When a Service Is Not a Service

IRC section 448(d)(2) imposed a flat tax rate of 35% on the taxable income of qualified personal service corporations, prohibiting them from using the graduated tax rates of 15% to 35% available to most corporations. A qualified personal service corporation is defined as one where substantially all activities involve the performance of services in the fields of health, law, architecture, engineering, accounting, actuarial science, performing arts or consulting. “Substantially all” means 95% or more of an employee’s time is spent performing services in one of these areas. Incidental activities, such as supervising employees and performing administrative and support services, are considered performing services in the field.

In a recent Tax Court case, a corporation was engaged in the business of providing geotechnical testing and engineering services. The nonengineers included clerical staff and full-time technicians, whose formal education ranged from earning high school diplomas to getting two-year civil engineering degrees. The technicians received their training on the job where they were taught how to operate the equipment and how to gather test data. They conducted the geotechnical testing, which consisted of physically testing concrete and soil samples in the field. The data then was put into a report for the client unless an engineering analysis had been requested.

Engineering services included recommendations on foundations, bridges and buildings. The engineering analysis was based on data the technicians collected or a third party provided. The corporation provided engineering services only if the client requested them. On its books and records, it differentiated between amounts billed for engineering services and for geotechnical testing.

The IRS argued that the engineering analysis and the geotechnical testing were both engineering services. Therefore, “substantially all” the services rendered were engineering services. The corporation countered that the geotechnical testing services were not.

The Tax Court agreed with the corporation and held that the geotechnical testing services were separate and distinct from the engineering services. The court reviewed the corporation’s itemized bills and found that more than 5% of the time was spent on geotechnical testing. Therefore, less than “substantially all” the corporation’s services were for engineering. Consequently, the corporation was not a personal service corporation and therefore, was not subject to the flat tax rate of 35%.

Observation. The “substantially all” test is based on time spent by employees performing specific services. It is not based on wages paid or amounts billed to clients.

The taxpayer won this case because it kept detailed books and records showing the time employees spent performing engineering and nonengineering services. The corporation also was able to prove that the geotechnical testing service was not an incidental service to the engineering business but a service offered to clients independent of an engineering analysis ( Alton Engineering and Testing Corp. v. Commissioner, TC Memo 2000-335).

—Michael Lynch, Esq., professor of tax accounting
at Bryant College, Smithfield, Rhode Island.