Section 280H - LOOKOUT!
The Tax Reform Act of 1986, as modified by the Revenue Act of 1987, placed severe restrictions on the ability of personal service corporations (PSCs) to utilize fiscal years. Under section 444, PSCs which had fiscal years at the time of the change could retain that year by filing an election. Absent the election, PSCs were required to adopt a calendar year and file a short year return for the year of change. PSCs which formed after the change could elect to use a September, October or November year end. The regulations provide the following mechanism for making the election:
"1.444-3T (b) Manner And Time Of Making Election
(1) General Rule. A section 444 election shall be made by filing a properly prepared Form 8716, "Election to Have a Tax Year Other Than a Required Tax Year", with the Service Center indicated by the instructions to Form 8716. Except as provided in paragraphs (b)(2) and (4) of this section, Form 8716 must be filed by the earlier of--
(i) The 15th day of the fifth month following the month that includes the first day of the taxable year for which the election will first be effective, or
(ii) The due date (without regard to extensions) of the income tax return resulting from the section 444 election."
In addition, a copy of Form 8716 must be attached to Form 1120 for the first taxable year for which the section 444 election is made. Form 8716 also needs to be signed by an individual authorized to sign Form 1120.
The making of a section 444 election was not without a price and therein lies the rationale for this article. Fiscal year PSCs were and are subject to limitations on the deductions they can claim for payments to owner-employees, pursuant to section 280H. The rationale behind the legislative change was simple: Budget Neutrality. The fiscal year provision was a last minute addition driven by the need to find a revenue offset for some new spending program. The Joint Committee on Taxation maintains a list of "revenue losers" for use in such situations. Fiscal year PSCs were deemed to lose revenue by permitting their owners to defer taxable income from one calendar year to the next. This is pretty much a one time savings, of course, unless income is increasing from year to year. The budget balancers used this one time catch up to generate their revenue offset.
In order to be able to deduct all of the payments made by the PSC to owner-employees, the PSC must make a "minimum distribution" of "applicable amounts" during the "deferral period" of each fiscal year. The deferral period is the portion of the fiscal year which ends on December 31
"1.280H-1T(b)(4) Definition Of Applicable Amount
(i) In General. For purposes of section 280H and the regulations thereunder, the term "applicable amount" means, with respect to a taxable year, any amount that is otherwise deductible by a personal service corporation in such year and includable at any time, directly or indirectly, in the gross income of a taxpayer that during such year is an employee-owner. Thus, an amount includable in the gross income of an employee-owner will be considered an applicable amount even though such employee owns no stock of the corporation on the date the employee includes the amount in income."
Applicable amounts thus include not only W-2 wages, but rent, interest, taxable fringe benefits and any other item deductible by the PSC and includable by the employee-owner.
The section also provides that indirect payments to owner-employees are included in the definition of applicable amounts. These include payments to a spouse, child under age 14, a more than 50% owned corporation or partnership, considering the interests owned by all stockholders of the PSC. For example, the rent paid to a partnership leasing real estate to the PSC, would be included in the definition of applicable amounts if more than 50% of the partnership were owned by any one or more of the PSC's stockholders. A similar rule applies to Trusts.
In order to avoid any limitation on the deduction of these applicable amounts, a PSC must meet one of the mechanical (mathematical) minimum distribution tests described below. Failure to meet the tests results in a deduction limitation. With one arguable exception, there is no method to avoid the limitation if the mechanical test is not met! If a test is not met, the PSC's deduction for applicable amounts will be limited to the amount actually paid during the deferral period annualized for twelve months.
Example
A PSC made applicable payments to its sole stockholder of $30,000 during the deferral period (the three months ended December 31, 1995) of the fiscal year ended September 30, 1996. It did not meet one of the tests and is therefore limited to a deduction of $120,000 for the entire fiscal year. Any amount not deductible is suspended and deductible in the succeeding fiscal year. Fiscal year PSC's are NOT allowed a net operating loss carryback to any year where a fiscal year election is in effect. Assume that taxable income before this limitation is zero and that the PSC paid applicable amounts of $160,000. $40,000 would be nondeductible in the current year and taxable income would be $40,000, resulting in $14,000 of federal tax due. THIS TAX CAN NEVER BE RECOVERED.
The Mechanical Tests of 280(H)
"280(H)(c)(2) Preceding Year Test--
(i) In General. The amount determined under the preceding year test is the product of--
(A) The applicable amounts during the taxable year preceding the applicable election year (the ":preceding taxable year"), divided by the number of months (but not less than one) in the preceding taxable year, multiplied by
(B) The number of months in the deferral period of the applicable election year."
Thus, if a PSC made applicable payments to its sole stockholder of $160,000 during the fiscal year ended September 30, 1995, it would be meet this test if it made payments to the stockholder of $40,000 by December 31, 1995 (the deferral period) of fiscal September, 1996.
"280(H)(c)(3) 3-Year Average Test--
(i) In General. The amount determined under the 3-year average test is the applicable percentage multiplied by the adjusted taxable income for the deferral period of the applicable election year.
(ii) Applicable Percentage. The term "applicable percentage" means the percentage (not in excess of 95 percent) determined by dividing--
(A) The applicable amounts during the 3 taxable years of the corporation (or, if fewer, the taxable years the corporation has been in existence) immediately preceding the applicable election year, by
(B) The adjusted taxable income of such corporation for such 3 taxable years (or, if fewer, the taxable years of existence).
(iii) Adjusted Taxable Income (ATI)
(A) In General. The term "adjusted taxable income" means taxable income determined without regard to applicable amounts."
Assume the following pattern:
| FY | App Amounts | Taxable Inc | Adj Tax Inc | Percent |
|---|---|---|---|---|
| 1995 | 160000 | 0 | 160000 | 100% |
| 1996 | 144000 | 11000 | 155000 | 92.9% |
| 1997 | 150000 | 18000 | 168000 | 89.29% |
| Totals | 454000 | 29000 | 483000 | 94% |
In this case, the PSC could retain 100% less 94.00%, or 6.00% of its ATI. A PSC can always retain 5% of its ATI during the deferral period. If ATI in the deferral period of fiscal year ended September 30, 1998 is $50,000, the PSC needs to pay out only $47,000 ($50,000 time 6% = $3,000) to meet this test.
Computing ATI during the period is the one area of this section which does, or should, provide some flexibility. However, where the terms of computation are not clear, danger lurks and in an audit situation, the IRS will likely choose the interpretation most disadvantageous to the taxpayer.
"280(H)(c)(iii)(B) Determination Of Adjusted Taxable Income For The Deferral Period Of The Applicable Election Year.
Adjusted taxable income for the deferral period of the applicable election year equals the adjusted taxable income that would result if the personal service corporation filed an income tax return for the deferral period of the applicable election year under its normal method of accounting. However, a personal service corporation may make a reasonable estimate of such amount." (emphasis added)
Obviously, there is no filing of a short period return as contemplated by the first sentence above, requiring the "reasonable estimate" of the second sentence. What is reasonable? A good question. The author is aware of a private letter ruling in which the Service held that the 'accrual' of an estimate of the ratable portion of the qualified retirement plan contribution for the full fiscal year was not allowed in making the "reasonable estimate" of ATI unless it was paid by March 15 of the year following December 31 - the ordinary due date of a calendar year corporate return would be. Further, I have been advised informally that this is a position the field agents are taking in all audits. In my view, this position is preposterous on its face, as a calendar year filer could obtain an extension until September 15 to both file and make its retirement contribution. Further, the regulation clearly states that a "reasonable estimate" may be made. It is equally clear that excluding a retirement contribution from the deferral period computation of ATI if not made in cash is unreasonable.
Another nuance of the 280H computation involves NOL carryforwards. Any portion of an NOL consisting of a deferred deduction of applicable amounts is ignored in determining the 'reasonable estimate' of the ATI for the deferral period, but the remaining NOL, if any, can be used to reduce ATI for the deferral period. The effect of this provision is to cause much higher payouts during the deferral period.
Actual Examples
Our practice has a significant number of fiscal year PSCs and specializes in physician practices. We perform the 280H computation for each client each December 31 (Happy New Year) to be certain that the Preceding Year or 95% tests are met. In fact, we generally pay out 100% of ATI if the Preceding Year test is not available in order to avoid any problem.
This past year, the bookkeeper for one of our clients made a substantial error in recording cash receipts in the general ledger. Since the data was faxed to us on December 31, there was no way to cross check it against anything. In fact, the error was not discovered until the bookkeeper attempted to reconcile cash in mid-January. This resulted in the 95% test failing, and the Preceding Year test was inapplicable due to the (apparent) lack of sufficient ATI to meet it. We promptly instituted an action plan and made certain that the client paid all available bills prior to their year end. In addition, employee bonuses were accelerated, fringe benefit programs reviewed and increased where appropriate, and retirement contributions were maximized.
The Northeast is a Market Segment Specialization Program (MSSP) area for physician practices and a large number have been audited with many 280H problems. Another situation we encountered involved a practitioner unaware that 280H or 444 existed. The client practice was audited and all open years resulted in significant assessments. Peculiarities in the timing of cashflows rather than any attempt to defer income were the reason. In one case, the 95% test was missed by less than $5,000.
Example
Assume a September 30 PSC has ATI for the deferral period of $400,000 and that applicable amounts of $375,000 are paid. The 95% test fails by $5,000. Owing to cashflow peculiarities, the Preceding Year Test required a payment of $425,000, and thus that test fails. ATI for the full fiscal year is $1,800,000, but a deduction will only be allowed for 12/3 of $375,000 or $1,500,000. The PSC is subject to tax on $300,000, or $105,000 - plus interest and penalties if discovered under an audit several years later.
Conclusion
The long interim between the adoption of sections 444 and 280H has resulted in many practitioners being unfamiliar with those provisions. The MSSP for physician practices, begun in the Northeast, will spread across the country, resulting in a large number of audits and tax assessments. Unfortunately, section 280H is in large part a purely quantitative matter, and there is little room for relief after the fact.
