Graduated Tax Rate Applies to Affiliated Group with Qualified Personal Service Corporation. (Parker Tax Publishing October 28, 2014)

The taxable income of an affiliated group including a qualified personal service corporation is taxed at the graduated corporate tax rates, but the income of the qualified personal service corporation is not separately taxed at the 35 percent rate. Applied Research Associates, Inc. v. Comm'r, 143 T.C. No. 17 (2014).

In 2006 and 2007, Applied Research owned all the outstanding stock of Oak Crest Land & Cattle Co., Inc. Oak Crest owned and operated a 400-acre ranch in Texas which owned between 200 and 300 head of cattle. Oak Crest is not a qualified personal service corporation. In 2006 and 2007, Applied Research and Oak Crest were an affiliated group and filed consolidated federal income tax returns. Applied Research generated taxable income, whereas Oak Crest generated tax losses and all of the reported taxable income was attributable to Applied Research. On the basis that the affiliated group, as a single entity, was not a qualified personal service corporation, Applied Research paid tax on the consolidated taxable income of the affiliated group at graduated rates set forth in Code Sec. 11(b)(1).

The IRS determined that the consolidated taxable income of the affiliated group was subject to the Code Sec. 11(b)(2) flat 35 percent tax rate applicable to qualified personal service corporations. The government found a deficiency on the grounds that each affiliate's status as a qualified personal service corporation should be examined separately.

Under Reg. Sec. 1.1502-2(a), once an affiliated group calculates its consolidated taxable income, it must apply the tax imposed by Code Sec. 11 on that income. Code Sec. 11(a) imposes a tax on the taxable income of every corporation. Code Sec. 11(b)(1) provides for graduated rates of tax based on the corporation's taxable income. Code Sec. 11(b)(2) imposes a flat 35 percent tax on the taxable income of a qualified personal service corporation, as defined in Code Sec. 448(d)(2).

The IRS argued that, if at least one member of the affiliated group is determined to be a qualified personal service corporation, the consolidated taxable income of the group must be split or broken up into separate baskets: one for the income of the qualified personal service corporation and another for the income of the other corporations. After doing so, the IRS claimed, a flat 35 percent rate is to be applied to the qualified personal service corporation's income and graduated rates are to be applied to the income of the corporation that is not a qualified personal service corporation. In contrast, Allied Research argued that because the consolidated return regulations do not provide for the splitting of an affiliated group's consolidated taxable income after it has been calculated, the entire amount of consolidated taxable income of the affiliated group is taxed at graduated rates. The IRS posited that just as insurance company income is taxed separately from the affiliated group's consolidated taxable income, qualified personal service corporation income is to be taxed separately from the affiliated group's consolidated taxable income.

The Tax Court was asked to decide whether it should:

(1) treat each member of the affiliated group separately and break the affiliated group's consolidated taxable income into separate baskets: one for the income of the qualified personal service corporation and another for the other corporation, or

(2) treat the affiliated group as a single entity and apply the same tax rate to both corporations.

The Tax Court held that the graduated rates apply to the affiliated group's consolidated taxable income. The court noted that, although Code Sec. 448(d)(4) provides special rules by which members of an affiliated group may determine their status as a qualified personal service corporation in electing whether to use the cash method of accounting, it provides no illumination as to the rate of tax to be applied to the consolidated taxable income of the entire group. Nor, the court noted, does Code Sec. 448(d)(4) provide support for the proposition that the consolidated taxable income of an affiliated group is to be broken up into separate baskets. The court reasoned that the character of consolidated income is determined by viewing the consolidated group as a whole. Thus, as the parties stipulated, Applied Research as a consolidated groups is not a qualified personal service corporation and therefore the graduated rates should be applied to the entire group's consolidated income.

The Tax Court rejected the IRS's assertion that when a member of an affiliated group has a special status, as Allied Research has, the tax applicable to that member is calculated and added to the non-special-status members' tax under Code Sec. 11.

For a discussion of the tax rates for qualified personal service corporations, see Parker Tax ¶48,110. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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