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Text File | 1996-08-23 | 21KB | 562 lines

@Q01

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

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

Definition #1 of "personal service corporations" has to do with
whether a corporation is subject to limits on passive activity
losses; #2 is a virtually identical definition of PSC's that
decides whether a corporation will be allowed to use certain
fiscal years for tax purposes; #3 is a slightly different
definition ("qualified personal service corporations"), that
determines 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
service corporation" are fully subject to the passive activity
loss restrictions that apply to all taxable entities other than
C corporations.  The law has a virtually identical definition
of "personal service corporation" that is used to determine
whether a corporation is restricted in its choice of fiscal
year.  Being determined to be a personal service corporation
("PSC") under EITHER definition is almost always bad news.

The first type of PSC is fully subject to the limits on loss
deductions from passive activities (like real estate rentals);
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
limitations.  To the contrary, ANY other kind of business
organization other than a C corporation (such as a
partnership, LLC, sole proprietorship or an S corporation)
is AUTOMATICALLY subject to the passive loss restrictions.

(Rules for business trusts, which may be treated as
corporations, 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
select 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
deferring 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
performance of personal services.  Personal services would
cover a wide range of activities, including professional
services such as law, medicine, dentistry, accounting,
architectural and engineering services, actuarial sciences,
and the like.  It would also cover areas such as consulting
services, the incorporated professional athlete or entertainer,
and miscellaneous other service businesses, such as an
incorporated 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
limitations on choice of fiscal year.  Thus, if it is a new
corporation, you can choose whichever month of the year as
its year-end that you desire.  You may be able to gain some
significant 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
limitations.  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 indirectly)
       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
subject 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
corporation." 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"
performed 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
performed 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 services rendered by the corporation
"substantially" performed by shareholder-employees?

@YN
01\Q09
02\Q05

@Q09

STOCK OWNERSHIP REQUIREMENT:  A corporation cannot be
treated 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
corporation 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
losses against its "net active income" (business income,
generally) or against its "portfolio income" (income from
dividends, interest, annuities, certain royalties, etc.).

It also means that your C corporation, unlike other C
corporations, 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 benefits from having your PSC elect a
fiscal year.

@STOP

@Q11

"QUALIFIED PERSONAL SERVICE CORPORATIONS:"  This definition
is very similar to, but has subtle differences from the
two definitions of "personal service corporations."  To
determine 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
income, 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
(over $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
chiefly 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
"qualified 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 entities, since their income or losses are
reported on the tax returns of their owners.

Also, from the standpoint of determining whether your business
may use the cash method of accounting, it does not matter
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

In a "qualified personal services corporation," substantially
all of a corporation's activities must involve the performance
of services in the fields of health, law, engineering
(including surveying and mapping), architecture, accounting,
actuarial science, performing arts, or consulting.  The
"substantially all" test is met if 95% or more of the firm's
employees' 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
related fields, such as operation of health spas.  Services
in the performing arts field do not include services of
managers, promoters, broadcasters, and athletes.

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

@Q14

CONCLUSION:  Your C corporation is apparently not a
"qualified 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
income and 25% on income over $50,000 and not over $75,000,
before 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
average 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
 corporation 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%,
rather 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 program
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 S  corporation  election on IRS Form
2553,  it is  an C  corporation.  Thus,
answer this question "N" ("NO") if your
company is an  S corporation,  or if it
is not incorporated at all.

@H\03

Note:  Virtually  all forms  of business
organization are subject to passive loss
restrictions,  as well  as  restrictions
on their choice of  a  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 all  limits on using passive activity
losses as deductions against other types
of income,  plus all of the restrictions
on the use of a fiscal tax year-end.

@H\04

Businesses selling any kind of property,
rather  than purely  services,  are  not
considered to  be engaged  in performing
services.   Although  such activities as
wholesale  or retail  sales of  goods or
sales  of  insurance,  real  estate,  or
financial  services  or products  have a
large  service  component,  they are not
considered to be performance of personal
services, under this special 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 defined as:  all
taxable income EXCEPT  portfolio income
and expenses or passive activity income
and loss. Portfolio income and expenses
include  the following items  of income
(less all allocable expenses):

 . Gross dividends, interest, 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
very  clear one way or the other whether
your    corporation's    owner-employees
perform enough of the company's services
to meet this test.  Thus, in some cases,
you may  have to take  your best shot at
guessing whether to answer "YES" or "NO"
to this  question,  in  which  case  the
answer you finally  arrive at as  to PSC
status will not necessarily be correct.
@H\09

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

@H\10
"Net active income" is simply taxable
income OTHER THAN portfolio income and
expenses or passive activity income
and loss. Portfolio income and expense
includes the following items of
income (less all allocable expenses):

 . Gross interest, dividends,
   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
elected to become an S corporation,  it
is a C corporation.  Therefore,  answer
this  question  "N" ("NO") only if your
company is an  S corporation, or is not
a corporation at all.

@H\13

Note that for purposes of the QPSC
definition, 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,
according to Treasury Regulations.

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

@H\16

Note  that  the  consequences  of  being
defined  as 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 you
can annually, by increasing your salary,
or taking other steps before year-end.

@END