Internal Revenue Service
Revenue Ruling
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smRev. Rul. 78-64
1978-1 C.B. 271
Sec. 1348
IRS Headnote
Maximum tax; personal service net income. An example illustrates the method used in computing personal service net income under the maximum tax provisions of section 1348 of the Code in a situation where the taxpayer has substantial income from wages and also incurs gains and losses from the operation of two proprietorships in which both personal services and capital are material income producing factors.
Full Text
Rev. Rul. 78-64
Advice has been requested as to the method of determining the amount of personal service net income under section 1348 of the Internal Revenue Code of 1954, under the circumstances described below.
During 1977 A received a salary of $80,000 attributable to services performed as an employee of a corporation. A incurred no deductible business expenses with respect to the salary income. In addition, A owned and operated two proprietorships, X and Y, in which both personal services and capital were material income-producing factors.
A derived gross income of $60,000 from business X during the taxable year and incurred expenses of $80,000. A reasonable allowance as compensation for the personal services rendered by A in the operation of X for such year was $12,000.
A derived gross income of $100,000 from business Y during the taxable year and incurred expenses of $50,000. A reasonable allowance as compensation for the personal services rendered by A in the operation of Y was $16,000.
Section 1348 of the Code provides for a 50-percent maximum marginal tax rate on personal service taxable income.
Prior to amendment of section 1348 of the Code by the Tax Reform Act of 1976, P.L. 94-455, 94th Cong., 2d Sess. (Oct. 4, 1976), 1976-3 (Vol. 1) C.B. 30, section 1348 limited the rate of tax imposed on "earned taxable income" rather than "personal service taxable income." The regulations currently in force under section 1348 interpret that section prior to its amendment by the Tax Reform Act of 1976; however, for purposes of the instant case, there is no material change in the provisions of section 1348.
Section 1348(b)(2) of the Code provides that personal service taxable income of an individual is the excess of the amount which bears the same ratio (but not in excess of 100 percent) to the individual's taxable income as the individual's personal service net income bears to the individual's adjusted gross income, over the sum of items of tax preference (as defined in section 57) for the taxable year. The term "personal service net income" means personal service income reduced by any deductions allowable under section 62 that are properly allocable to or chargeable against such earned income.
Section 1.1348-2(d)(2) of the Income Tax Regulations provides, in part, that deductions are properly allocable to or chargeable against earned income if, and to the extent that, they are allowable in respect of expenses paid or incurred in connection with the production of earned income and have not been taken into account in determining the net profits of a trade or business in which both personal services and capital are material income-producing factors (as defined in section 1.1348-3(a)(3)). Deductions properly allocable to or chargeable against earned income include deductions attributable to a trade or business from which earned income is derived, except that if less than all the gross income from a trade or business constitutes earned income, only a ratable portion of the deductions attributable to such trade or business is allowable in respect of expenses paid or incurred in connection with the production of earned income.
Section 1.1348-3(a)(3) of the regulations provides, in part, that if an individual is engaged in a trade or business (other than in corporate form) in which both personal services and capital are material income-producing factors, a reasonable allowance as compensation for the personal services actually rendered by the individual shall be considered earned income, but the total amount that shall be treated as the earned income of the individual from such trade or business shall in no case exceed 30 percent of the individual's share of the net profits of such trade or business.
When the expenses of a business exceed the income from that business, a portion of the expenses may be allocable to personal service income. Furthermore, in those situations in which only a part of the income from a trade or business constitutes personal service income, only a ratable portion of the expenses will be allocable to the personal service income. Example 7 of section 1.1348-2(d)(4) of the regulations illustrates the manner in which this allocation is made. To determine the portion of the business expenses allocable to the taxpayer's personal service income, the total allowable business expenses must be multiplied by the ratio of the reasonable value of the taxpayer's service to the business over the gross receipts of that business.
This calculation must be separately applied to each business of the taxpayer that incurs a loss and the profits or losses of one business may not be netted against the profits or losses of another business.
Applying these principles to the instant case, A's personal service net income is $91,000 computed as follows:
A's Salary _______________________________________ $80,000
Plus a reasonable allowance as compensation for
A's personal services with respect to X ________ 12,000
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$92,000
Less the ratable portion of deductible expenses
of X ($12,000/$60,000 X $80,000) _______________ 16,000
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$76,000
Plus a reasonable allowance as compensation for
A's personal services with respect to Y
(limited to 30 percent of net profits of
$50,000) _______________________________________ 15,000
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A's personal service net income __________________ $91,000