Taxing Lessons Case Summaries

Case — Group Rates

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What tax rate applies when one member of a consolidated tax return is a personal service corporation?


Taxpayer Says: The consolidated company is not subject to the personal service corporation tax rates.

Internal Revenue Service Says: Each company in the group should pay tax based on its entity type.


From Internal Revenue Code Section 11(a): Imposes a tax on the taxable income of every corporation.

From Internal Revenue Code Section 11(b)(1): Provides for graduated rates of tax based on the corporation’s taxable income.

From Internal Revenue Code Section 11(b)(2): Imposes a flat 35% tax on the taxable income of a qualified personal service corporation, as defined in section 448(d)(2).

From Internal Revenue Code Section 448(d)(2): Lists the requirements for when a corporation is considered a qualified personal service corporation.

From Internal Revenue Code Section 1502: Provides that the Secretary shall prescribe such regulations as he may deem necessary in order that the tax liability of the affiliated group, and of each of its members, may be computed, assessed, and collected in such manner as to clearly reflect its income tax liability and to prevent avoidance of tax liability.

From Internal Revenue Code Section 1503(a): Provides that in any case in which a consolidated return is made, the tax shall be determined in accordance with the regulations promulgated under section 1502.

From Regulation 1.1502-2: Provides that the computation of an affiliated group’s tax liability shall be determined by adding together certain categories of tax (as listed in the regulation).

From Regulation 1.1502-2(a): Once the affiliated group calculates its consolidated taxable income, this section directs the affiliated group to apply “[t]he tax imposed by section 11” on that consolidated taxable income.

From Regulation 1.1502-11: Provides that consolidated taxable income is computed by first taking into account the separate taxable income of each member of the group. Each member’s separate taxable income is calculated as if the member were a separate corporation and then certain modifications are made for any intercompany transactions and other items.

From First Nat’l Bank in Little Rock v. Commissioner, 83 T.C. 202, 209 (1984): Consolidated taxable income principally represents the affiliated group’s dealings with the outside world after the elimination of intercompany profit and loss.


Corporations generally pay federal income tax based on a graduated rate table that currently ranges from 15% to 39%. Corporations performing “personal services” such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, are taxed at a flat rate of 35%.

This case involves two corporations with the same owners who combine (or “consolidate”) their income to file a single return. One of the corporations qualifies as a personal service corporation, the other does not.

The question is what tax rate applies to the consolidated entity. That is, should the income be split into “baskets” where the personal service corporation pays the flat rate of 35% while the other corporation uses the graduated rate table?

The taxpayer says the consolidated return regulations do not provide for splitting an affiliated group’s consolidated taxable income after the consolidated taxable income has been calculated. In addition, the rules say to calculate the tax of an affiliated group using the graduated rates. Therefore, the entire amount of consolidated taxable income of the affiliated group is taxed at graduated rates.

The IRS says each member corporation is to be examined separately to determine whether it is a qualified personal service corporation. If at least one member of the affiliated group is a qualified personal service corporation, the consolidated taxable income of the group should be split or broken up into separate baskets. The baskets would consist of one for the income of the qualified personal service corporation and another for the income of the other type of corporation.

After splitting the income into baskets, the flat 35% rate would be applied to the qualified personal service corporation’s income. Graduated rates would be applied to the income of the corporation that is not a qualified personal service corporation.


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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit and

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For the Taxpayer.

The taxpayer’s primary argument is that there is no guidance in the code, the regulations, or other authority regarding the method of establishing the proper rate or rates of tax on consolidated taxable income where one member, but not all members, of the affiliated group is a qualified personal service corporation.

While the taxpayer is correct that there is no guidance with respect to such a situation, acceptance of his position is fraught with danger.

Section 11(b) was intended to deny the benefits of graduated corporate income tax rates to qualified personal service corporations. Although we can envision circumstances where this intent could be circumvented by the taxpayer’s position, we are nevertheless compelled to find in favor of the taxpayer.

In computing the proper tax liability of an affiliated group, we begin with income tax regulation 1.1502-2.

Regulation 1.1502-2(a) does not distinguish between taxable income under section 11(b)(1) and (2), and we find no authority to permit the breakup of an affiliated group’s consolidated taxable income into separate baskets.

We look to the affiliated group as a whole, i.e., the entity which generated the consolidated taxable income, to determine the characterization of the consolidated taxable income. And in this regard, the parties agree that, when viewed as a whole, the taxpayer’s affiliated group is not a qualified personal service corporation.

To conclude, we hold that in the situation involved herein, graduated rates set forth in section 11(b)(1) should be applied to the affiliated group’s consolidated taxable income.