The U.S. Tax Court has ruled that bookkeeping services are considered to be in the business of “accounting. Thus, bookkeeping companies that operate as a “C” corporation are subject to a flat 35 percent rate of tax that applies to “personal service corporations” instead of being able to use the graduated tax rates that apply to C corporations. That’s a big deal - C corporations are taxed at a 15 percent rate on the first $50,000 of C-corporate taxable income. A C corporation may keep up to $50,000 of profits in the business for a relatively low tax rate of 15 percent - a real advantage for a company that would like to retain funds for use in the business. However, C corporations where substantially all of the corporate activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting and 95 percent of the corporate stock is owned by employees who perform those services, are classified as personal service corporations (PSCs) under Section 448 of the Internal Revenue Code. Some businesses don’t have to worry about being a PSC - the definition does not include sales and brokerage services, or businesses that are compensated on a commission or contingent basis where a product is sold, such as real estate, insurance, investments and similar businesses. The downside of being a PSC is that a flat 35 percent rate of tax applies to every dollar of taxable income - no 15 percent bracket on the first $50,000 of taxable income. That’s a $10,000 tax difference just on the first $50,000 of taxable income. There are other drawbacks of being a PSC - filing of tax returns on a calendar year basis; deducting payments made to an owner-employee only in the tax year in which the employee included the payment in income; and not being able to carry back any net operating loss to offset a prior year’s income (if an election is in place under Section 444 of the Code).
This case involved a Las Vegas firm that performed bookkeeping and tax return preparation services for local clients. All of the corporate stock was owned by the founder’s widow who managed the business and provided personally tax return preparation services. None of the firm’s employees were CPAs, and the firm did not perform services that required a CPA license (so, it wasn’t a public accounting firm). The firm filed a C corporate tax return, thereby utilizing the graduated tax brackets that apply to C corporations. IRS disagreed, taking the position that the firm was a PSC. The firm argued that it couldn’t be a PSC because it didn’t perform “accounting” services due to the fact that none of the employees were required to be CPAs. The Tax Court, while noting that “accounting” had not been defined in the Regulations, agreed with the IRS position on the basis that bookkeeping constitutes a “branch” of accounting and that the system of double entry bookkeeping is the basis for modern financial accounting. Also, state law defined “public accounting” as including “the preparation of tax returns. Likewise, in a 2006 Tax Court case, the taxpayer agreed with the government that tax return preparation services constituted accounting services (that issue wasn’t decisive to the outcome of the case - the case turned on the number of hours employees spent on accounting services as compared to investment advice conducted through another entity).
So, how does a firm avoid being classified as a PSC? There are several options - (1) elect “S” corporation status; (2) have enough other business activity conducted by the employees to fall below the 95 percent threshold; or (3) simply pay all of the corporate income out as bonus and salary (but, if the corporation is going to pay all the income out, it would be best to elect S corporate status).
One other point - the Tax Court’s opinion was issued as a decision of the full Tax Court rather than the usual “Memorandum” opinion. That is rare. This means that the Court has put some extra effort into its decision and is probably anticipating that the case will be appealed to the U.S. Court of Appeals for the Ninth Circuit. Rainbow Tax Service, Inc. v. Commissioner, 128 T.C. No. 5 (2007).