Planning for service corporations requiring change to the accrual method of accounting.

• Author: Wendland, Sherri L.

The Internal Revenue Code permits taxpayers to select any method of accounting as long as it clearly reflects income. Service businesses typically prefer the use of the cash-basis method for tax purposes because it matches cash flow with the tax to be paid. The cash method also presents the greatest opportunities for tax planning via controlling the timing of receipts and payments. This ability to "distort" income has been a cause for concern at the IRS and in Congress; in recent years, legislation has been moving in the direction of restricting the use of this method of accounting. Sec. 448 prevents the use of the cash method for certain entities.

The general rule is that C corporations may not use the cash method, but with several very broad exceptions. Two of those exceptions are: (1) C corporations with less than $5 million in average annual gross receipts for a three-year period (gross receipts test) and (2) qualified personal service corporations (QPSCs). S corporations are exempt from this general rule.

Like an S corporation, a QPSC may use the cash method of accounting regardless of the level of its gross receipts. To qualify as a QPSC, the corporation must meet two tests: a function test and an ownership test. A taxpayer must switch to the accrual method for the first year in which it fails to meet either of these tests. In addition, an entity must meet both of these tests for the entire year in order to be treated as a QPSC for purposes of being able to use the cash method.

The function test requires that substantially all of the corporation's activities for a tax year involve the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. "Substantially all" is defined to mean that at least 95% of the time spent by employees is devoted to the performance of services in a qualifying field. Activities incident to the actual performance of services, including supervision of employees and performance of administrative and support services, are all considered the performance of services in the field.

The ownership test is met if at all times during the tax year substantially all (i.e., 95% or more by value) of the corporation's stock is held (directly or indirectly) by:

1. Employees performing services for the corporation in a qualifying field.

2. Retired employees who performed such services for the corporation.

3. The estate of an employee in item 1...