Tax Court Tells IRS "Update Your Regulations"

Published on: 19:11PM Oct 10, 2014

In an US Tax Court case released on October 9, 2014, the Court essentially told the IRS to update their income tax regulations to reflect changes made to the US Income Tax Code almost 20 years before.

If a service business (such as an accounting firm, law practice, medical practice, etc.) incorporates its business, it is treated as a personal service corporation (PSC). Regular corporations enjoy graduated income tax brackets. The first $50,000 is subject to a tax rate of 15% and the next $25,000 is taxed at 25%. Thus a regular corporation can enjoy up to $12,500 of tax savings versus a PSC since the PSC is taxed at a flat 35% tax rate. Prior to 1987, this was not the case. Up to that time, all corporations enjoyed the benefit of graduated tax rates; this is the rub of the current court case.

In the case, the taxpayer (Applied Research) was a personal service corporation providing engineering services. It also had a wholly owned corporate subsidiary (Oak Crest) that raised about 200 head of cattle in Texas. This was a "regular" corporation. The PSC reported about $265,000 of taxable income and Oak Crest had a loss of about $185,000.

Without filing a consolidated tax return which combines the income of Applied Research and the loss of Oak Crest, Applied Research would owe tax of about $93,000 and Oak Crest would have a loss with no tax benefit. However, by filing a consolidated tax return, Applied Research is allowed to take the loss from Oak Crest and offset its income. This resulted in the consolidated filer paying slightly less than $16,000 of corporate taxes. That is not in dispute in this case. The dispute is whether the net income of about $81,000 is subject to a flat rate of 35% (the IRS position) or is subject to graduated tax rates (the taxpayer's position). The difference in tax is $12,500.

The Income Tax Code was amended in 1987 to prevent personal service corporations from reaping the benefits of graduated corporate tax rates. However, the Regulations that the IRS follow in interpreting the Code were never updated. Therefore, the Tax Court ruled in favor of the taxpayer.

Based on this ruling, any personal service corporation could simply create a non-PSC corporate subsidiary (perhaps to raise cattle) and file a consolidated tax return to reap the benefits of graduated corporate tax rates. However, the maximum tax savings is $12,500, you have to deal with filing a consolidated tax return and contend with another corporate tax entity. Probably not worth the effort, but it is refreshing that the US Tax Court has essentially told the IRS "Update Your Regulations" if you want us to rule in your favor.