                        T.C. Memo. 2006-35



                      UNITED STATES TAX COURT



                 RON LYKINS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 6795-03.              Filed March 2, 2006.



     Ronald G. Lykins, pro se.

     Stephen J. Neubeck, for respondent.



                        MEMORANDUM OPINION


     HOLMES, Judge:   Ron Lykins, Inc., is a well-established firm

in central Ohio that for many years sold both accounting and

financial advice to its clients.   In 2000, the sole owner of the

company--Ronald Lykins--split off the financial advisory business

to a new company.   This left Lykins Inc. selling nothing but

accounting services, and the Commissioner argues that this made
                               - 2 -

it a “qualified personal services corporation.”    If he is right,

the Code would tax Lykins Inc. at a flat rate of 35 percent; if

he isn't, its rate would be lower.

                             Background

     Ronald Lykins is a well-educated man, with an M.B.A. and

Ph.D.; he is also a C.P.A.   He started preparing tax returns in

1969 to supplement his income, and when he opened an accounting

practice it quickly came to focus on tax preparation and advice.

His clients began trusting him for financial and investment

advice as well, and his business steadily grew.    He incorporated

it as Ron Lykins, Inc. in 1980, and Lykins Inc. has ever since

filed tax returns as a Subchapter C corporation.   The financial

and investment services side of the business took more and more

of his time, and Lykins was advised by his lawyer that it would

make sense for him to segregate the tax preparation side of the

business from the investment advice side--should Lykins wish to

retire, he was told, he would be able to market his businesses to

a wider variety of buyers if they were separate.

     In 2000, he took that advice and formed Lykins Financial

Group, LLC, a limited liability company under Ohio law.   Lykins

Inc. continued to offer tax services, but Lykins Financial now

began offering all the financial and investment services.   Lykins

himself was the sole owner of both companies.   Fully separating

the companies proved difficult.   Segregating their income was
                               - 3 -

easy--in 2000, Lykins Financial’s income came exclusively in the

form of commissions on the sale of securities and investment

advice; Lykins Inc.’s income came exclusively from fees that it

charged for tax preparation and advice.   But the formation of

Lykins Financial had led to few physical changes.    The firms

shared the same office space, and had the same address, same

phone number, same copying machine and fax, same employee manual,

and even the same coffee machine.   This all made segregating the

two firms’ expenses quite difficult.   The firms also had no

written agreement defining whose employees were whose, and while

some employees worked only on financial services and investments

and some worked only on tax preparation, there were also some who

worked on both.   Further complicating the situation, Lykins Inc.

provided overhead services such as reception and payroll to

Lykins Financial.   It also continued to pay all the rent on the

shared office space, and all the employees’ wages and payroll

taxes.   Lykins credibly testified that he gave up on dividing

expenses in a more sophisticated way, and simply allocated them

between the two companies based on his own estimate of each

firm’s share of their combined total hours worked.

     Lykins Inc. and Lykins Financial did file separate corporate

tax returns.   The Commissioner audited Lykins Inc., and issued it

a notice of deficiency for 1999 and 2000 after concluding that

the firm had become a “qualified personal services corporation”
                                - 4 -

(QPSC).    The Commissioner later conceded that Lykins Inc. was not

a QPSC in 1999, but stood firm in his belief that it became one

in 2000.   Trial was held in Ohio, where Lykins Inc. has always

had its principal place of business.

                             Discussion

     The Code’s various definitions of personal services

corporations date back to a time when the top tax rate for

individual income was much higher than the rate for corporations.

This gave professionals an incentive to incorporate their

practices to win the benefits available both to employees1 or

corporations.2   Identifying certain personal services

corporations as “qualified professional services corporations,”

and taxing them at a flat rate of 35 percent, see sec. 11(b)(2),3

was Congress’s way to reduce the incentive for professionals to

shelter part of their income in a corporate form with a lower

marginal rate.   As the House Ways and Means Committee explained:


     1
       As employees of a corporation, professionals could avail
themselves of group term life insurance, medical reimbursement
plans, death benefits, and a more generous retirement plan than
if they remained self-employed. See Phillips, et al., “Origins
of Tax Law: The History of the Personal Service Corporation”, 40
Wash. & Lee L. Rev. 433, 434-435 (1983); see also Chickasaw
Ambulance Serv. Inc. v. United States, 1999 WL 33656862 (N.D.
Iowa).
     2
       See sec. 469(a)(1)-(2), which prevent personal service
corporations from deducting passive activity losses on the same
terms as other corporations.
     3
       Unless otherwise stated, section references are to the
Internal Revenue Code and regulations as amended and in effect
for 2000.
                                - 5 -

     The personal service income of corporations owned by
     its employees is taxed to the employee-owners at the
     individual graduated rates as it is paid out as salary.
     The committee believes that it is inappropriate to
     allow the retained earnings to be taxed at the lower
     corporate graduated rates.

H. Rept. 100-391 (II), U.S.C.C.A.N. 2313-712 (1987).

     Section 448(d)(2) defines QPSCs as corporations

     (A) substantially all of the activities of which
     involve the performance of services in the fields of
     health, law, engineering, architecture, accounting,
     actuarial science, performing arts, or consulting, and
     (B) substantially all of the stock of which (by value)
     is held * * * by--

          (i) employees performing services for such
     corporation * * *

(Emphasis added).

     This definition sets up two tests--an ownership test and a

function test.    Deciding whether Lykins Inc. meets the ownership

test is easy.    A regulation defines “substantially all” of a

corporation’s stock to mean “an amount equal to or greater than

95 percent.”    Sec. 1.448-1T(e)(4)(i) and (ii), Temporary Income

Tax Regs., 52 Fed. Reg. 22768, 22770 (June 16, 1987), Lykins is

the sole shareholder of Lykins Inc., and he is an employee

because he performs more than a de minimis amount of accounting

services for the firm, sec. 1.448-1T(e)(5)(i) and (ii), Temporary

Income Tax Regs., 52 Fed. Reg. 22770 (June 16, 1987), so Lykins

Inc. passes.

     A second regulation--the key one for this case--tells us

that “substantially all” of a firm’s functions are in one or
                               - 6 -

another of the professions snagged in the QPSC net:

     only if 95 percent or more of the time spent by
     employees of the corporation, serving in their capacity
     as such, is devoted to the performance of services in a
     qualifying field. For purposes of determining whether
     this 95 percent test is satisfied, the performance of
     any activity incident to the actual performance of
     services in a qualifying field is considered the
     performance of services in that field. Activities
     incident to the performance of services in a qualifying
     field include the supervision of employees engaged in
     directly providing services to clients, and the
     performance of administrative and support services
     incident to such activities. * * *

Sec. 1.448-1T(e)(4)(i), Temporary Income Tax Regs, 52 Fed. Reg.

22766 (June 16, 1987) (emphasis added).

     Lykins’s decision to split his business thus threatens to

ensnare him:   The Code itself lists “accounting” as one of the

qualifying fields, and the regulations carefully distinguish

investment advice sold for a fee from investment advice sold

incident to a brokerage service producing commissions.4   Lykins

Financial, whose income was entirely in the form of commissions

was not, under the regulation, selling services in a qualifying

field.   Lykins Inc. was.

     The Commissioner argues that when Lykins Inc. hived off its

investment business from its accounting services, it necessarily

left behind only the qualifying field of accounting.   He asserts

that if employees generated commission income, they were Lykins



     4
       Sec. 1.448-1T(3)(4)(iv)(B), Examples (4),(5),(10),
Temporary Income Tax Regs. 22767 (June 16, 1987).
                                 - 7 -

Financial employees.    He backs up his argument by pointing to

Lykins Inc.’s allocation of payroll costs to Lykins Financial,

and Lykins Financial’s reimbursement of those costs as proof that

those employees who were performing investment services were

employees of Lykins Financial.

     An unstated assumption of the Commissioner’s position is

that someone is the employee only of the firm he’s producing

income for.    There is no caselaw interpreting the regulation’s

phrase “employees of the corporation, serving in their capacity

as such,” sec. 1.448-1T(e)(4)(i), Temporary Income Tax Regs., and

the Commissioner’s argument is at least plausible.    But

“employer” and “employee” are legal terms with a rich history of

construction in the many other places that they are found in

Federal law.   The Supreme Court has, moreover, laid down as a

general rule that “when Congress has used the term ‘employee’

without defining it, we have concluded that Congress intended to

describe the conventional master-servant relationship as

understood by common-law agency doctrine;” see also Nationwide

Mut. Ins. Co. v. Darden, 503 U.S. 318, 322-323 (1992).      The

Commissioner has likewise adopted common law rules to distinguish

employees from independent contractors.    See Rev. Rul. 87-41,

1987-1 C.B. 296; Darden, 503 U.S. at 324 (citing that revenue

ruling with approval); Clackamas Gastroenterology Associates,

P.C. v. Wells, 538 U.S. 440, 448 (2003)(calling the common law
                               - 8 -

element of control the “principal guidepost”).

     So, in the absence of a different definition in either the

statute or the regulation, we think that the answer to the

question “Which workers were Lykins Inc.’s employees?” should be

found by applying common law principles.    At common law, the key

criterion is one of control--an employer is one with the right to

control the manner and means by which an employee does his

chores.   See Rev. Rul. 87-41, 1987-1 C.B. 296.    And the common

law recognizes that “a person may be the servant of two masters

* * * at one time as to one act, if the service to one does not

involve the abandonment of the service to the other.”

2 Restatement Agency 2d, sec. 226 (1958).   There is even an

“inference” (by which the Restatement seems to mean a rebuttable

presumption) that “the actor remains in his general employment so

long as, by the service rendered another, he is performing the

business entrusted to him by the general employer.     There is no

inference that because the general employer has permitted a

division of control, he has surrendered it.”      Id. sec. 227,

comment b.

     This presumption of continued employment and this

recognition that in law--if not in life, see Matthew 6:24--a man

can serve two masters, speak directly to this case.     Lykins’s

testimony (which we specifically find credible on this point) and

the exhibits he introduced, reinforce rather than rebut the
                                - 9 -

presumption.    They show that those who worked at Lykins Financial

continued to receive paychecks drawn on Lykins Inc., continued to

receive benefits provided by Lykins Inc., and continued to have

their Social Security tax paid for by Lykins Inc.     They had

worked at Lykins Inc. at the start of 2000, and those working on

financial services during the year were told to do so by Lykins

Inc.    Lykins Financial even reimbursed Lykins Inc. for their

wages, taking a deduction; Lykins Inc. reported those

reimbursements as income.

       Simply allocating the costs of Lykins Inc. employees to

Lykins Financial does not make them Lykins Financial employees.

And, while the line between Lykins Inc. and Lykins Financial was

clear only in its blurriness, we conclude on the peculiar facts

of this case--especially the fact that before Lykins Financial

was formed, all these employees were Lykins Inc. employees, and

continued to have their wages, benefits, and taxes paid by Lykins

Inc.--that they continued to be Lykins Inc. employees throughout

the year.

       This makes deciding the case easy.   Lykins Inc. and the

Commissioner stipulated to a breakdown of Lykins Inc.’s

employees’ hours into two categories:    hours spent on accounting

and consulting services, and hours spent on investment services.

The exhibit shows that 80.53 percent of employee hours in 2000

were spent on accounting services, while 19.47 percent of
                             - 10 -

employee hours were spent on investment services.

     Because 80.53 percent is less than 95 percent, Lykins Inc.

was not a QPSC in 2000, and so not subject to tax at the QPSC

rate used in the notice of deficiency.   The Commissioner’s

assertion of a penalty disappears with that deficiency, and so

                                   Decision will be entered

                              for petitioner.
