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Under Internal Code Section 11(b)(2) the taxable income of a qualified professional service corporation is taxed at the flat tax rate of 35%.  The graduated rates of Internal Code Section 11(b)(1) do not apply.  In Applied Research Associates, Inc. et al. v. Commissioner, the Tax Court held that the graduated tax rates in Internal Code Section 11(b)(1) and not the flat tax rate of Internal Code Section 11(b)(2) applies to the consolidated income of a corporate group that contains a professional corporation.  The IRS wanted the Court to segregate the income of the professional corporation into a separate basket and tax that income at the flat Internal Code Section 11(b)(2) rate of 35%.  The Tax Court held that the affiliate group was a single entity that was not a qualified personal service corporation and therefore the group’s taxable income should be taxed at the graduated rates.  The Tax Court also noted that Treas. Reg. Section 1.1503-2 enumerates taxes on separate types of income to be included in an affiliated group’s tax liability and that qualified personal service income is not one of those enumerated types of income.

In the Applied Research case, the taxpayer and his wife each owned 50% of Applied Research, a qualified professional service corporation providing engineering services.  Applied Research owned 100% of the stock in Oak Crest Land & Cattle Co., which owned and operated a 400 acre ranch in Texas and was not a qualified personal service corporation.  The two corporations constituted an affiliated group and filed consolidated returns, treating the consolidated income as taxable under the graduated rates of Internal Code Section 11(b)(1).  For the reasons noted above, the Tax Court held that, contrary to the IRS assertions, the taxpayer was correct in applying the graduated rates of Internal Code Section 11(b)(1).

This provides some planning opportunities for qualified professional service corporations that want to accumulate income.  If the owners of the qualified professional service corporation own stock in another corporation that is not a qualified professional service corporation, they could consider making it a subsidiary of the qualified professional service corporation.  Also, there may be certain aspects of the qualified professional service corporation that could be performed by a non-qualified professional service corporation.  For example, a CPA firm may provide payroll services.  If the services were performed by a separate non-qualified professional service corporation that is a subsidiary of the qualified professional service corporation and a consolidated return was filed, the group’s income would be taxed at the graduated tax rates of Internal Code Section 11(b)(1) under the Applied Research case.

There may be disadvantages to creating a parent subsidiary relationship that more than offset the benefits of the graduated rates.  For example, if the qualified professional service corporation wanted to sell the stock of its subsidiary, the qualified professional service corporation would pay tax on the gain at ordinary income tax rates and there would be an additional second tax if the sales proceeds were distributed to the shareholders.  If the shareholders of the qualified professional service corporation owned the stock individually, the stock sale would result in a single capital gains tax at the shareholder level.

Note also that the issue of the flat rate versus the graduated rates obviously does not apply if the qualified professional service corporation is an S-corporation.