An Ohio CPA can thank his inability to properly separate his accounting business from his financial planning business for a win in U.S. Tax Court that saved him thousands in additional tax."It was an uphill battle against overwhelming odds, but victory always makes it worthwhile," said Ron Lykins, a metropolitan Columbus, Ohio, CPA.
Through his C corporation, Lykins provided accounting services, focusing mainly on tax preparation and advice, and financial services, mainly commission-based sales of securities and investment advice.
Lykin's attorney advised him to separate the two sides of his business so that he could market them to a wider variety of potential buyers when the time came to retire. Accordingly, Lykins spun off the financial services side into an LLC.
As a result, the Internal Revenue Service said that Ron Lykins Inc., the corporation that now contained the accounting practice, was a qualified personal services corporation. Consequently, its income would now be taxed at the flat rate of 35 percent, rather than the more favorable graduated rate applicable to other C corporations.
"I didn't think it was a QPSC and I gave my reasons," said Lykins. "But I could tell the auditor wasn't accepting my argument. They completed the audit and found nothing wrong with taxable income but they recalculated tax using the 35 percent rate."
Lykins started preparing tax returns in 1969 to supplement his income, and when he opened an accounting practice it quickly came to focus on tax preparation and advice. His clients began trusting him for financial and investment advice as well, and his business steadily grew. He incorporated it as Ron Lykins Inc. in 1980, and Lykins Inc. has ever since filed tax returns as a C corporation.
When Lykins followed his attorney's advice in 2000, he formed Lykins Financial Group, LLC, a limited liability company under Ohio law. Lykins Inc. continued to offer tax services, but Lykins Financial was now the sole vehicle through which financial and investment services were offered. Lykins was the sole owner of both companies.
The IRS audited Lykins Inc. and issued a notice of deficiency after concluding that the firm had become a "qualified personal services corporation" that was subject to tax at a flat rate of 35 percent.
The tax court disagreed.
Under the code, substantially all of the activities of a personal services corporation must involve the performance of services in one of eight fields: health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. Regs define "substantially all" as 95 percent or more.
When Lykins separated his investment services from his accounting services, it exposed him to personal service income treatment from his income from Lykins Inc., since accounting services amounted to more than 95 percent of the time spent by Lykins Inc.'s personnel, according to the IRS.
But the court found that the employees of Lykins Financial continued to be employees of Lykins Inc., with the result that only 80 percent of total employee hours were spent on accounting services, while 20 percent were spent on investment services.
The court noted that the code's various definitions of personal services corporations date from the time when the top tax rate for individual income was much higher than the rate for corporations. This gave professionals an incentive to incorporate their practices to win the benefits available both to employees or corporations.
Identifying corporations as QPSCs and taxing them at a flat rate of 35 percent was Congress's way to reduce the incentive for professionals to shelter part of their income in a corporate form with a lower marginal rate, according to the court.
The code sets up two tests for a QPSC - an ownership test and a function test. Although Lykins met the ownership test by virtue of the fact that he was the sole owner of Lykins Inc., the tax court held that he failed the function test.
While Lykins Inc. and Lykins Financial filed separate corporate tax returns, fully separating the companies proved difficult. The formation of Lykins Financial led to few physical changes, according to the court. The firms shared the same office space, and had the same address, same phone number, same copying machine and fax, same employee manual, and even the same coffee machine.
Moreover, there was no written agreement defining which employees belonged to which entity - while some employees worked only on investments and some worked only on tax preparation, there were also some who worked on both. Employees who worked at Lykins Financial continued to receive paychecks drawn on Lykins Inc., continued to receive benefits provided by Lykins Inc., and continued to have their Social Security tax paid for by Lykins Inc. Therefore, all the Lykins
Financial employees continued to be Lykins Inc. employees throughout the year.
"If you're in one of the eight enumerated occupations, you have to spend more than 5 percent of your time in a nonrelated field to avoid QPSC treatment," said Lykins. "My time was well above that level. I never bought the fact that just because you're a CPA firm you automatically qualify."
"However, the IRS position was that, 'Hey, you're a CPA firm, so you're automatically a QPSC,'" he added. "That was the attitude that prevailed at audit and appeals and in litigation with the IRS attorney."
Lykins noted the advantages and disadvantages of operating as a C corporation.
"I initially formed a Subchapter S corporation, but as the business grew, I wanted to accumulate capital to help it grow, so I switched to a C corporation. There's an advantage to operating as a C corporation, but you ultimately have to pay the double tax," he said.
LLCs are becoming more common for professional firms, but firms that began as C corps may not have changed their identity where doing so could trigger gain, according to Bob D. Scharin, senior tax analyst at RIA. "Accountants thinking of splitting their practice should be aware that they could be triggering the QPSC rules. They should look at their practice to see if they are a QPSC. If they feel they are, they should know that selling other services may bring the firm outside the QPSC definition."
"It might be better for someone in this situation to have an internal restructuring of the business into separate divisions, rather than splitting into different entities," said Scharin. "That would make it easier to sell one division by tracking income and expenses separately for each division."
"Also, the accountant should keep in mind that consulting is one of the enumerated categories. Lykins didn't fall afoul of that because income from Lykins Financial was generated by commissions. If instead of commissions he received an hourly fee for investment advice, he could be considered a consulting business and thus be a QPSC," Scharin added.
"In hindsight, I would have kept operating just as I was, instead of splitting the businesses," said Lykins.
"For small firms, when you have the same people doing both functions, it's better to operate as one business," he said. "However, you need to keep records to separate tax and accounting from unrelated services so that you can show that you're not a QPSC."
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