In tax, as in medicine, diagnosis can be tricky without all the facts. The taxpayer in Summary Opinion 2017-39 (Sound Diagnostic Imaging, Inc.) diagnosed his C corporation as a regular C corporation, subject to graduated tax rates. The IRS said the corporation should be taxed as a personal service corporation at the flat rate of 35%.
Typically, C corporations pay federal income tax at rates ranging from 15% to 39%, depending on taxable income. However, C corporations that provide personal services pay federal income tax at a flat rate of 35%.
A corporation is considered a “qualified personal service corporation” subject to the 35% flat tax when the services are in one of eight professions (health, law, engineering, architecture, accounting, actuarial science, the performing arts, and consulting).
In addition, 95% of the corporation’s stock (by value) must be owned by the employees providing the services for the corporation, and 95% of the corporation’s activities must involve the performance of the qualifying services.
These tests are known as the “ownership” test and the “function” test.
In Summary Opinion 2017-39, the taxpayer and his spouse were the sole shareholders of the corporation, which provided ultrasound services to medical offices and clinics. The taxpayer was the president, he and his spouse were the only employees, and the corporation paid both of them wages.
The corporation had professional service agreements with three medical clinics. Under the agreements, the corporation provided ultrasound machines and “licensed medical professionals” qualified to perform echocardiography, cardiovascular, and vascular ultrasound services in the medical field of cardiology. The agreements stated the corporation would obtain and maintain accreditation with organizations such as the American College of Radiology, a professional medical society.
The taxpayer, either personally or by arranging contract labor, provided the ultrasound services. He also testified that he attended and completed a two-year ultrasound associate program and worked for a hospital for a few years performing ultrasound services before forming the corporation in 2006. His wife did not perform any ultrasound services but took care of the corporate bookkeeping, recordkeeping, and banking, and both of them signed checks drawn on the corporate bank account.
Because the taxpayer and his spouse owned 100% of the corporate stock and were the only employees, the court determined the ownership test was met.
But what about the function test? If the taxpayers performed services for the corporation in connection with activities in a qualifying field, the corporation would be a “qualified personal service corporation” subject to the 35% flat tax.
The IRS said the taxpayer was a qualified professional services corporation because ultrasound services are medical services.
The taxpayer argued that corporate employees did not perform services in the field of health because employees who operated the ultrasound equipment (sonographers) were not required to be licensed in the state where the corporation did business, and were not subject to minimum requirements to provide ultrasound services. The taxpayer also said corporate employees did not provide direct treatment services to patients, and did not make healthcare decisions.
Finally, the taxpayer argued the qualified personal service corporation rules did not apply because less than 20% of corporate revenue was generated by personal services.
Here’s the relevant law for the function test.
From temporary regulation section 1.448-1T(e)(4)(i): Provides that the requirements of the function test are met if substantially all of the corporation’s activities involved the performance of services in one of the following qualifying fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. “Substantially all of the activities” are measured by time spent by employees providing services.
From temporary regulation section 1.448-1T(e)(4)(ii): Defines the provision of activities in the field of health as follows: The performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and other similar health-care professionals. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to customers.
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The taxpayer asserts that corporate employees do not perform services in the field of health because employees who operate the ultrasound equipment (sonographers) are not required to be licensed in the state in which the corporation operates, do not provide direct treatment services to patients, and do not make healthcare decisions.
Healthcare professionals, however, are not limited to physicians or to licensed medical service providers.
The court has held that the scope of the qualifying fields does not turn on state licensing laws. Rather, whether a service is performed in one of the qualifying fields “is to be decided by all relevant indicia, including the text of the statute, its legislative history and regulations, application of the normal meaning of the term ‘health’ * * * and examination of services historically regarded as within the qualifying field.”
The taxpayer proposes a narrow interpretation of the term “health.”
The court has previously rejected taxpayers’ overly restrictive arguments in defining the various services listed in the section 448 temporary income tax regulations. The temporary income tax regulations do not so narrowly construe the requirements of the function test under section 448(d)(2).
Rather, the phrase “field of health” includes services provided by healthcare professionals that are directly related to a medical field.
Thus, the court rejects the taxpayer’s narrow reading and finds that the services performed by corporate employees were in the field of health.
The temporary regulations distinguish between healthcare professionals who perform services directly related to a medical field–which include but are not limited to physicians, nurses, dentists–and persons who are not healthcare professionals who perform services that provide physical exercise or conditioning, such as employees who work at health clubs or health spas.
Sonographers are more similar to physicians and nurses than to health club or health spa employees. Therefore, the taxpayer, in performing the ultrasound activities as a sonographer, was a healthcare professional.
The taxpayer also argues that the corporation was not a qualified personal service corporation because less than 20% of its revenue was generated by personal services. The fatal flaw with this approach is that it relies upon revenue rather than time spent by employees.
Under the function test “substantially all of the activities” of a corporation are measured by the time employees spent on activities, not the amount of revenue the employees generated. Substantially all of the activities are in the qualifying field if the employees of the corporation spend 95% or more of their time in one of the qualifying fields.
The corporation’s only employees were the taxpayers. The performance of any activity incident to the actual performance of qualifying field services, including administrative services, is considered the performance of services in that field.
Administrative services include secretarial, purchasing, and payroll services. The bookkeeping, recordkeeping, and banking services performed by the taxpayer’s spouse are administrative services and considered for purposes of the function test. The taxpayer and his spouse were both employees of the corporation, and 95% or more of their time as such employees was spent on activities in the field of health.
Therefore, the corporation meets the function test.