[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.448-1T]

[Page 85-95]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.448-1T  Limitation on the use of the cash receipts and disbursements 
method of accounting (temporary).

    (a) Limitation on accounting method--(1) In general. This section 
prescribes regulations under section 448 relating to the limitation on 
the use of the cash receipts and disbursements method of accounting (the 
cash method) by certain taxpayers.
    (2) Limitation rule. Except as otherwise provided in this section, 
the computation of taxable income using the cash method is prohibited in 
the case of a--
    (i) C corporation,
    (ii) Partnership with a C corporation as a partner, or
    (iii) Tax shelter.

A partnership is described in paragraph (a)(2)(ii) of this section, if 
the partnership has a C corporation as a partner at any time during the 
partnership's taxable year beginning after December 31, 1986.
    (3) Meaning of C corporation. For purposes of this section, the term 
``C corporation'' includes any corporation that is not an S corporation. 
For example, a regulated investment company (as defined in section 851) 
or a real estate investment trust (as defined in section 856) is a C 
corporation for purposes of this section. In addition, a trust subject 
to tax under section 511 (b) shall be treated, for purposes of this 
section, as a C corporation, but only with respect to the portion of its 
activities that constitute an unrelated trade or business. Similarly, 
for purposes of this section, a corporation that is exempt from federal 
income taxes under section 501 (a) shall be treated as a C corporation 
only with respect to the portion of its activities that constitute an 
unrelated trade or business. Moreover, for purposes of determining 
whether a partnership has a C corporation as a partner, any partnership 
described in paragraph (a)(2)(ii) of this section is treated as a C 
corporation. Thus, if partnership ABC has a partner that is a 
partnership with a C

[[Page 86]]

corporation, then, for purposes of this section, partnership ABC is 
treated as a partnership with a C corporation partner.
    (4) Treatment of a combination of methods. For purposes of this 
section, the use of a method of accounting that records some, but not 
all, items on the cash method shall be considered the use of the cash 
method. Thus, a C corporation that uses a combination of accounting 
methods including the use of the cash method is subject to this section.
    (b) Tax shelter defined--(1) In general. For purposes of this 
section, the term ``tax shelter'' means any--
    (i) Enterprise (other than a C corporation) if at any time 
(including taxable years beginning before January 1, 1987) interests in 
such enterprise have been offered for sale in any offering required to 
be registered with any federal or state agency having the authority to 
regulate the offering of securities for sale,
    (ii) Syndicate (within the meaning of paragraph (b)(3) of this 
section), or
    (iii) Tax shelter within the meaning of section 6661 (b)(2)(C)(ii) 
(relating to (A) a partnership or other entity, (B) any investment plan 
or arrangement, or (C) any other plan or arrangement, whose principal 
purpose is the avoidance or evasion of Federal income tax).
    (2) Requirement of registration. For purposes of paragraph (b)(1)(i) 
of this section, an offering is required to be registered with a federal 
or state agency if, under the applicable federal or state law, failure 
to register the offering would result in a violation of the applicable 
federal or state law (regardless of whether the offering is in fact 
registered). In addition, an offering is required to be registered with 
a federal or state agency if, under the applicable federal or state law, 
failure to file a notice of exemption from registration would result in 
a violation of the applicable federal or state law (regardless of 
whether the notice is in fact filed).
    (3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of 
this section, the term ``syndicate'' means a partnership or other entity 
(other than a C corporation) if more than 35 percent of the losses of 
such entity during the taxable year (for taxable years beginning after 
December 31, 1986) are allocated to limited partners or limited 
entrepreneurs. For purposes of this paragraph (b)(3), the term ``limited 
entrepreneur'' has the same meaning given such term in section 464 
(e)(2). In addition, in determining whether an interest in a partnership 
is held by a limited partner, or an interest in an entity or enterprise 
is held by a limited entrepreneur, section 464 (c)(2) shall apply in the 
case of the trade or business of farming (as defined in paragraph (d)(2) 
of this section), and section 1256 (e)(3)(C) shall apply in any other 
case. Moreover, for purposes of this paragraph (b)(3), the losses of a 
partnership, entity, or enterprise (the enterprise) means the excess of 
the deductions allowable to the enterprise over the amount of income 
recognized by such enterprise under the enterprise's method of 
accounting used for federal income tax purposes (determined without 
regard to this section). For this purpose, gains or losses from the sale 
of capital assets or section 1221 (2) assets are not taken into account.
    (4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of 
this section, marketed arrangements in which persons carrying on farming 
activities using the services of a common managerial or administrative 
service will be presumed to have the principal purpose of tax avoidance 
if such persons use borrowed funds to prepay a substantial portion of 
their farming expenses (e.g., payment for farm supplies that will not be 
used or consumed until a taxable year subsequent to the taxable year of 
payment).
    (5) Taxable year tax shelter must change accounting method. A 
partnership, entity, or enterprise that is a tax shelter must change 
from the cash method for the later of (i) the first taxable year 
beginning after December 31, 1986, or (ii) the taxable year that such 
partnership, entity, or enterprise becomes a tax shelter.
    (c) Effect of section 448 on other provisions. Nothing in section 
448 shall have any effect on the application of any other provision of 
law that would otherwise limit the use of the cash method, and no 
inference shall be drawn

[[Page 87]]

from section 448 with respect to the application of any such provision. 
For example, nothing in section 448 affects the requirement of section 
447 that certain corporations must use an accrual method of accounting 
in computing taxable income from farming, or the requirement of Sec. 
1.446-1(c)(2) that an accrual method be used with regard to purchases 
and sales of inventory. Similarly, nothing in section 448 affects the 
authority of the Commissioner under section 446(b) to require the use of 
an accounting method that clearly reflects income, or the requirement 
under section 446(e) that a taxpayer secure the consent of the 
Commissioner before changing its method of accounting. For example, a 
taxpayer using the cash method may be required to change to an accrual 
method of accounting under section 446(b) because such method clearly 
reflects that taxpayer's income, even though the taxpayer is not 
prohibited by section 448 from using the cash method. Similarly, a 
taxpayer using an accrual method of accounting that is not prohibited by 
section 448 from using the cash method may not change to the cash method 
unless the taxpayer secures the consent of the Commissioner under 
section 446(e), and, in the opinion of the Commissioner, the use of the 
cash method clearly reflects that taxpayer's income under section 
446(b).
    (d) Exception for farming business--(1) In general. Except in the 
case of a tax shelter, this section shall not apply to any farming 
business. A taxpayer engaged in a farming business and a separate 
nonfarming business is not prohibited by this section from using the 
cash method with respect to the farming business, even though the 
taxpayer may be prohibited by this section from using the cash method 
with respect to the nonfarming business.
    (2) Meaning of farming business. For purposes of paragraph (d) of 
this section, the term ``farming business'' means--
    (i) The trade or business of farming as defined in section 
263A(e)(4) (including the operation of a nursery or sod farm, or the 
raising or harvesting of trees bearing fruit, nuts, or other crops, or 
ornamental trees), or
    (ii) The raising, harvesting , or growing of trees described in 
section 263A(c)(5) (relating to trees raised, harvested, or grown by the 
taxpayer other than trees described in paragraph (d)(2)(i) of this 
section).

Thus, for purposes of this section, the term ``farming business'' 
includes the raising of timber. For purposes of this section, the term 
``farming business'' does not include the processing of commodities or 
products beyond those activities normally incident to the growing, 
raising or harvesting of such products. For example, assume that a C 
corporation taxpayer is in the business of growing and harvesting wheat 
and other grains. The taxpayer processes the harvested grains to produce 
breads, cereals, and similar food products which it sells to customers 
in the course of its business. Although the taxpayer is in the farming 
business with respect to the growing and harvesting of grain, the 
taxpayer is not in the farming business with respect to the processing 
of such grains to produce food products which the taxpayer sells to 
customers. Similarly, assume that a taxpayer is in the business of 
raising poultry or other livestock. The taxpayer uses the livestock in a 
meat processing operation in which the livestock are slaughtered, 
processed, and packaged or canned for sale to customers. Although the 
taxpayer is in the farming business with respect to the raising of 
livestock, the taxpayer is not in the farming business with respect to 
the meat processing operation. However, under this section the term 
``farming business'' does include processing activities which are 
normally incident to the growing, raising or harvesting of agricultural 
products. For example, assume a taxpayer is in the business of growing 
fruits and vegetables. When the fruits and vegetables are ready to be 
harvested, the taxpayer picks, washes, inspects, and packages the fruits 
and vegetables for sale. Such activities are normally incident to the 
raising of these crops by farmers. The taxpayer will be considered to be 
in the business of farming with respect to the growing of fruits and 
vegetables, and the processing activities incident to the harvest.

[[Page 88]]

    (e) Exception for qualified personal service corporation--(1) In 
general. Except in the case of a tax shelter, this section does not 
apply to a qualified personal service corporation.
    (2) Certain treatment for qualified personal service corporation. 
For purposes of paragraph (a)(2)(ii) of this section (relating to 
whether a partnership has a C corporation as a partner), a qualified 
personal service corporation shall be treated as an individual.
    (3) Meaning of qualified personal service corporation. For purposes 
of this section, the term ``qualified personal service corporation'' 
means any corporation that meets--
    (i) The function test paragraph (e)(4) of this section, and
    (ii) The ownership test of paragraph (e)(5) of this section.
    (4) Function test--(i) In general. A corporation meets the function 
test if substantially all the corporation's activities for a taxable 
year involve the performance of services in one or more of the following 
fields--

    (A) Health,
    (B) Law,
    (C) Engineering (including surveying and mapping),
    (D) Architecture,
    (E) Accounting,
    (F) Actuarial science,
    (G) Performing arts, or
    (H) Consulting.

Substantially all of the activities of a corporation are involved in the 
performance of services in any field described in the preceding sentence 
(a qualifying field), 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.
    (ii) Meaning of services performed in the field of health. For 
purposes of paragraph (e)(4)(i)(A) of this section, the performance of 
services in the field of health means the provision of medical services 
by physicians, nurses, dentists, and other similar healthcare 
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 their customers.
    (iii) Meaning of services performed in the field of performing arts. 
For purposes of paragraph (e)(4)(i)(G) of this section, the performance 
of services in the field of the performing arts means the provision of 
services by actors, actresses, singers, musicians, entertainers, and 
similar artists in their capacity as such. The performance of services 
in the field of the performing arts does not include the provision of 
services by persons who themselves are not performing artists (e.g., 
persons who may manage or promote such artists, and other persons in a 
trade or business that relates to the performing arts). Similarly, the 
performance of services in the field of the performing arts does not 
include the provision of services by persons who broadcast or otherwise 
disseminate the performances of such artists to members of the public 
(e.g., employees of a radio station that broadcasts the performances of 
musicians and singers). Finally, the performance of services in the 
field of the performing arts does not include the provision of services 
by athletes.
    (iv) Meaning of services performed in the field of consulting--(A) 
In general. For purposes of paragraph (e)(4)(i)(H) of this section, the 
performance of services in the field of consulting means the provision 
of advice and counsel. The performance of services in the field of 
consulting does not include the performance of services other than 
advice and counsel, such as sales or brokerage services, or economically 
similar services. For purposes of the preceding sentence, the 
determination of whether a

[[Page 89]]

person's services are sales or brokerage services, or economically 
similar services, shall be based on all the facts and circumstances of 
that person's business. Such facts and circumstances include, for 
example, the manner in which the taxpayer is compensated for the 
services provided (e.g., whether the compensation for the services is 
contingent upon the consummation of the transaction that the services 
were intended to effect).
    (B) Examples. The following examples illustrate the provisions of 
paragraph (e)(4)(iv)(A) of this section. The examples do not address all 
types of services that may or may not qualify as consulting. The 
determination of whether activities not specifically addressed in the 
examples qualify as consulting shall be made by comparing the service 
activities in question to the types of service activities discussed in 
the examples. With respect to a corporation which performs services 
which qualify as consulting under this section, and other services which 
do not qualify as consulting, see paragraph (e)(4)(i) of this section 
which requires that substantially all of the corporation's activities 
involve the performance of services in a qualifying field.

    Example (1). A taxpayer is in the business of providing economic 
analyses and forecasts of business prospects for its clients. Based on 
these analyses and forecasts, the taxpayer advises its clients on their 
business activities. For example, the taxpayer may analyze the economic 
conditions and outlook for a particular industry which a client is 
considering entering. The taxpayer will then make recommendations and 
advise the client on the prospects of entering the industry, as well as 
on other matters regarding the client's activities in such industry. The 
taxpayer provides similar services to other clients, involving, for 
example, economic analyses and evaluations of business prospects in 
different areas of the United States or in other countries, or economic 
analyses of overall economic trends and the provision of advice based on 
these analyses and evaluations. The taxpayer is considered to be engaged 
in the performance of services in the field of consulting.
    Example (2). A taxpayer is in the business of providing services 
that consist of determining a client's electronic data processing needs. 
The taxpayer will study and examine the client's business, focusing on 
the types of data and information relevant to the client and the needs 
of the client's employees for access to this information. The taxpayer 
will then make recommendations regarding the design and implementation 
of data processing systems intended to meet the needs of the client. The 
taxpayer does not, however, provide the client with additional computer 
programming services distinct from the recommendations made by the 
taxpayer with respect to the design and implementation of the client's 
data processing systems. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example (3). A taxpayer is in the business of providing services 
that consist of determining a client's management and business structure 
needs. The taxpayer will study the client's organization, including, for 
example, the departments assigned to perform specific functions, lines 
of authority in the managerial hierarchy, personnel hiring, job 
responsibility, and personnel evaluations and compensation. Based on the 
study, the taxpayer will then advise the client on changes in the 
client's management and business structure, including, for example, the 
restructuring of the client's departmental systems or its lines of 
managerial authority. The taxpayer is considered to be engaged in the 
performance of services in the field of consulting.
    Example (4). A taxpayer is in the business of providing financial 
planning services. The taxpayer will study a particular client's 
financial situation, including, for example, the client's present 
income, savings and investments, and anticipated future economic and 
financial needs. Based on this study, the taxpayer will then assist the 
client in making decisions and plans regarding the client's financial 
activities. Such financial planning includes the design of a personal 
budget to assist the client in monitoring the client's financial 
situation, the adoption of investment strategies tailored to the 
client's needs, and other similar services. The taxpayer is considered 
to be engaged in the performance of services in the field of consulting.
    Example (5). A taxpayer is in the business of executing transactions 
for customers involving various types of securities or commodities 
generally traded through organized exchanges or other similar networks. 
The taxpayer provides its clients with economic analyses and forecasts 
of conditions in various industries and businesses. Based on these 
analyses, the taxpayer makes recommendations regarding transactions in 
securities and commodities. Clients place orders with the taxpayer to 
trade securities or commodities based on the taxpayer's recommendations. 
The taxpayer's compensation for its services is typically based on the 
trade orders. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in brokerage services. Relevant to this

[[Page 90]]

determination is the fact that the compensation of the taxpayer for its 
services is contingent upon the consummation of the transaction the 
services were intended to effect (i.e., the execution of trade orders 
for its clients).
    Example (6). A taxpayer is in the business of studying a client's 
needs regarding its data processing facilities and making 
recommendations to the client regarding the design and implementation of 
data processing systems. The client will then order computers and other 
data processing equipment through the taxpayer based on the taxpayer's 
recommendations. The taxpayer's compensation for its services is 
typically based on the equipment orders made by the clients. The 
taxpayer is not considered to be engaged in the performance of services 
in the field of consulting. The taxpayer is engaged in the performance 
of sales services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its services it contingent upon the 
consummation of the transaction the services were intended to effect 
(i.e., the execution of equipment orders for its clients).
    Example (7). A taxpayer is in the business of assisting businesses 
in meeting their personnel requirements by referring job applicants to 
employers with hiring needs in a particular area. The taxpayer may be 
informed by potential employers of their need for job applicants, or, 
alternatively, the taxpayer may become aware of the client's personnel 
requirements after the taxpayer studies and examines the client's 
management and business structure. The taxpayer's compensation for its 
services is typically based on the job applicants, referred by the 
taxpayer to the clients, who accept employment positions with the 
clients. The taxpayer is not considered to be engaged in the performance 
of services in the field of consulting. The taxpayer is involved in the 
performance of services economically similar to brokerage services. 
Relevant to this determination is the fact that the compensation of the 
taxpayer for its services is contingent upon the consummation of the 
transaction the services were intended to effect (i.e., the hiring of a 
job applicant by the client).
    Example (8). The facts are the same as in example (7), except that 
the taxpayer's clients are individuals who use the services of the 
taxpayer to obtain employment positions. The taxpayer is typically 
compensated by its clients who obtain employment as a result of the 
taxpayer's services. For the reasons set forth in example (7), the 
taxpayer is not considered to be engaged in the performance of services 
in the field of consulting.
    Example (9). A taxpayer is in the business of assisting clients in 
placing advertisements for their goods and services. The taxpayer 
analyzes the conditions and trends in the client's particular industry, 
and then makes recommendations to the client regarding the types of 
advertisements which should be placed by the client and the various 
types of advertising media (e.g., radio, television, magazines, etc.) 
which should be used by the client. The client will then purchase, 
through the taxpayer, advertisements in various media based on the 
taxpayer's recommendations. The taxpayer's compensation for its services 
is typically based on the particular orders for advertisements which the 
client makes. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of services economically similar to brokerage 
services. Relevant to this determination is the fact that the 
compensation of the taxpayer for its services is contingent upon the 
consummation of the transaction the services were intended to effect 
(i.e., the placing of advertisements by clients).
    Example (10). A taxpayer is in the business of selling insurance 
(including life and casualty insurance), annuities, and other similar 
insurance products to various individual and business clients. The 
taxpayer will study the particular client's financial situation, 
including, for example, the client's present income, savings and 
investments, business and personal insurance risks, and anticipated 
future economic and financial needs. Based on this study, the taxpayer 
will then make recommendations to the client regarding the desirability 
of various insurance products. The client will then purchase these 
various insurance products through the taxpayer. The taxpayer's 
compensation for its services is typically based on the purchases made 
by the clients. The taxpayer is not considered to be engaged in the 
performance of services in the field of consulting. The taxpayer is 
engaged in the performance of brokerage or sales services. Relevant to 
this determination is the fact that the compensation of the taxpayer for 
its services is contingent upon the consummation of the transaction the 
services were intended to effect (i.e., the purchase of insurance 
products by its clients).

    (5) Ownership test--(i) In general. A corporation meets the 
ownership test, if at all times during the taxable year, substantially 
all the corporation's stock, by value, is held, directly or indirectly, 
by--
    (A) Employees performing services for such corporation in connection 
with activities involving a field referred to in paragraph (e)(4) of 
this section,
    (B) Retired employees who had performed such services for such 
corporation,

[[Page 91]]

    (C) The estate of any individual described in paragraph (e)(5)(i) 
(A) or (B) of this section, or
    (D) Any other person who acquired such stock by reason of the death 
of an individual described in paragraph (e)(5)(i) (A) or (B) of this 
section, but only for the 2-year period beginning on the date of the 
death of such individual.

For purposes of this paragraph (e)(5) of this section, the term 
``substantially all'' means an amount equal to or greater than 95 
percent.
    (ii) Definition of employee. For purposes of the ownership test of 
this paragraph (e)(5) of this section, a person shall not be considered 
an employee of a corporation unless the services performed by that 
person for such corporation, based on the facts and circumstances, are 
more than de minimis. In addition, a person who is an employee of a 
corporation shall not be treated as an employee of another corporation 
merely by reason of the employer corporation and the other corporation 
being members of the same affiliated group or otherwise related.
    (iii) Attribution rules. For purposes of this paragraph (e)(5) of 
this section, a corporation's stock is considered held indirectly by a 
person if, and to the extent, such person owns a proportionate interest 
in a partnership, S corporation, or qualified personal service 
corporation that owns such stock. No other arrangement or type of 
ownership shall constitute indirect ownership of a corporation's stock 
for purposes of this paragraph (e)(5) of this section. Moreover, stock 
of a corporation held by a trust is considered held by a person if, and 
to the extent, such person is treated under subpart E, part I, 
subchapter J, chapter 1 of the Code as the owner of the portion of the 
trust that consists of such stock.
    (iv) Disregard of community property laws. For purposes of this 
paragraph (e)(5) of this section, community property laws shall be 
disregarded. Thus, in determining the stock ownership of a corporation, 
stock owned by a spouse solely by reason of community property laws 
shall be treated as owned by the other spouse.
    (v) Treatment of certain stock plans. For purposes of this paragraph 
(e)(5) of this section, stock held by a plan described in section 401 
(a) that is exempt from tax under section 501 (a) shall be treated as 
held by an employee described in paragraph (e)(5)(i)(A) of this section.
    (vi) Special election for certain affiliated groups. For purposes of 
determining whether the stock ownership test of this paragraph (e)(5) of 
this section has been met, at the election of the common parent of an 
affiliated group (within the meaning of section 1504 (a)), all members 
of such group shall be treated as one taxpayer if substantially all 
(within the meaning of paragraph (e)(4)(i) of this section) the 
activities of all such members (in the aggregate) are in the same field 
described in paragraph (e)(4)(i)(A)-(H) of this section. For rules 
relating to the making of the election, see 26 CFR 5h.5 (temporary 
regulations relating to elections under the Tax Reform Act of 1986).
    (vii) Examples. The following examples illustrate the provisions of 
paragraph (e) of this section:

    Example (1). (i) X, a Corporation, is engaged in the business of 
providing accounting services to its clients. These services consist of 
the preparation of audit and financial statements and the preparation of 
tax returns. For purposes of section 448, such services consist of the 
performance of services in the field of accounting. In addition, for 
purposes of section 448, the supervision of employees directly preparing 
the statements and returns, and the performance of all administrative 
and support services incident to such activities (including secretarial, 
janitorial, purchasing, personnel, security, and payroll services) are 
the performance of services in the field of accounting.
    (ii) In addition, X owns and leases a portion of an office building. 
For purposes of this section, the following types of activities 
undertaken by the employees of X shall be considered as the performance 
of services in a field other than the field of accounting: (A) services 
directly relating to the leasing activities, e.g., time spent in leasing 
and maintaining the leased portion of the building; (B) supervision of 
employees engaged in directly providing services in the leasing 
activity; and (C) all administrative and support services incurred 
incident to services described in (A) and (B). The leasing activities of 
X are considered the performance of services in a field other than the 
field of accounting, regardless of whether such leasing activities 
constitute a trade or business under the Code. If the employees of X 
spend 95% or

[[Page 92]]

more of their time in the performance of services in the field of 
accounting, X satisfies the function test of paragraph (e)(4) of this 
section.
    Example (2). Assume that Y, a C corporation, meets the function test 
of paragraph (e)(4) of this section. Assume further that all the 
employees of Y are performing services for Y in a qualifying field as 
defined in paragraph (e)(4) of this section. P, a partnership, owns 40%, 
by value, of the stock of Y. The remaining 60% of the stock of Y is 
owned directly by employees of Y. Employees of Y have an aggregate 
interest of 90% in the capital and profits of P. This, 96% of the stock 
of Y is held directly, or indirectly, by employees of Y performing 
services in a qualifying field. Accordingly, Y meets the ownership test 
of paragraph (e)(5) of this section and is a qualified personal service 
corporation.
    Example (3). The facts are the same as in example (2), except that 
40% of the stock of Y is owned by Z, a C corporation. The remaining 60% 
of the stock is owned directly by the employees of Y. Employees of Y own 
90% of the stock, by value, of Z. Assume that Z independently qualifies 
as a personal service corporation. The result is the same as in example 
(2), i.e., 96% of the stock of Y is held, directly or indirectly, by 
employees of Y performing services in a qualifying field. Thus, Y is a 
qualified personal service corporation.
    Example (4). The facts are the same as in example (3), except that Z 
does not independently qualify as a personal service corporation. 
Because Z is not a qualified personal service corporation, the Y stock 
owned by Z is not treated as being held indirectly by the Z 
shareholders. Consequently, only 60% of the stock of Y is held, directly 
or indirectly, by employees of Y. Thus, Y does not meet the ownership 
test of paragraph (e)(5) of this section, and is not a qualified 
personal service corporation.
    Example (5). Assume that W, a C corporation, meets the function test 
of paragraph (e)(4) of this section. In addition, assume that all the 
employees of W are performing services for W in a qualifying field. 
Nominal legal title to 100% of the stock of W is held by employees of W. 
However, due solely to the operation of community property laws, 20% of 
the stock of W is held by spouses of such employees who themselves are 
not employees of W. In determining the ownership of the stock, community 
property laws are disregarded. Thus, Y meets the ownership test of 
paragraph (e)(5) of this section, and is a qualified personal service 
corporation.
    Example (6). Assume that 90% of the stock of T, a C corporation, is 
directly owned by the employees of T. Spouses of T's employees directly 
own 5% of the stock of T. The spouses are not employees of T, and their 
ownership does not occur solely by operation of community property laws. 
In addition, 5% of the stock of T is held by trusts (other than a trust 
described in section 401(a) that is exempt from tax under section 
501(a)), the sole beneficiaries of which are employees of T. The 
employees are not treated as owners of the trusts under subpart E, part 
I, subchapter J, chapter 1 of the Code. Since a person is not treated as 
owning the stock of a corporation owned by that person's spouse, or by 
any portion of a trust that is not treated as owned by such person under 
subpart E, only 90% of the stock of T is treated as held, directly or 
indirectly, by employees of T. Thus, T does not meet the ownership test 
of paragraph (e)(5) of this section, and is not a qualified personal 
service corporation.
    Example (7). Assume that Y, a C corporation, directly owns all the 
stock of three subsidiaries, F, G, and H. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, G, and H. Y is not engaged in the performance of services in a 
qualifying field. Instead, Y is a holding company whose activities 
consist of its ownership and investment in its operating subsidiaries. 
Substantially all the activities of F involve the performance of 
services in the field of engineering. In addition, a majority of (but 
not substantially all) the activities of G involve the performance of 
services in the field of engineering; the remainder of G's services 
involve the performance of services in a nonqualifying field. Moreover, 
a majority of (but not substantially all) the activities of H involve 
the performance of services in the field of engineering; the remainder 
of H's activities involve the performance of services in the field of 
architecture. Nevertheless, substantially all the activities of the 
group consisting of Y, F, G, and H, in the aggregate, involve the 
performance of services in the field of engineering. Accordingly, Y 
elects under paragraph (e)(5)(vi) of this section to be treated as one 
taxpayer for determining the ownership test of paragraph (e)(5) of this 
section. Assume that substantially all the stock of Y (by value) is held 
by employees of F, G, or H who perform services in connection with a 
qualifying field (engineering or architecture). Thus, for purposes of 
determining whether any member corporation is a qualified personal 
service corporation, the ownership test of paragraph (e)(5) of this 
section has been satisfied. Since F and H satisfy the function test of 
paragraph (e)(4) of this section, F and H are qualified personal service 
corporations. However, since Y and G each fail the function test of 
paragraph (e)(4) of this section, neither corporation is a qualified 
personal service corporation.
    Example (8). The facts are the same as in example (7), except that 
less than substantially all the activities of the group consisting of Y, 
F, G, and H, in the aggregate, are performed in the field of 
engineering.

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Substantially all the activities of the group consisting of Y, F, G, and 
H, are, in the aggregate, performed in two fields, the fields of 
engineering and architecture. Y may not elect to have the affiliated 
group treated as one taxpayer for purposes of determining whether group 
members meet the ownership test of paragraph (e)(5) of this section. The 
election is available only if substantially all the activities of the 
group, in the aggregate, involve the performance of services in only one 
qualifying field. Moreover, none of the group members are qualified 
personal service corporations. Y fails the function test of paragraph 
(e)(4) of this section because less than substantially all the 
activities of Y are performed in a qualifying field. In addition, F, G, 
and H fail the ownershp test of paragraph (e)(5) of this section because 
substantially all their stock is owned by Y and not by their employees. 
The owners of Y are not deemed to indirectly own the stock owned by Y 
because Y is not a qualified personal service corporation.
    Example (9). (i) The facts are the same as in example (8), except Y 
itself satisfies the function tests of paragraph (e)(4) of this section 
because substantially all the activities of Y involve the performance of 
services in the field of engineering. In addition, assume that all 
employees of Y are involved in the performance of services in the field 
of engineering, and that all such employees own 100% of Y's stock. 
Moreover, assume that one-third of all the employees of Y are separately 
employed by F. Similarly, another one-third of the employees of Y are 
separately employed by G and H, respectively. None of the employees of Y 
are employed by more than one of Y's subsidiaries. Also, no other 
persons except the employees of Y are employed by any of the 
subsidiaries.
    (ii) Y is a personal service corporation under section 448 because Y 
satisfies both the function and the ownership test of paragraphs (e) (4) 
and (5) of this section. As in example (8), Y is unable to make the 
election to have the affiliated group treated as one taxpayer for 
purposes of determining whether group members meet the ownership test of 
paragraph (e)(5) of this section because less than substantially all the 
activities, in the aggregate, of the group members are performed in one 
of the qualifying fields. However, because Y is a personal service 
corporation, the stock owned by Y is treated as indirectly owned, 
proportionately, by the owners of Y. Thus, the employees of F are 
collectively treated as owning one-third of the stock of F, G, and H. 
The employees of G and H are similarly treated as owning one-third of 
each subsidiary's stock.
    (iii) F, G, and H each fail the ownership test of paragraph (e)(5) 
of this section because less than substantially all of each 
corporation's stock is owned by the employees of the respective 
corporation. Only one-third of each corporation's stock is owned by 
employees of that corporation. Thus, F, G, and H are not qualified 
personal service corporations.
    Example (10). (i) Assume that Y, a C corporation, directly owns all 
the stock of three subsidiaries, F, G, and Z. Y is a common parent of an 
affiliated group within the meaning of section 1504(a) consisting of Y, 
F, and G. Z is a foreign corporation and is excluded from the affiliated 
group under section 1504. Assume that Y is a holding company whose 
activities consist of its ownership and investment in its operating 
subsidiaries. Substantially all the activities of F, G, and Z involve 
the performance of services in the field of engineering. Assume that 
employees of Z own one-third of the stock of Y and that none of these 
employees are also employees of Y, F, or G. In addition, assume that Y 
elects to be treated as one taxpayer for determining whether group 
members meet the ownership tests of paragraph (e)(5) of this section. 
Thus, Y, F, and G are treated as one taxpayer for purposes of the 
ownership test.
    (ii) None of the members of the group are qualified personal service 
corporations. Y, F, and G fail the ownership test of paragraph (e)(5) of 
this section because less than substantially all the stock of Y is owned 
by employees of either Y, F, or G. Moreover, Z fails the ownership test 
of paragraph (e)(5) of this section because substantially all its stock 
is owned by Y and not by its employees.

    (6) Application of function and ownership tests. A corporation that 
fails the function test of paragraph (e)(4) of this section for any 
taxable year, or that fails the ownership test of paragraph (e)(5) of 
this section at any time during any taxable year, shall change from the 
cash method effective for the year in which the corporation fails to 
meet the function test or the ownership test. For example, if a personal 
service corporation fails the function test for taxable year 1987, such 
corporation must change from the cash method effective for taxable year 
1987. A corporation that fails the function or ownership test for a 
taxable year shall not be treated as a qualified personal service 
corporation for any part of that taxable year.
    (f) Exception for entities with gross receipts of not more than $5 
million--(1) In general. Except in the case of a tax shelter, this 
section shall not apply to any C corporation or partnership with a C 
corporation as a partner for any taxable year if, for all prior taxable 
years beginning after December 31, 1985, such corporation or partnership

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(or any predecessor thereof) meets the $5,000,000 gross receipts test of 
paragraph (f)(2) of this section.
    (2) The $5,000,000 gross receipts test--(i) In general. A 
corporation meets the $5,000,000 gross receipts test of this paragraph 
(f)(2) for any prior taxable year if the average annual gross receipts 
of such corporation for the 3 taxable years (or, if shorter, the taxable 
years during which such corporation was in existence) ending with such 
prior taxable year does not exceed $5,000,000. In the case of a C 
corporation exempt from federal income taxes under section 501(a), or a 
trust subject to tax under section 511(b) that is treated as a C 
corporation under paragraph (a)(3) of this section, only gross receipts 
from the activities of such corporation or trust that constitute 
unrelated trades or businesses are taken into account in determining 
whether the $5,000,000 gross receipts test is satisfied. A partnership 
with a C corporation as a partner meets the $5,000,000 gross receipts 
test of this paragraph (f)(2) for any prior taxable year if the average 
annual gross receipts of such partnership for the 3 taxable years (or, 
if shorter, the taxable years during which such partnership was in 
existence) ending with such prior year does not exceed $5,000,000. The 
gross receipts of the corporate partner are not taken into account in 
determining whether the partnership meets the $5,000,000 gross receipts 
test.
    (ii) Aggregation of gross receipts. For purposes of determining 
whether the $5,000,000 gross receipts test has been satisfied, all 
persons treated as a single employer under section 52 (a) or (b), or 
section 414 (m) or (o) (or who would be treated as a single employer 
under such sections if they had employees) shall be treated as one 
person. Gross receipts attributable to transactions between persons who 
are treated as a common employer under this paragraph shall not be taken 
into account in determining whether the $5,000,000 gross receipts test 
is satisified.
    (iii) Treatment of short taxable year. In the case of any taxable 
year of less than 12 months (a short taxable year), the gross receipts 
shall be annualized by (A) multiplying the gross receipts for the short 
period by 12 and (B) dividing the result by the number of months in the 
short period.
    (iv) Determination of gross receipts--(A) In general. The term 
``gross receipts'' means gross receipts of the taxable year in which 
such receipts are properly recognized under the taxpayer's accounting 
method used in that taxable year (determined without regard to this 
section) for federal income tax purposes. For this purpose, gross 
receipts include total sales (net of returns and allowances) and all 
amounts received for services. In addition, gross receipts include any 
income from investments, and from incidental or outside sources. For 
example, gross receipts include interest (including original issue 
discount and tax-exempt interest within the meaning of section 103), 
dividends, rents, royalties, and annuities, regardless of whether such 
amounts are derived in the ordinary course of the taxpayer's trade of 
business. Gross receipts are not reduced by cost of goods sold or by the 
cost of property sold if such property is described in section 1221 (1), 
(3), (4) or (5). With respect to sales of capital assets as defined in 
section 1221, or sales of property described in 1221 (2) (relating to 
property used in a trade or business), gross receipts shall be reduced 
by the taxpayer's adjusted basis in such property. Gross receipts do not 
include the repayment of a loan or similar instrument (e.g., a repayment 
of the principal amount of a loan held by a commercial lender). Finally, 
gross receipts do not include amounts received by the taxpayer with 
respect to sales tax or other similar state and local taxes if, under 
the applicable state or local law, the tax is legally imposed on the 
purchaser of the good or service, and the taxpayer merely collects and 
remits the tax to the taxing authority. If, in contrast, the tax is 
imposed on the taxpayer under the applicable law, then gross receipts 
shall include the amounts received that are allocable to the payment of 
such tax.
    (3) Examples. The following examples illustrate the provisions of 
paragraph (f) of this section:

    Example (1). X, a calendar year C corporation, was formed on January 
1, 1986. Assume

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that in 1986 X has gross receipts of $15 million. For taxable year 1987, 
this section applies to X because in 1986, the period during which X was 
in existence, X has average annual gross receipts of more than $5 
million.
    Example (2). Y, a calendar year C corporation that is not a 
qualified personal service corporation, has gross receipts of $10 
million, $9 million, and $4 million for taxable years 1984, 1985, and 
1986, respectively. In taxable year 1986, X has average annual gross 
receipts for the 3-taxable-year period ending with 1986 of $7.67 million 
($10 million + 9 million + 4 million /3). Thus, for taxable year 1987, 
this section applies and Y must change from the cash method for such 
year.
    Example (3). Z, a C corporation which is not a qualified personal 
service corporation, has a 5% partnership interest in ZAB partnership, a 
calendar year cash method taxpayer. All other partners of ZAB 
partnership are individuals. Z corporation has average annual gross 
receipts of $100,000 for the 3-taxable-year period ending with 1986 
(i.e., 1984, 1985 and 1986). The ZAB partnership has average annual 
gross receipts of $6 million for the same 3-taxable-year period. Since 
ZAB fails to meet the $5,000,000 gross receipts test for 1986, this 
section applies to ZAB for its taxable year beginning January 1, 1987. 
Accordingly, ZAB must change from the cash method for its 1987 taxable 
year. The gross receipts of Z corporation are not relevant in 
determining whether ZAB is subject to this section.
    Example (4). The facts are the same as in example (3), except that 
during the 1987 taxable year of ZAB, the Z corporation transfers its 
partnership interest in ZAB to an individual. Under paragraph (a)(1) of 
this section, ZAB is treated as a partnership with a C corporation as a 
partner. Thus, this section requires ZAB to change from the cash method 
effective for its taxable year 1987. If ZAB later desires to change its 
method of accounting to the cash method for its taxable year beginning 
January 1, 1988 (or later), ZAB must comply with all requirements of 
law, including sections 446(b), 446(e), and 481, to effect the change.
    Example (5). X, a C corporation that is not a qualified personal 
service corporation, was formed on January 1, 1986, in a transaction 
described in section 351. In the transaction, A, an individual, 
contributed all of the assets and liabilities of B, a trade or business, 
to X, in return for the receipt of all the outstanding stock of X. 
Assume that in 1986 X has gross receipts of $4 million. In 1984 and 
1985, the gross receipts of B, the trade or business, were $10 million 
and $7 million respectively. The gross receipts test is applied for the 
period during which X and its predecessor trade or business were in 
existence. X has average annual gross receipts for the 3-taxable-year 
period ending with 1986 of $7 million ($10 million + $7 million + $4 
million/3). Thus, for taxable year 1987, this section applies and X must 
change from the cash method for such year.

[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR 
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993]