Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F303.SBE

Text File | 1992-04-30 | 21KB | 534 lines

@Q01

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

Our federal tax laws can be terribly confusing.  A case in point is the
fact that the tax code uses 3 very similar definitions of "PERSONAL
SERVICE CORPORATIONS" and "QUALIFIED PERSONAL SERVICE CORPORATIONS" for
several purposes.  Even tax professionals find the minor differences
between the three definitions to be excessively complex and maddening.

Definition #1 of "personal service corporations" has to do with deter-
mining whether a corporation is subject to the limitations on passive
activity losses; #2 is a virtually identical definition of "personal
service corporations" that decides whether a corporation will be al-
lowed 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 34% tax rate and
whether it can use cash method accounting in certain circumstances.

  QUESTION:  Which definition do you want to test your company against?
              1- "Personal Service Corporation" -- Subject to passive
                  loss rules and unable to freely choose fiscal year.
              2- "Qualified P.S.C." -- Subject to flat 34% tax rate.
@MC\02
01\Q02
02\Q11

@Q02

LIMITATIONS ON CERTAIN "PERSONAL SERVICE CORPORATIONS."  Certain C
corporations that fall under the definition of "personal service cor-
poration" are fully subject to the passive activity loss restrictions
that apply to all taxable entities other than C corporation.  The tax
code also has another virtually identical definition of "personal
service corporation" that applies for purposes of determining whether
a corporation may be restricted in its choice of fiscal year.  Note
that being determined to be a personal service corporation ("PSC")
under EITHER of these two definitions is almost always bad news.

The first type of PSCs are fully subject to the limitations on deduct-
ing losses from passive activities (such as real estate rental proper-
ties); they cannot offset net passive activity losses against either
portfolio income or "net active income."  The second type of PSC's are
severely limited in their choice of fiscal year, usually being required
to use the calendar year for tax purposes. 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 start celebrating 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, sole proprietorship or an S corpor-
ation) 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 partner-
ships, 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 enter-
tainer, 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

CONCLUSIONS:  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
considered a "personal service corporation," the personal services
performed by the corporation must be "substantially performed" by
employees who own stock in the corporation.  To determine whether the
services to customers, clients, etc. are "substantially" performed by
employee-owners, the Income Tax Regulations say that more than 20% of
the corporation's compensation expense attributable to its service
activities have to be attributable to personal services performed by
its employee-owners.  If it is clear that over 20% of the cost of per-
forming services (of the types described in the previous question) are
attributable to services performed by owners, you should 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
             "substantially" performed by employee-owners of
             the corporation?

@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 cor-
poration 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 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 prevent you from obtaining any tax-
deferral benefits from having the PSC elect a fiscal year.

@STOP

@Q11

"QUALIFIED PERSONAL SERVICE CORPORATIONS:"  This tax definition is
very similar to, but has subtle differences from the two definitions
of "personal service corporations."  The determination 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 (34%) 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 gross receipts) that would otherwise be forced to
use the accrual method of accounting are allowed to choose the cash
method of accounting (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 34% flat tax rate that
applies to C corporations is not relevant.  S corporations and un-
incorporated 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 corpora-
tions 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," 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.  This "substantially all" test is met if 95% or
more of the corporation's employees' time is devoted to services in
the particular field, or to activities that are incident to performing
such services (such as 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 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--which 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 also satisfy an ownership test before it is
determined to be 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 34%, 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 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
34% 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\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