@Q01 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � PERSONAL SERVICE CORPORATIONS � � AND QUALIFIED PERSONAL SERVICE CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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 34% 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 34% 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 (34%) 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 34% flat tax rate that applies to C corporations 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 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--which would apply to ALL of its taxable income if it were a QPSC. This is a sig- nificant 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 34%, 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 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\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