Recognizing when the IRS can reallocate income

Transactions between related parties come under close scrutiny by the IRS because they are not always conducted at arm's length. If the amounts involved in the transaction do not represent fair market values, the IRS can change the characteristics of the transaction to reflect its actual nature.

The IRS may attempt to reallocate income between a closely held corporation and its shareholders based on several sets of rules, including the following:

• Assignment-of-income rules that have been developed through the courts;
• The allocation-of-income theory of Sec. 482; and
• The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A.

Income reallocation under the assignment-of-income doctrine is dependent on determining who earns or controls the income. Justice Oliver Wendell Holmes made the classic statement of the assignment-of-income doctrine when he stated that the Supreme Court would not recognize for income tax purposes an "arrangement by which the fruits are attributed to a different tree from that on which they grew" (Lucas v. Earl, 281 U.S. 111, 115 (1930)).

Reallocation under Sec. 482 is used to prevent tax evasion or to more clearly reflect income when two or more entities are controlled by the same interests. Note the use of the word "or" in the preceding sentence. The Code empowers the IRS to allocate income even if tax evasion is not present if the allocation will more clearly reflect the income of the controlled interests. The intent of these provisions is to place the controlled entity in the same position as if it were not controlled so that the income of the controlled entity is clearly reflected (Regs. Sec. 1.482-1(a)).

Example 1. Performing services for another group member:  Corporations P and S are members of the same controlled group. S asks P to have its financial staff perform an analysis to determine S's borrowing needs. P does not charge S for this service. Under Sec. 482, the IRS could adjust each corporation's taxable income to reflect an arm's-length charge by P for the services it provided toS.

Under Sec. 269A(a), the IRS has the authority to allocate income, deductions, credits, exclusions, and other items between a personal service corporation (PSC) and its employee-owners if:

• The PSC performs substantially all of its services for or on behalf of another corporation, partnership, or other entity; and
• The PSC was formed or used for the principal purpose of avoiding or evading federal income tax by reducing the income or securing the benefit of any expense, deduction, credit, exclusion, or other item for any employee-owner that would not otherwise be available.

A PSC will not be considered to have been formed or availed of for the principal purpose of avoiding or evading federal income taxes if a safe harbor is met. The safe harbor applies if the employee-owner's federal income tax liability is not reduced by more than the lesser of (1) $2,500 or (2) 10% of the federal income tax liability of the employee-owner that would have resulted if the employee-owner personally performed the services (Prop. Regs. Sec. 1.269A-1(c)).

For purposes of this rule, a PSC is a corporation, the principal activity of which is the performance of personal services when those services are substantially performed by employee-owners (Sec. 269A(b)(1)). An employee-owner is any employee who owns on any day during the tax year more than 10% of the PSC's outstanding stock. As with many related-party provisions, the Sec. 318 stock attribution rules (with modifications) apply in determining stock ownership (Sec. 269A(b)(2)).

Example 2. Reallocation of income: H forms M Corp., which is a PSC. A few months later, he transfers shares of stock of an unrelated corporation to M. The following year, M receives dividends from the unrelated corporation and claims the Sec. 243(a) 50% dividend exclusion. The IRS may reallocate the dividend income from M to H if the principal purpose of the transfer of the unrelated stock to M was to use the 50% dividend exclusion under Sec. 243. However, the amounts to reallocate to H must exceed the safe-harbor amounts.

These rules usually apply when an individual performs personal services for an employer that does not offer tax-advantaged employee benefits (such as a qualified retirement plan and other employee fringe benefits). In those situations, the individual may set up a 100%-owned C corporation that contracts with the employer. The employer then pays the corporation. The individual functions as the employee of the corporation, and the corporation sets up tax-advantaged fringe benefit programs. The individual generally is able to "zero out" the income of the corporation with payments for salary and fringe benefits.

Despite the significant authority that Sec. 269A grants to the IRS, there is little evidence of the IRS or the courts using this statute. In a 1987 private letter ruling, the IRS held that a one-owner, one-employee medical corporation did not violate the statute, even though it retained only nominal amounts of taxable income, and the corporate structure allowed the individual to achieve a significant pension plan deduction. These facts were not sufficient to establish a principal purpose of tax avoidance (IRS Letter Ruling 8737001). In Sargent, 929 F.2d 1252 (8th Cir. 1991), the Eighth Circuit indicated a lack of interest in applying Sec. 269A because, in that case, the court felt the PSC had been set up for other legitimate reasons.   

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 31st Edition (March 2018), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).