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By Mark A. Segal

As a result of RRA '93, the maximum marginal tax rates for individual taxpayers (39.6%) is higher than corporate taxpayers (35%). This difference is a factor to be considered when deciding whether to use the corporate format for conducting business. Use of a corporation enables deferral of some amount of tax, splitting of income, and greater availability of fringe benefit provisions. Where an individual incorporates and derives revenue from the rendering of services, the corporation is commonly referred to as a personal service corporation (PSC). A controversial subject for PSCs that derive their revenue primarily from one client or customer is whether the shareholder-worker should be treated as an employee of the PSC or of the client (customer).

Employee of PSC or Third Party?

The IRS can seek to have income taxable to an shareholder-worker of a PSC rather than the PSC by either ignoring the PSC or having the amount reallocated to the shareholder-worker. Protecting recognition of a PSC is the long-held notion that a corporation that serves a business related function should be respected for tax purposes. The tax court has consistently held that determination of to whom amounts are taxable depends upon application of the common law factors for ascertaining whether a worker shall be deemed an employee of the PSC or the third party. Application of this approach is reflected in a trilogy of cases of which Leavell is the most recent.

Leavell: On January 31, 1995, the tax court in Leavell [104 T.C. No. 6 (January 1, 1995)] held that amounts earned by a professional basketball player were directly taxable to him rather than his PSC. In Leavell, the taxpayer formed a PSC with which he then entered into a contract to render services. The PSC then entered into a contract with a professional basketball team (Houston Rockets), providing the shareholder-worker's services for a two-year period. The contract was a standard NBA contract. To protect its rights, the team also had the player sign a guarantee.

Despite the apparent contract between the team and the PSC, the court found the player to be a common law employee of the team and, as such, held that all renumeration for his services were directly taxable to him. In reaching this decision, the court appeared to reject the position taken in Sargent, wherein the Eighth Circuit overturned a tax court decision and held amounts taxable to a PSC rather than an shareholder-worker.

Sargent: Sargent [919 F.1d 1151 (1990), rev'g 93 T.C. 571 (1989)] involved a professional hockey player who formed a PSC with which he entered into a contract to perform services as a professional hockey player and consultant for a fixed salary. The PSC then entered into a contract with a professional hockey team pursuant to which the PSC would provide the team with the player's services in return for a salary. Both contracts were complied with. The player was covered by a deferred compensation plan provided by the PSC rather than the traditional NHL pension plan. Based upon these facts, the Eighth Circuit held that a principal-agency relationship between the PSC and player should be recognized, and the salary paid by the team attributed to the PSC. According to the Eighth Circuit, to adopt the position taken by the tax court in rejecting such recognition would both be‹

**inconsistent with other tax court decisions that have found a principal-agency relationship, despite the presence of a common law employment relationship between the service provider and third party; and

* inequitable in that it would enable a PSC of an independent contractor to establish a principal-agency relationship, but not the PSC of an employee.

Johnson: The Eighth Circuit decision in Sargent appeared to be influenced by the approach taken by the tax court in the 1984 case of Johnson [698 F.1d 371 (9th Cir. 1981), aff'g 78 T.C. 881 (1981)]. In Johnson, amounts paid by a team for the services of a professional basketball player were found to be directly taxable to the player rather than the player's PSC, due to the lack of any evident, relevant contractual arrangement between the team and the PSC.

Agency-Relevant Factors

A critical issue in identifying the appropriately taxable party is whether the shareholder-worker is, in fact, functioning as an agent of the PSC. Examination of case law reveals several relevant factors in making this analysis. According to these courts, no one of these factors is determinative. These factors include the following:

* The degree of control exercised over the worker by the alleged principal.

* The respective rights to remuneration held by the alleged agent and principal.

* The purpose of the principal's existence.

* The type of work performed by the worker in comparison to the purpose of the PSC.

* The nature and amount of dealings between the worker and the third party in determining what work will be performed.

* The dealings between the principal and the third party.

Other Grounds of Attack‹Reallocation

In addition to the issue over whether the presence of a common law employee relationship should be deemed to exist between the third party and the worker or whether the worker and the PSC should be considered to possess a principal-agency relationship, several other issues have surfaced as relevant to the tax treatment of worker-PSC arrangements. These issues are both doctrinal and statutory. Two statutory weapons available to the IRS enable the reallocation of income between the PSC and worker. These provisions are IRC Secs. 269A and 482.

In contrast to the traditional argument that all of the remuneration earned as a result of the services of the shareholder-worker should be attributed to the worker, application of IRC Secs. 269A or 482 have generally resulted in at least some portion of the amount involved being found taxable to the PSC.

IRC Sec 482: According to IRC Sec. 482, the commissioner is authorized to allocate items of gross income, deductions, credits, or allowances between two or more controlled organizations, trades, or businesses where such is necessary to prevent the evasion of taxes or to clearly reflect the income of the organizations, trades, or businesses.

IRC Sec. 269A: Under IRC Sec. 269A, the secretary is authorized to allocate all income, deductions, credits, exclusions, and other allowances between a PSC and its shareholder-employees, if necessary, to prevent the avoidance or evasion of income taxes or to clearly reflect income. The two requisites that must be met before IRC Sec. 269A can be applied are‹

* substantially all of the services of the PSC must be performed for (or on behalf of) another corporation, partnership, or entity; and

* the principal purpose of forming, or availing of the PSC, is the avoidance or evasion of Federal income tax by reducing the income of, or securing the benefit of an expense, deduction, credit, or other exclusion.

Although directly applicable to PSCs, IRC Sec. 269A has been rarely utilized in litigation. This is, in part, because the statute is effective for transactions occurring after December 31, 1981. Other obstacles to effective use of the statute include the narrowness of the statute and the need to establish both requisites. This is particularly true in light of proposed regulations that suggest the formation of the PSC to enable utilization of enhanced retirement plans does not constitute a proscribed interest.

In light of these obstacles, it is likely that the more flexible IRC Sec. 482 reallocation provisions will remain significantly more prevalent in controversies concerning PSCs.

Reallocation Court Cases

The IRS has met with some success in asserting reallocation of income between a PSC and shareholder-worker in scenarios involving a clear tax avoidance purpose or where the third party does not appear to have an exclusive contract with the PSC and has not looked to the shareholder-worker rather than the PSC for the rendering of services. Reallocation under IRC Sec. 482 in these situations is reflected in the trilogy of Ach, Borge, and Rubin.

Ach: In Ach [358 F.1d 341 (6th Cir. 1966), aff'g 41 T.C. 114 (1964), cert. denied 385 U.S. 899], the taxpayer transferred a profitable business to a corporation owned by her son for an amount substantially below market price. Prior to transfer, the acquiring corporation had losses it could not utilize due to insufficient income. After the transaction, the loss corporation sought to offset its losses against income generated by the acquired business. Following the transfer, the taxpayer became the president and treasurer of the son's corporation.

The tax court viewed the transaction as a clear attempt to avoid taxes and the taxpayer as remaining in business through her ties to the transferred business. As a result, the court reallocated 70% of the income of the transferred business to the taxpayer.

Borge: A similar result was reached in Borge [405 F.1d 673 (1nd Cir. 1968), cert. denied 395 U.S. 933]. The taxpayer was an entertainer who controlled an unprofitable corporation engaged in the poultry business. The taxpayer entered into a contract with the corporation to render services for a salary well below that which the taxpayer actually commanded for his services. The difference between the amount earned by the corporation from his services and the salary paid the taxpayer could effectively be offset by the losses produced by the poultry business. As funding the corporation did little to enhance the taxpayer's already established entertainment business, a substantial amount of the entertainment earnings were allocated to the taxpayer.

Rubin: In Rubin [56 T.C. 1155 (1971) aff'g per curia 466 F.1d 1116 (1nd Cir. 1971), rev'd on other grounds], IRC Sec. 482 was applied by the tax court to reallocate income to the taxpayer despite the underlying tax avoidance motive not being as blatant as in Ach or Borge. Rubin involved a taxpayer established in the textile industry who formed a corporation with his brothers that, in turn, provided his services for a salary to another corporation controlled by the taxpayer. The taxpayer provided services beyond those provided for in the contract to the corporation. Both the tax court and Second Circuit found the taxpayer had clearly engaged in a separate trade or business and the amount he received was not at arms length, particularly in light of his control over both corporations and then reallocated a substantial amount of income to him.

Separate Trade or Business

An issue that has arisen in recent years concerns whether the IRC Sec. 482 prerequisite of a separate trade, business, or organization is satisfied where the worker has an exclusive and binding contract with the PSC and engages in no separate business activities. As reflected by case law, the IRS maintains that IRC Sec. 482 is applicable in these circumstances. Implicit in this position is the view that the shareholder-worker can be viewed as engaged in a separate trade or business by virtue of being an employee. In general, courts have found little difficulty in finding IRC Sec. 482 applicable to PSC and shareholder-worker relationships. As suggested by the tax court in Ach, the fact that a party does not cease to be a taxpayer may be viewed as tantamount to being a trade, business, or organization for purposes of IRC Sec. 482. Other tax court cases indicate that no reallocation will be made where the combined amount of salary, deferred compensation, and benefits received by the shareholder-worker approximate the amount that would have been received had he or she rendered the services outright to the third party. Cases reflect that should the combination of salary received and retirement plan contributions made on behalf of the shareholder-worker be 86% or 87%, reallocation under IRC Sec. 482 will not be necessary.

Research Before Trying

According to the assignment of income doctrine, income should be taxable to the person who earns it. Where an individual provides services as an agent of another, amounts earned will be taxable to the individual's principal. Determining whether a person is acting as an agent of a PSC, where the individual controls the PSC and primarily provides services to one third party, has been a subject of considerable controversy. As reflected in the recent tax court decision of Leavell, the tax court maintains that, in such a case, the worker should be treated as a common law employee of the third party. Other courts have not always sided with this viewpoint. How the matter will be resolved in a particular case is dependent upon the facts and circumstances and the court involved. *

Mark A. Segal, LLM, CPA, is professor of accounting at the University of South Alabama.


Edwin B. Morris, CPA

Rosenberg, Neuwirth & Kuchner

Contributing Editor:

Richard M. Barth, CPA


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