity losses  to offset  other types of
income,  as well as to  the restrictions
on use of fiscal tax year-end.

@H\04

Businesses that  sell some form of prop-
erty,  rather than purely services,  are
not considered to be engaged in perform-
ing services.   Although such activities
as wholesale or retail sales of goods or
sales of insurance, real estate, or fin-
ancial services or products have a large
service component,  they are not consid-
ered to be  performance of personal ser-
vices, for purposes of this definition.

@H\05

Don't think you can get around the "five
or fewer persons owning  over 50% of the
value of the  stock" rule by putting 10%
of the stock in the  hands of each of 10
related people.  The "attribution" rules
of the tax law lump  all related parties
together and treat them as one person.

@H\06
"Net active income" is simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, annuities, or royalties not
   derived in the ordinary course of a
   trade or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\08
The Regulations contain a number of very
technical  rules explaining this test as
to whether services  are "substantially"
performed by owner-employees,  which are
much too complex and detailed to explain
here, so in some cases it may not be to-
tally clear one way or the other whether
your corporation's  owner-employees per-
form enough of the company's services to
meet this test. Thus, in some cases, you
may have to take your best shot at gues-
sing whether to answer "YES"  or "NO" to
this question,  in which case the answer
you finally  arrive at as  to PSC status
may well be wrong.
@H\09

If the total combined ownership of stock
in the corporation by employees, includ-
ing shares they are deemed to own (stock
owned by  their children,  related enti-
ties and so forth),  is more than 10% of
the corporation's  stock (by value), you
should answer "Y" ("YES")  to this ques-
tion.  Otherwise, answer "N" ("NO").

@H\10
"Net active income" is simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, annuities, or royalties not
   derived in the ordinary course of a
   trade or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\11

A "C corporation" is  a technical term,
but, fortunately,  is a relatively easy
one to understand.  A C corporation is,
quite  simply,  any corporation  (other
than a  not-for-profit  one) OTHER THAN
an "S corporation" (formerly known as a
Subchapter S corporation). Thus, unless
your corporation  is one that  has made
an election to be taxed as an S corpor-
ation,  it is an C corporation.  There-
fore,  answer this  question "N" ("NO")
only if your  company is an  S corpora-
tion, or is not a corporation at all.

@H\13

Note that for purposes of the QPSC defi-
nition,  services performed in the field
of consulting include advice and counsel
but do  not include  sales of  brokerage
services or  economically similar  types
of services.

@H\15

The  "substantially all"  requirement is
satisfied  by  ownership of  95% of  the
value of the corporation's stock, accor-
ding to Treasury Regulations.

I.T. Regs. Sec. 1.448-1T(e)(5)(i)

@H\16

Note that the  consequences of being de-
fined to be a QPSC  are quite harsh,  if
the corporation has taxable income.  For
a QPSC the federal income tax on $75,000
of taxable income would be $25,500,  vs.
only $13,750 for a C corporation that is
NOT a QPSC.   (For taxable income levels
above $335,000 there is no difference.)

PLANNING TIP:   If your QPSC  has fairly
low levels of taxable income, try to cut
its net income to as near zero as possi-
ble each year by increasing your salary,
or taking other steps before year-end.

@END