Affiliated group with QPSC allowed graduated tax rates

Regulations do not support the IRS’s “two baskets” approach of separating qualified personal service corporation income, the Tax Court holds.

The Tax Court did not break up consolidated taxable income and allowed graduated corporate income tax rates for an affiliated group that included a qualified personal service corporation (QPSC) that by itself would have been subject to a flat 35% rate.

Facts: In 2006 and 2007, Kenneth Heathington and his wife, Beth Heathington, provided professional engineering, consulting, and administrative services through Applied Research Associates Inc., a Tennessee QPSC. During the same period, the taxpayers also devoted time to Applied Research’s wholly owned subsidiary, Oak Crest Land & Cattle Co., a Texas corporation. The Heathingtons’ time spent on Oak Crest included farming, ranching, and administering the company’s financial operations.

On the 2006 and 2007 consolidated corporate tax returns of Applied Research, the affiliated group paid tax based on graduated corporate tax rates under Sec. 11(b)(1). Applied Research’s gross receipts for the two-year period averaged 90% of the total consolidated gross receipts and all of the affiliated group’s taxable income, since Oak Crest recorded net operating losses both years.

Issues: The IRS contended that under Sec. 448(d)(4), the taxable income of each member corporation of an affiliated group consisting of a QPSC and a non-QPSC should be examined separately, and the consolidated group’s taxable income should be split into two “baskets,” with the taxable income of the QPSC subject to the flat 35% income tax rate under Sec. 11(b)(2) and that of the other corporation subject to graduated rates under Sec. 11(b)(1).

Both parties agreed that Applied Research, as a separate entity, was a QPSC as defined in Sec. 448(d)(2), and that Oak Crest was not. Further, the parties agreed that, “when viewed as a whole, Applied Research’s affiliated group [was] not a qualified personal service corporation.”

Applied Research maintained that under Regs. Sec. 1.1502-2(a), the affiliated group should be treated as a consolidated unitary entity in which a single member’s QPSC income would not taint the consolidated entity’s taxable income, therefore allowing the graduated rates to be applied to the entire affiliated group’s income.

Decision: Finding in favor of Applied Research, the court held that Regs. Sec. 1.1502-2(a) does not permit the IRS to “break up” an affiliated group’s consolidated taxable income into QPSC and non-QPSC income.

The court stated that the “affiliated group as a whole, i.e., the entity which generated the consolidated taxable income … determine[s] the characterization of the consolidated taxable income.” The court acknowledged that its holding could allow taxpayers to circumvent the intent of the QPSC flat rate. But it said it was nonetheless compelled by the regulation, which predated enactment of the flat rate in Sec. 11(b)(2). The IRS knew of the interplay between the consolidated return regulations and the statute, yet had failed to amend the regulations. The court therefore refused to interfere in what is essentially a legislative and administrative matter.

• Applied Research Associates, Inc., 143 T.C. No. 17 (2014)

By David W. Clark, CPA, MPA, instructor of accounting and health care management, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.