I. INTRODUCTION

In 1997, the IRS initiated an aggressive nationwide audit program in which veterinary hospitals operating as "C" corporations were arbitrarily reclassified as personal service corporations ("PSC"). The significance of this change was to subject "C" corporations to a flat 35% tax rate as opposed to the lower graduated tax rates normally applicable to "C" corporations which begin at 15%.

Dr. Tom Kendall, owner of Arden Animal Hospital, Inc. ("AAH") in Sacramento, California, was one of the unfortunate practice owners selected for audit by the IRS. At stake were thousands of dollars of additional income taxes calculated on the difference between the 15% tax bracket used by AAH and the 35% tax bracket proposed by the IRS. Dr. Kendall was not willing to acquiesce so quickly to the IRS' proposed reclassification of his "C" corporation and decided that he would rather fight than switch. With the assistance of his faithful tax advisors, Dr. Kendall rolled up his sleeves and took on the IRS.

At the outset of the audit process, Dr. Kendall contacted Jay O'Brian at ABD Insurance Agency, which is the endorsed insurance carrier of the California Veterinary Medical Association. Mr. O'Brian was very interested in the audit because of the significant financial impact it would have on ABD's clients operating as "C" corporations. Using ABD's database, Mr. O'Brian mailed a questionnaire to over 400 California veterinary corporations alerting them to the PSC issue and suggesting that any veterinarians receiving an IRS audit letter contact Dr. Kendall.

II. ANALYSIS

After carefully reviewing the relevant Internal Revenue Code sections, Treasury Regulations and IRS tax rulings, Dr. Kendall's advisors set sail on a treacherous and untested course without any certainty of a favorable tax result. From a purely technical standpoint, an exception to PSC treatment existed if AAH could demonstrate that less than 95% of the time spent by its employees was devoted to the performance of veterinary medical services or services incident to the performance of veterinary medical services (referred to in the IRS lexicon as the "95% function test"). Stated another way, Dr. Kendall was required to prove that AAH failed the 95% function test because the time spent by AAH's employees on non-veterinary activities was greater than 5% of all of AAH's business activities as reflected in its accounting records.

To support Dr. Kendall's position, we adopted a 2-pronged attack. First, we argued that since grooming, boarding of pets, retail sales of pet products and bathing are not defined as veterinary medical services in the California Practice Act which governs veterinary medical practices, these services are non-veterinary activities and are not incident to the performance of veterinary medical services. To further strengthen this argument, we pointed out that these non-veterinary activities are often provided by non-veterinary business owners in California. Second, we argued that annual gross revenues were the most accurate and detailed measure of time spent by AAH's employees on various veterinary and non-veterinary services rendered at AAH. In this regard, Dr. Kendall provided detailed accounting records which separated the veterinary sales and services revenue from the non-veterinary sales and services revenue and clearly reflected that more than 5% of AAH's annual revenues were generated from non-veterinary activities. The accounting system utilized by AAH assigned a unique code and price for each type of service rendered making it easy to differentiate veterinary from non-veterinary sales and services and to track all revenues received by AAH. For example, if a medical procedure on an animal required overnight hospital-ization, it was coded as hospitalization instead of non-medical boarding.

III. CONCLUSION

Make no bones about it, the IRS proved to be a formidable opponent and made Dr. Kendall traverse down a long and winding road. However, after waging nearly a two year battle, the IRS conceded on two critical issues, namely: (1) that grooming, boarding of pets, retail sales of pet products and bathing are non-veterinary activities not incident to the performance of veterinary medical services; and (2) based on Dr. Kendall's detailed accounting records, AAH's annual revenues were considered a better measure of time spent by AAH's employees on its overall business activities. In light of these findings, the IRS determined that more than 5% of AAH's annual revenues were derived from non-veterinary activities and AAH was permitted to avoid being treated as a PSC.

For "C" corporations that pay income taxes each year and wish to continue filing their tax returns without being treated as a PSC, this decision may have far reaching results. On the other hand, if your "C" corporation "zeros-out" taxable income each year by way of compensation bonuses and retirement plan contributions and does not pay any corporate level tax, Dr. Kendall's victory will be less significant.

Since this case was resolved at the audit level and is not a published opinion, it is not binding on the IRS and may not be cited as authority by other taxpayers. Nonetheless, the ability to show that you fail the 95% function test will be helpful for "C" corporations currently being audited by the IRS on the PSC issue as well as for existing PSC's that wish to avoid continuing to be treated as a PSC. Any corporation currently being treated as a PSC should determine whether it can avoid PSC treatment by failing the 95% function test. As noted above, the key will be to provide the IRS with accounting records detailed enough to prove that more than 5% of the revenues are for non-veterinary activities. If a PSC should not have been classified as a PSC, it should consider whether to file a refund claim for overpaid taxes.

Finally, please bear in mind that the PSC issue only applies to "C" corporations. If you operate your veterinary practice as either an "S" corporation, partnership or sole proprietorship, this decision has no application.

For further information regarding the IRS' attempt to reclassify "C" corporations as a PSC, I suggest you contact Dr. Kendall's accountant, Ron Clark, C.P.A. at (916) 363-1010, who was instrumental in securing Dr. Kendall's favorable outcome.