Does Your Company Qualify for QPSC Status?

Using the cash method of accounting for tax purposes is perhaps the most powerful tax planning tool available to companies. It is important, however, that corporations using the cash method be aware that it is only available under certain conditions.

Table of Contents

Inventory Restriction

First of all, the company must not have inventory. IRS regulations prohibit the use of the cash method “when inventory is a material income producing factor.” If an S-corporation does not have inventory, generally there are not restrictions on the use of the cash method. C-corporations, on the other hand, generally may not use the cash method of accounting even if they don’t have inventory, unless they meet one of two exceptions:

Average gross receipts for the three preceding years must be less than $5 million, or
The corporation must meet the definition of a Qualified Personal Service Corporation (QPSC).

QPSC

A QPSC, as defined by section 448 of the Internal Revenue Code, is generally a corporation where substantially all of its activities for a tax year involve the performance of personal services (function test), and at all times during the year substantially all of the corporations stock was held directly or indirectly by employee-owners (ownership test). The ownership test can be performed rather simply, but provides relatively little latitude in determining if the corporation is a QPSC. First, “substantially all” is defined to mean equal to or greater than ninety five percent (95%) of the corporation’s stock. Second, the term “employee” requires that services provided by such an employee must constitute more than de minimis services. In applying the ownership test, either the requirements are met, or they are not. There is little, if any, room for interpretation.

The real issue, however, facing companies regarding QPSC is the function test. As provided for in the Internal Revenue Code, the function test is met if substantially all of the corporation’s activities for a tax year involve the performance of personal services. In this test, “substantially all” requires that 95% or more of employee’s time is devoted to the performance of personal services. Furthermore, personal services are defined as providing services in the areas of health, law, engineering, architecture, accounting, advanced science, performing arts, or consulting. The primary focus of this article, and the personal service most subject to interpretation is consulting. Section 448 of the Internal Revenue Code goes on to define consulting as follows: “. . .the performance of services in the field of consulting means the provision of advice and counsel. The performance of services in the field of consulting does not include. . . sales or brokerage services.”

IRS Challenging QPSC

The function test may be used by the IRS to challenge QPSC status because there is room for interpretation. A corporation stating involvement in the consulting field could be walking a very fine line, which could prove troublesome should the IRS find otherwise. Consider further the fact that many companies use computer consulting as their business definition. On the surface, this should be straightforward enough and would not appear to preclude a corporation from obtaining or maintaining QPSC status. However, many of these consulting companies purchase various hardware and/or software programs for their clients as a result of the consulting services performed. Although these products might be ordered from an outside source specifically for a contract and the goods themselves might not belong to the company for long, if at all, the IRS could determine that such a contract involves a sale or brokerage service. If several of these types of contract exist, as they often do, the 95% concentration in consulting services might become difficult, even impossible to adhere to. The end result would be failing to qualify as a QPSC, which could have some serious tax ramifications.

Safeguards can be put into place which would make the above types of contracts, should they exist, appear like true consulting activities, which they are. Most importantly, the contracts should be formally drafted to conform with IRS regulations. That is, make note that if equipment or other products should be required during or as a result of the specified contract, the contractor will make recommendations and/or set up the transaction; however,the actual purchase will be made by the customer. The IRS might propose a challenge if a significant portion of a contract’s revenue is generated by the procurement of equipment. The key point, once again, is to draft the contract in a way that indicates that any activities related to the sale or delivery of goods is purely coincidental and immaterial to either contract revenue or employee time as a whole on a contract. That is, do not structure the contract in such a way that a substantial portion of revenue is based upon the sale or delivery of equipment.

Caution

There are many technical issues involved with maintaining QPSC status. Each issue must be analyzed and reviewed on a case by case basis and are not readily generalized into the format of this article. It should also be mentioned that a major downside to being a QPSC is that you are subject to a flat tax rate of 35% instead of the graduated rates available to other C-corporations. This disadvantage, however, can often be outweighed by the positive effects of using the cash method of accounting.

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