Rev. Proc. 65-27

SECTION 1. SCOPE.

This Revenue Procedure prescribes the position and procedure of the Internal Revenue Service for the application of the regulations under section 7701 of the Internal Revenue Code of 1954, relating to the tax classification of professional service organizations, contained in section 301.7701-2(h) of the Regulations on Procedure and Administration.

SEC. 2. BACKGROUND AND PURPOSE.

On November 17, 1960, Treasury Decision 6503 was promulgated, C.B. 1960-2, 409. That Treasury Decision contained regulations for the tax classification of organizations under section 7701 of the Code. Those regulations are applicable only to taxable years beginning after December 31, 1960. Since 1960, more than 30 States have in various manners authorized the conduct of professions in so-called professional service corporations and associations. The Internal Revenue Service has received many inquiries and requests for rulings on the tax classification of these various types of professional service organizations. On May 8, 1963, the Service announced in Technical Information Release No. 471, Announcement 63-57, I.R.B. 1963-21, 42, that no individual determinations or rulings would be issued since a proposed amendment to the regulations, relating to the tax classification of professional service organizations, under section 7701 of the Code was being drafted. The amendments were issued in proposed form in December 1963. The final rules were promulgated in Treasury Decision 6797 on February 3, 1965, C.B. 1965-1, 553. These rules are also applicable only to taxable years beginning after December 31, 1960. The purpose of this Revenue Procedure is to set forth some of the standards and the procedures the Service will follow in handling cases arising under the professional service organization regulations.

SEC. 3. APPLICABILITY.

.01 General rule .-Section 301.7701-2(h) of the regulations defines the term `professional service organization' as `an organization formed by one or more persons to engage in a business involving the performance of professional services for profit which under local law, may not be organized and operated in the form of an ordinary business corporation having the usual characteristics of such a corporation.' Section 301.7701-1(c) of the regulations provides that `the labels applied by local law to organizations, which may now or hereafter be authorized by local law, are in and of themselves of no importance in the classification of such organization for the purposes of taxation under the Internal Revenue Code.'

.02 Organizations to which the professional service organization regulations do not apply .

1. The professional service organization regulations are not applicable to any organization, regardless of the manner in which it is organized or operated, which does not provide professional services for profit. For example, the professional service organization regulations are not applicable in classifying a manufacturing concern organized and operated in the form of an ordinary business corporation. Similarly, such regulations are not applicable in classifying a firm of plumbing contractors organized and operated in the form of an ordinary business corporation. In addition, the regulations are not applicable in classifying a commercial banking organization organized and operated under a special local statute relating to commercial banking.

2. The professional service organization regulations are not applicable to any organization organized and operated in the form of an ordinary business corporation which possesses the usual characteristics of such a corporation, even though the organization provides professional services for profit. For example, the regulations are not applicable in classifying an engineering firm or an architectural firm if, under local law, such firms are organized and operated as ordinary business corporations which posses the usual characteristics of such corporations. A professional service organization which is organized as an ordinary business corporation possesses the usual characteristics of such a corporation if it has sufficient corporate characteristics to be classifiable as a corporation under the provisions of section 301.7701-2(a) of the regulations. In determining whether a particular organization was such corporate characteristics, the provisions of section 301.7701-2(h) of the regulations are applicable.

.03 Organizations to which the professional service organization regulations do apply .-The professional service organization regulations are applicable to any organization providing professional services for profit, without regard to its form or how it is labeled under local law, if such organization is not organized and operated under local law in the form of an ordinary business corporation having the usual characteristics of such a corporation. For example, the tax classification of an organization which provides professional services for profit and which is formed as an association under State common law, a partnership association, a business trust, a joint-stock company, or a professional service corporation or association formed under a local law or regulatory rule specifically authorizing the formation of such organizations, is determined pursuant to the provisions of section 301.7701-2(h) of the regulations. The regulations are also applicable to an organization formed as an ordinary business corporation under a local general business corporation statute when such organization providing professional services for profit is subject to local regulatory rules or special restrictions which deprive the organization of the usual characteristics of an ordinary business corporation. For example, the tax classification of a law firm organized under a local general business corporation statute is determined pursuant to the provisions of section 301.7701-2(h) of the regulations when local regulatory rules and the special professional requirements of the legal profession deprive the firm of the usual characteristics of an ordinary business corporation.

SEC. 4. TREATMENT AS A CORPORATION FOR CERTAIN TAXABLE YEARS.

.01 Corporate treatment .-Pursuant to section 7805(b) of the Code and section 301.7701-2(a)(5) of the regulations, the rules of section 301.7701-2(h) of the regulations shall not be applicable, for taxable years beginning after December 31, 1960, and ending on or before December 31, 1964, to an organization formed as-

1. An unincorporated organization providing professional services for profit formed uner an agreement if it has a preponderance of corporate characteristics determined solely by the terms of such agreement,

2. A partnership association,

3. A business trust,

4. An ordinary business corporation,

5. A joint-stock company,

6. A so-called professional service corporation or a professional service association formed under a local law or regulatory rule specifically authorizing the formation of such organizations,

if such organization made its return, filed at or prior to the time (including extensions thereof) that the return for such taxable year was required to be filed, as if its income for such year were subject to the tax imposed by section 11 of the Code (relating to tax imposed on corporations). The Service will treat any such organization as if it were a corporation for any taxable year for which it meets such requirements. Similarly, the Service will treat those who engaged in the professional practice in such an organization as if they were corporate employees for any such taxable year, and the members as if they were corporate shareholders for any such taxable year. Such treatment is afforded to those organizations for each taxable year for which they relied on the previously existing regulations under section 7701 of the Code and indicated that reliance by filing timely corporate income tax returns for one or more such taxable years. Therefore, the tax classification of a professional service organization to which the classification rules of section 301.7701-2(h) of the regulations are applicable and which could otherwise qualify for corporate treatment but for its failure to make and file its return in the manner described in section 301.7701-2(a)(5) of the regulations and this paragraph is determined under the classification rules of section 301.7701-2(h) of the regulations.

.02 Cases involving taxable years beginning before January 1, 1961 .-A number of pending cases involve the tax classification of professional service organizations for taxable years beginning before January 1, 1961. The Service does not, in general, intend to pursue tax classification questions arising under section 7701 of the Code involving such organizations. If a professional service organization made its return for any taxable year beginning before January 1, 1961, as if its income were subject to the tax imposed by section 11 of the Code (relating to tax imposed on corporations), the Service will treat any such organization as if it were a corporation for such taxable year. Similarly, the Service will treat those who engage in the professional practice in such an organization as if they were corporate employees for any such taxable year, and the members as if they were corporate shareholders for any such taxable year.

SEC. 5. RULES APPLICABLE TO ORGANIZATIONS TREATED AS CORPORATIONS.

.01 Application of usual corporate rules .-Any organization treated as a corporation by the Service under the provisions of section 4 above is subject to all of the normal rules of taxation applicable to corporations. For example, if a professional service organization is treated as if it were a corporation for a taxable year ending on or before December 31, 1964, such organization is subject to the normal rules of deductibility of items such as reasonable compensation under section 162 of the Code (relating to trade or business expenses) and contributions to an employees' pension, profit-sharing, or annuity plan and compensation under a deferred-payment plan referred to in section 404 of the Code, to the rules for corporate distributions and adjustments contained in subchapter C of chapter 1 of the Code, and to the rules for corporations used to avoid tax on shareholders contained in subchapter G of chapter 1 of the Code. Similarly, those who engage in the professional practice in such organizations and are treated for such year as corporate employees may be permitted to exclude certain amounts from their gross income under section 79 of the Code (relating to group-term life insurance purchased for employees). In addition, under section 106 of the Code, the gross income of such persons does not include contributions by such organization to accident or health plans for compensation to such persons for personal injuries or sickness.

.02 Effect of change of tax classification .-A professional service organization is not considered to have been liquidated and its associates are not subject to the provisions of section 331 of the Code if, for any taxable year beginning after December 31, 1960, such organization is no longer treated by the Service as a corporation for Federal income tax purposes and the change in status has come about without any action of the organization or its members. In such case there is no voluntary act of liquidation by the members of the organization and no tax consequence by way of a constructive liquidation results from the involuntary change in tax classification. The basis of property in the hands of a professional service organization and the basis of each member's interest in the organization is not affected by a change in tax classification. See Revenue Ruling 63-107, C.B. 1963-1, 71.

.03 Treatment of deferred compensation plans .-The same rules which are applicable for the qualification and operation of any pension, annuity, profit-sharing, or stock bonus plan established by a corporation are applicable to any such plan established by an organization which the Service will treat as a corporation under the provisions of section 4 above for any taxable year for which the Service treats such organization as a corporation. For purposes of sections 402(a)(2) and 403(a)(2) of the Code, no person who is treated as an employee of an organization treated by the Service as a corporation for Federal income tax purposes for any taxable year shall be deemed, in any subsequent taxable year, to have been separated from the service of such organization because such organization is no longer treated by the Service as a corporation for Federal income tax purposes and the change in status has come about without any action of the organization or its members. The Service intends to issue in the near future guidelines for resolving other problems arising in connection with deferred compensation plans.

SEC. 6. PROCEDURES TO BE FOLLOWED RESPECTING CASES WITHIN THE JURISDICTION OF THE INTERNAL REVENUE SERVICE AND CASES DOCKETED IN THE TAX COURT OF THE UNITED STATES.

.01 Pending cases .-The Service intends to process, as expenditiously as possible, pending cases involving the tax classification of professional service organizations for taxable years ending on or before December 31, 1964, on the basis of this Revenue Procedure. In any such case pending before the Tax Court of the United States, a taxpayer may secure the treatment afforded by this Revenue Procedure by requesting such relief.

.02 Requests for determination letters and rulings .-If a taxpayer has already made a proper request for a determination letter or ruling involving the tax classification of a professional service organization for any taxable year ending on or before December 31, 1964, it is unnecessary to submit a new request. A taxpayer may request and will be issued, in appropriate cases, a determination letter or ruling in any case involving the tax classification of a professional service organization. A request for such a determination letter or ruling must be made and will be processed in the manner described in section 601.201 of the Statement of Procedural Rules. Such determination letter or ruling will be made in accordance with the provisions of the applicable regulations under section 7701 of the Code and this Revenue Procedure.

SEC. 7. EFFECT ON OTHER DOCUMENTS.

Revenue Procedure 62- 31, C.B. 1962-2, 517, is hereby modified to eliminate the requirement, contained in section 6.06 thereof, that the District Director will refer to the National Office any case involving the tax classification of an organization if he is of the opinion that the organization is an association taxable as a corporation and that the proper employer-employee relationship exists between the organization and its associates.

¹ Based on Technical Information Release 770, dated Oct. 6, 1965.