Personal Service Corporations: Tax Reform's Destruction of Fiscal Year Ends and the Aftermath

Publication year1987
Pages1818
CitationVol. 16 No. 10 Pg. 1818
16 Colo.Law. 1818
Colorado Lawyer
1987.

1987, October, Pg. 1818. Personal Service Corporations: Tax Reform's Destruction of Fiscal Year Ends and the Aftermath




1818


Vol. 16, No. 10, Pg. 1818

Personal Service Corporations: Tax Reform's Destruction of Fiscal Year Ends and the Aftermath

by Bradley P. Burnett

The Tax Reform Act of 1986 ("1986 Act") is forcing many changes on all taxpayers. Fiscal year personal service corporations, S corporations, partnerships and trusts bear the brunt of one such change. The 1986 Act generally requires these entities to switch from fiscal taxable years to calendar taxable years.(fn1)

Switching from fiscal to calendar taxable years hampers the ability of such entities and their owners to defer the payment of taxes as done under prior law. The consequences, particularly in the short run, can be quite costly. With planning, some entities may sidestep this new rule entirely, while others have no choice but to comply with it and plan to soften its "ripple effect."

A fiscal year "personal service corporation" ("PSC") is one type of entity required to switch to a December 31 taxable year. A PSC is a corporation "the principal activity of which is the performance of personal services and such services are substantially performed by employee-owners."(fn2) PSCs include, but are not limited to, professional corporations ("PCs") under state law. Any corporation, the purpose of which is to furnish services provided by individuals, could be a PSC.

This article focuses on how to determine whether a corporation is a PSC and, if it is, how to deal with the related consequences.

PRIOR LAW TAX DEFERRAL

PSCs and their owners had been able to defer the payment of taxes under prior law through the use of fiscal taxable years. If a PSC had a taxable year different than the taxable year of its employee-owner, prior law allowed the deferral of taxation by one month for each month the corporation's taxable year ended sooner than the taxable year of its employee-owner.

A PSC could declare sizeable bonuses after the end of its employee-owner's calendar taxable year but within its own fiscal taxable year. In so doing, that corporation would shelter its income by deducting the bonus, while its employee-owner waited up to an extra eleven months to pay taxes on his bonus income.

Example: A medical PSC with a January 31, 1987, fiscal year nets $480,000 (earned ratably $40,000 per month) before employee-owner salaries. The PSC pays its employee-owners total salaries of $360,000 (paid ratably $30,000 per month) and bonuses totalling $110,000 declared and paid in January.

The corporation's federal income tax liability is $1,500 (i.e., $480,000 - 360,000 - 110,000 = $10,000 taxable income multiplied by 15 percent tax rate = $1,500 tax). Assume the alternative minimum tax does not apply.

The corporation sheltered most of its income by paying large bonuses in January. At the same time, the employee-owners enjoyed an eleven-month deferral. Except for their minimum required estimated tax payments, they do not have to pay tax on their January 1987 salary and bonus income until 1988 when they file their 1987 tax returns.

PSC TAXABLE YEAR CHANGES UNDER THE 1986 ACT

The 1986 Act requires that the taxable year of any PSC be the calendar year, unless the corporation establishes a business purpose for having a different period for its taxable year. The deferral of income to employee-owners does not qualify as a business purpose.(fn3)

Fiscal year PSCs required to switch to a calendar year will have two taxable periods ending in 1987: the usual fiscal year end ("FYE") and the short calendar year ending ("CYE") on December 31, 1987. One consequence is that an employee-owner of such an entity will not be able to defer income as illustrated above. He therefore must include salary and bonus income from both periods on his 1987 return. This may dramatically increase his 1987 individual income tax liability. Conversely, if excess earnings are left untapped at the corporate level at the end of 1987, the PSC will be faced with a high tax bill.

Example (continued): The medical PSC continues to earn income and incur expenses at the same pace through January 31, 1988. For the eleven months ended December 31, 1987, the PSC nets $440,000 (earned ratably $40,000 per month) before employee-owner salaries. Total employee-owner salaries are $330,000 (paid ratably $30,000 per month). Since the employee-owners want to avoid unreasonably high 1987 individual income taxes, no bonuses are paid within the eleven-month period.

The corporation's federal income tax liability for the eleven-month period ended December 31, 1987, is $29,058 (i.e., $440,000 - 330,000 - 0 = $110,000 taxable income(fn4) multiplied by applicable tax rates(fn5) = $29,058 tax). Assume the alternative minimum tax does not apply.


Since the PSC fails to shelter its income through bonuses, it suffers its day of reckoning. The employee-owners have kept their 1987 taxes low at the corporation's expense. The corporation's tax liability for 1987 is $30,558 ($1,500 for FYE 1-31-87 + $29,058 for CYE 12-31-87). By comparison its tax liability, absent tax reform, would have been only $3,000 ($1,500 for FYE 1-31-87 + $1,500 for 1-31-88).

Planning Point: Employee-owners must simultaneously keep an eye on both their individual returns and their PSC's returns in order to keep the 1987 taxes of each as low as possible. Many factors, including the new tax rates and the respective tax positions of the PSC and all employee-owners, must be considered.

Under legislation recently introduced by the American Institute of CPAs,(fn6) a PSC which is otherwise required to switch to a calendar year could elect to retain its fiscal year. The optional election would be made at the corporate level. Under a complex formula, if payments to owner-employees are not made ratably before and after December 31, the electing PSC will have to postpone some or all of its deduction for such payments until the following fiscal year. In other words, to the extent employee-owners achieve a more-than-average amount of deferral, the PSC will have to wait to take its corresponding deduction.

The purpose of the legislation is to ease the highly seasonal workload created for accountants by the 1986 Act and to allow taxpayers more time to plan. The legislation is currently gathering steam in Congress and could be law by year end.

PSC
...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT