Tax Court Rules C-Corp Is Not a Qualified Personal Service Corporation

When is an accounting firm not a qualified personal service corporation (QPSC)? According to Judge Holmes of the U.S. Tax Court, it is when the accounting firm’s employees spend less than 95 percent of their time on accounting and accounting related tasks, even if they are nominally the employees of a financial and investment services firm.


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The case of Ron Lykins, Inc. v. Commissioner of Internal Revenue began in 2000 when Ronald Lykins, sole owner of Ron Lykins, Inc., a well-established accounting and financial services firm in central Ohio, split off the financial advisory business into a new company, Lykins Financial Group, LLC. This left Lykins, Inc. selling accounting services exclusively.

The decision to split the firms left Lykins in a challenging position, potentially increasing his tax liability if it was determined to be a QPSC. If the accounting firm was not determined to be a QPSC, the split would allow Lykins to market his businesses to a wider variety of buyers when he retires.

“If caught as a personal service firm, the split was a bad idea,” Bob D. Scharin, Senior Tax Analyst, RIA, a Thomson business and provider of tax information and software to tax professionals, told AccountingWEB. “The split was probably tax neutral the way things turned out.”

After audits in 1999 and 2000, the Commissioner argued that the split made Lykins, Inc., which was structured as a Subchapter C corporation, a QPSC subject to taxation at a flat rate of 35 percent in 2000. In the Commissioner’s favor was the fact that splitting the income generated by both firms was simple. Lykins Financial’s income came exclusively from commissions on the sale of securities and investment advice. Lykins Inc.’s income came exclusively from fees charged for tax preparation and advice. Some employees also worked exclusively for one firm or the other. Both firms filed separate corporate tax returns.

Other aspects of separating the firms, however, proved more difficult. Lykins was the owner of both companies. Both firms share the same office space; address; phone number; copy and fax machines; employee manual; and even coffee-maker. There is no written agreement defining which firm employees worked for and some employees did work for both. Overhead services, including reception, payroll, and rent for both firms, were provided Lykins Inc..

For Judge Holmes, the decision came down to the issue of whether employees of the corporation spent 95 percent of their time engaged in activities of a qualifying field, such as accounting. He found that simply allocating the costs of Lykins Inc. employees to Lykins Financial did not make them Lykins Financial employees when their wages, benefits, and taxes were paid by Lykins Inc.. Therefore, the determination of whether or not Lykins Inc. was a QPSC depended on the number of hours employees spent on accounting services and the hours spent on investment services. Since only 80.53 percent of employees’ time was spent on accounting services, Lykins Inc. is not a QPSC, and the decision of the Tax court will be entered for Lykins.

“Look at both the tax and non-tax implications when considering splitting a business into multiple firms,” Schrain advises. “Look at payroll tax implications since running payroll through two businesses may mean the employers’ share of FICA is greater. The costs of benefits may also increase with multiple employers.”

Although the taxpayer in this case had split activities into different entities, other accounting firms may choose to add to their service offerings without splitting up. As accounting firms increase their range of services to better meet client needs, these firms may find that their choice-of-entity considerations change. A firm, that previously would have been a QPSC if structured as a C corporation, may find that its additional services would allow it to be a C corporation without falling into the QPSC category. The case also serves as a reminder that busy tax professionals should consider all the ramifications of their own business activities with the same level of care that they would apply to advising their clients regarding similar business transactions.

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