Keller v. Commissioner , 77 T.C. 1014 ( 1981 )

Wilbur, J.,

dissenting: Petitioner was engaged with 11 other pathologists in a full service pathology practice, from hemotol-ogy to bacteriology, including cytology, endocrine studies, surgical pathology, and other fields of the practice. The practice averaged from 20,000 to 25,000 tissue examinations a year and between 75,000 and 80,000 cytology examinations, each accompanied by a corresponding report. There were various other clinical pathology and consultation reports, ranging between 300 and 1,000 per day. The practice served various primary care physicians and several hospitals.

The business was conducted by the pathologists through well-equipped laboratories, principally at two different locations, and incidentally at various hospitals. The labs were staffed by from 30 to 50 employees, ineluding many highly trained technicians. The laboratories and the equipment belonged to MAL, Inc., a corporation owned by petitioner and his fellow pathologists. The technicians and clerical help, though working for and with the pathologists, were technically employees of MAL, Inc. The pathologists themselves formed a partnership (MAL) that handled all the billing and collections, and entered into all the contracts with the hospitals served. The partnership billed for these procedures, and reimbursed the corporation for use of their laboratory facilities and employees.

Sometime prior to 1974, the partners engaged in extensive discussions about whether to form a professional corporation, incorporating the partnership slice of the business, but turned this down. Although the partners declined to incorporate the partnership slice of the business, petitioner nevertheless created a professional corporation under Oklahoma law (Keller, Inc.). This corporation entered into agreements with the incorporated laboratory facilities (MAL, Inc.) and the partnership (MAL). The agreement between petitioner and the partnership "substituted” his corporation as a partner but required petitioner to "personally guarantee all obligations arising out of the relationship between the partnership and Dan F. Keller, M.D., Inc.” The net effect of these agreements entitled Keller, Inc., to receive petitioner’s share of the income earned by the collective efforts of the partnership in providing comprehensive pathology services through its contracts and contacts, and also to receive the salary petitioner earned for his efforts in supervising the laboratory facilities and procedures of MAL, Inc.¹

In his opening statement, petitioner’s counsel conceded that these arrangements were not simple and might be unusual. He also asserted that "the evidence will show that Keller, Inc. owned no medical supplies, owned no office furniture, had no technical medical equipment, employed no medical technicians, employed no nurses.” The evidence showed this and more. On the particular facts before us, I agree with respondent that petitioner earned his share of the income (was the "true earner” of the income) and simply assigned it to a corporate shell he created.

Prior to the formation of petitioner’s corporation, the comprehensive pathology practice or business was artificially sliced in two — with one integrally related half relegated to a corporation (MAL, Inc.), the other to a partnership (MAL)— both of them owned and controlled as to all essential details by the partners. The addition of petitioner’s corporation is one slice too many, tissue paper thin, without functional reality or economic substance. The corporation was a small and barely discernible shadow on a thin edge of the partnership — and the partnership controlled every essential element of the business. Indeed, along with MAL, Inc., it was the business. The particular facts and circumstances before us bring this case within Roubik v. Commissioner, 53 T.C. 365 (1969), wherein we stated:

Pfeffer Associates appears to have existed during 1965 as a mere set of bookkeeping entries and bank accounts. It did not enter into any arrangements to provide the service of its "employees” to any of the institutions, doctors, etc., for whom petitioners provided services. It did not own any equipment, incur any debts for rent, office or medical supplies or services or for salaries, except for the salaries of the petitioners. The only "shared” expense, i.e., the only expense which was incurred jointly by the petitioners was $45 a month for the time Ramin’s Hampton office secretary devoted to maintaining records of income and expenses received and paid by Pfeffer Associates. The maintenance of these records for tax purposes appears to b.e the only real business activity engaged in by the corporation. * * * [53 T.C. at 379.]

See also Rubin v. Commissioner, 51 T.C. 251 (1968), revd. and remanded 429 F.2d 650 (2d Cir. 1970), decided on remand 56 T.C. 1155 (1971), affd. 460 F.2d 1216 (2d Cir. 1972).

The same and more may be said of petitioner and his corporation. Keller, Inc., "did not own any equipment, incur any debts for rent, office or medical supplies or services or for salaries, except the salaries of the petitioner.” It had no expenses — petitioner continued to practice with the same facilities at the same locations owned or leased by MAL and MAL, Inc.

It had no medical records, business records, or any other item or paraphernalia of business of any kind whatsoever. It supervised no employees and had no contracts with hospitals or contacts with primary care physicians — these all belonged to and were completely controlled by MAL. "The maintenance of these records for tax purposes appears to be the only real business activity engaged in by the corporation.”²

The partnership has both the contracts with the hospitals and the contacts with other customers. The partnership establishes every essential element of the business — from fees charged and customers served to the division of the income among the 11 partners in accordance with the partnership agreement. The partners, using the adjunct facilities, equipment, and employees of MAL, Inc., earned this income by providing comprehensive pathological services to all of its customers.

A very brief and legally ambiguous agreement with the partners of MAL, whereby petitioner’s corporation "was substituted in [his] place” in the partnership, did not change any of these basic facts — it simply provided a vehicle for assigning petitioner’s share of the fruits of the partnership enterprise to his corporation. Indeed, the agreement itself suggests all the parties (the partners) viewed it this way, because the agreement specifically required petitioner "to personally guarantee all obligations arising out of the relationship between Keller, Inc., and the partnership.” In other words, the partners were willing to transfer petitioner’s share of the earnings to his corporation, but as to the basic partnership arrangement — particularly any of petitioner’s obligations to the other partners — they looked in the final analysis to petitioner, and he agreed.³

As to MAL, Inc., petitioner continued to receive checks made out to him for his services and reported them on his income tax return for 1974, taking a corresponding deduction. Subsequently, a change was made and the checks were issued directly to his corporation. The majority opinion taxes petitioner on his salary from MAL, Inc., prior to this perfunctory mechanical change and taxes his corporation on the salary after this perfunctory mechanical change. I have difficulty drawing this dividing line. All of the stock of MAL, Inc., continued to be owned by petitioner and his partners. Again, these partners owned and controlled MAL, Inc., which was functionally a closely integrated, if not indivisible, part of their comprehensive pathology business. They determined all of the operations of MAL, Inc., as surely as they did MAL, both before and after creation of petitioner’s shell corporation. Substituting Keller, Inc., for petitioner as a director (hardly the typical role for a professional corporation) effected no real change in any of this.

The partnership controlled all of the elements that determined the income earned by the collective efforts of the partners. Petitioner was subject to these constraints to the same extent as the other partners, and he remained personally liable to the partnership in fulfilling his obligations as a partner. He simply assigned his share of the earnings and his salary from the corporation (MAL, Inc.) to his corporate shell. Keller, Inc., was "nothing more than a few incorporating papers lying in a desk drawer of no significance except when a tax return is due.” Foglesong v. Commissioner, 621 F.2d 865, 873 (7th Cir. 1980) (Wood, J., dissenting), revg. and remanding a Memorandum Opinion of this Court. Its functional relationship to the comprehensive pathology enterprise represented by the MAL partnership and MAL, Inc., was simply as a bank account into which petitioner’s salary from MAL, Inc., and his share of the income from the partnership was funneled. Here the attenuated subtleties triumph over economic substance and practical reality, and form and artifice reclaim center stage of our tax laws.

The majority opinion produces strange results indeed, for as I read it, each individual partner could incorporate. We would have MAL, Inc., at the center surrounded by the partnership and 11 corporate arms extending out in different directions, each a hollow prosthetic device without offices, a laboratory, equipment, facilities, employees, medical records, or any other items normally used in the practice of pathology. The sole function of this paper octopus would be to serve as an incorporated pocketbook, enabling each physician to have a pension plan and fringe benefit package tailored to his own preferences without regard to the quite different preferences of each of his partners and whether or not the employees of the business were provided anything at all.⁴ After this decision, anyone may form a corporation, paper the file a little, and market his services with his salary being paid to his corporation. If Dr. Keller can do this, so can the technicians of MAL, Inc., working by his side. And nurses, teachers, pilots, truck drivers, and virtually any other employee one can think of, for this is the logical and practical consequence of the majority opinion. This may be a good idea, but I never thought it was the law until today.

Petitioner suggests that, in applying the assignment of income doctrine to professional corporations, respondent is renewing an attack on one-man professional service corporations that was lost long ago. Unfortunately, as the following statement from the majority opinion makes clear, the majority has subscribed to petitioner’s theory:

Although respondent maintains that it is not Keller, Inc.’s classification as a corporation that is being disputed, but rather the determination of the true earner of the instant income which is in issue, this distinction is largely semantic rather than substantive. * * * [Emphasis supplied.]

The net effect is to subtly raise the spectre that the Service in this case is again attacking the proper classification of professional service corporations.

This is simply not so, as a brief review of history will show. A service business could always incorporate, but the incorporation of a professional service business presented unique ethical and policy problems. The States resolved the problems by permitting the incorporation of a professional practice or business, subject to certain constraints, the most important preserving individual liability for malpractice. This greatly restricted the limited liability normally associated with the corporate form.⁵ After considerable litigation over the proper classification of these organizations, the Service in Rev. Rul. 70-101,1970-1 C.B. 278, conceded they were corporations. But that concession, like the cases litigated and the professional service corporation statutes enacted, focused on the incorporation of a professional business — a physician or several physicians incorporating their practice, with the assets, contracts, goodwill, books and records, accounts receivable and payable, medical facilities, equipment and supplies, physical facilities, and employees normally associated with that practice. As to these organizations, the dust has settled, and any further changes — if any are appropriate — will have to emanate from Congress. Respondent’s concession clearly was confined to that type of creature, for he specifically stated in Rev. Rui. 70-101:

A professional service organization must be both organized and operated as a corporation to be classified as such. See Jerome J. Roubik and Joan M. Roubik, et al., v. Commissioner, 53 T.C. 365, No. 36 (1969).

***** * *

The foregoing position relates solely to the issue of the tax classification of professional service organizations. Professional service organizations classifiable as corporations are subject to audit to the same extent as other corporations, and nothing contained herein is to be construed as waiving the assertion of any issues against such organizations other than that of classification. [1970-1 C.B. 278,280.]

Plainly, we here confront an entirely different creature within this unmistakably clear reservation by respondent. For Keller, Inc., is not a professional business, but a piece of a piece of this, incorporated into an empty shell having none of these features and no practical control over the earning of the income by the business. When each professional becomes a paper corporation that in turn becomes a partner in a partnership conducting the ongoing business (whether the assets, facilities, employees, etc. are attached to that partnership or farmed out to still another corporation) we have an entirely new phenomenon. As any lawyer knows, quite different legal questions arise in many areas of law — corporations, partnerships, contracts, torts, taxes.⁶

The tax consequences of using multiple professional service corporations that are little more than empty shells as partners in an ongoing professional business has simply not been squarely presented to the courts. There is no reason to hold that these new creatures are immune from the assignment of income doctrine. Assuming that Keller, Inc., is not a sham (as the majority must — not without uncommon faith — to reach the result it does), then the income may have been earned either by the corporation or by Dr. Keller. Mere existence— either of Mrs. Earl or petitioner’s corporation — does not carry automatic immunity from the assignment of income doctrine. As the prior discussion clearly demonstrates, under the facts here present, Dr. Keller earned the income and assigned it to his corporation, and there is no immutable rule of law to the contrary. It is clear that income may be assigned to a corporation or to a trust or an individual. (See United States v. Basye, 410 U.S. 441 (1973); Rubin v. Commissioner, 51 T.C. 251 (1968), revd. and remanded 429 F.2d 650 (2d Cir. 1970), decided on remand 56 T.C. 1155 (1971), affd. 460 F.2d 1216 (2d Cir. 1972); Roubik v. Commissioner, supra; Jones v. Commissioner, 64 T.C. 1066 (1975); and Vnuk v. Commissioner, 621 F.2d 1318 (8th Cir. 1980)).⁷

The hornbook law on assignment of income was set out by Justice Holmes in Lucas v. Earl, 281 U.S. 111 (1930), when he stated:

But this case is not to be decided by attenuated subleties. It turns on the import and reasonable construction of the taxing act. There is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew. [281 U.S. at 114-115.]

During the last half century since Lucas v. Earl, we have been repeatedly advised of the fundamental rule that income must be taxed to him who earns it; indeed, the Supreme Court has referred to the assignment of income rule as "the first principle of income taxation.” Commissioner v. Culbertson, 337 U.S. 733, 739 (1949); United States v. Basye, supra. See Lyon and Eustice, "Assignment of Income: Fruit and Tree as Irrigated by the P. G. Lake Case,” 17 Tax L. Rev. 295 (1962). That the majority chose to ignore this may explain why it also holds that the assignment of income doctrine, for all practical purposes, is inapplicable to these creatures if they pass the Moline Properties⁸ threshold and "actually conduct business.” This is, to me, an extraordinary proposition, entirely inconsistent with both the long evolution of the assignment of income theory and its present status. Recently, the Supreme Court has said the following on this subject:

The principle of Lucas v. Earl, that he who earns income may not avoid taxation through anticipatory arrangements no matter how clever or subtle, has been repeatedly invoked by this Court and stands today as a cornerstone of our graduated income tax system. See, e.g., Commissioner of Internal Revenue v. Harmon, 323 U.S. 44 (1944); United States v. Joliet & Chicago R. Co., 315 U.S. 44 (1942); Helvering v. Eubank, 311 U.S. 122 (1940); Burnet v. Leininger, 285 U.S. 136 (1932). And, of course, that principle applies with equal force in asessing partnership income. [United States v. Basye, supra at 450,451.] [⁹]

Some of the earliest analyses of the problems presented by professional service corporations, although focusing on their proper classification, clearly pointed out that these associations, in appropriate circumstances, would be subject to the assignment of income doctrine. See Bittker, "Professional Associations and Federal Income Taxation: Some Questions and Comments,” 17 Tax L. Rev. 1, 5 n. 8 (1961). The case before us presents the appropriate circumstances. We do not have a professional corporation operating a going professional business owned by one or more practitioners. Rather, we have a professional corporation that is nothing more than an empty paper shell with none of the attributes of an ongoing business, and that corporation is serving as a partner. Here it is the partnership (combined with MAL, Inc.) that is conducting the ongoing business with all of its attributes, that is controlling all of the essential elements through which the partnership collectively earns the income — including the pro rata share attributable to Dr. Keller’s services and assigned to his corporation. As between the collection of meaningless paper going by the name of Keller, Inc., and Dr. Keller, can there be any doubt on the facts before us who is the true earner of the income at issue? My answer to that is Dr. Keller, and I would apply the assignment of income doctrine to directly tax him on the income earned.¹⁰

Finally, it isn’t just that the majority gives the wrong answer to this question — the majority opinion also leaves the precedent in a state of confusion. I believe we have an obligation to establish a clear and consistent body of precedent that enables lawyers to determine our views on a particular issue with a reasonable expenditure of effort. We were reversed in Rubin v. Commissioner, 51 T.C. 251 (1968), revd. and remanded 429 F.2d 650 (2d Cir. 1970), and told to eschew such inconsequential common law principles of taxation as the assignment of income doctrine in favor of section 482. In view of the directions of the Second Circuit in that particular case, we applied section 482 on remand. Rubin v. Commissioner, 56 T.C. 1155 (1971), affd. 460 F.2d 1216 (2d Cir. 1972).

In dismissing the assignment of income doctrine and applying section 482, we follow both the language and procedure of the Second Circuit in Rubin, but we go a good deal further. Floating alone on a sea of contrary precedent, the opinion of the Second Circuit reversing our decision in Rubin is the only source of the unique doctrine propounded by the majority today.¹¹

How the majority can announce this new doctrine without overruling our Rubin decision is difficult for me to see. Not only does the majority avoid this, it never even directly cites the Second Circuit’s Rubin opinion. (The most we get is '‘see” or "see also Rubin.") And what is the Court’s view regarding Foglesong v. Commissioner, 621 F.2d 865 (7th Cir. 1980), revg. and remanding a Memorandum Opinion of this Court? I believe we have an obligation to those who rely on our precedents to forthrightly tell them what we are about— whether or not we are overruling Rubin and whether or not we are following the reversal of the Seventh Circuit in Foglesong. Either our opinions in Rubin and Foglesong are right or the opinion in this case is right — they cannot stand together.

Fay, Dawson, Simpson, Irwin, and Chabot, JJ., agree with this dissenting opinion.

1 teller, Inc., was substituted for petitioner as a member of the board of directors of MAL, Inc. The salary for petitioner’s efforts continued to be paid to him by check for a period of time, but subsequently, the checks were made out directly to petitioner’s corporation.

2 And precious few records there were, for the only assets shown on Keller, Inc.’s fiscal 1976 franchise return were $4,658.85 in cash and an unspecified intangible asset listed at $240. And under "statement of business,” the only entry was the $86,981.97 paid to Dr. Keller.

3 And to some extent, this particular provision may have been redundant, for despite the interposition of this corporate shell, it seems probable on the facts herein that petitioner remains personally liable as a partner for the wrongful acts of his partners in the course of partnership business and vice versa. Partners are jointly and severally liable for a tort committed in the course of partnership business (see Okla. Stat. Ann. tit. 54, secs. 213, 215 (West 1969); 60 Am. Jur. 2d Partnership sec. 102). It is doubted petitioner’s transparent arrangements would be sufficient to circumvent this rule, particularly in view of his continuing obligations to his partners. It is hard to see, then, in what sense petitioner’s corporate bankbook is a partner.

4 For the years in question, neither sec. 414(b) or (c) or the applicable decisions would interfere with this. See Garland v. Commissioner, 73 T.C. 5 (1979), and Kiddie v. Commissioner, 69 T.C. 1055 (1978). For plan years subsequent to 1980, sec. 414(m) would appear to circumscribe the discrimination involved as to pensions, and sec. 105(hX8) as to medical reimbursement. This simply demonstrates that each time Congress has spoken, it has unmistakably expressed its displeasure at the transparent manipulations involved. For the years in issue, the majority holding also permits petitioner (through his medical reimbursement plan) to funnel his share of net fees through his corporate shell, insulating him from the 3-percent floor on medical deductions so nettlesome to the patients who paid these fees.

5 For example, Okla. Stat. Ann. tit. 18, sec. 812 (West Cum. Supp. 1980) provides:

Sec. 812. Professional relationship preserved

This act does not alter any law applicable to the relationship between a person rendering professional services and a person receiving such services, including liability arising out of such professional services.

6 See note 3 supra. As to taxes, the incorporation of a going professional business (with assets, employees, and other normal business paraphernalia), or its liquidation or reorganization raises many of the typical issues normally raised under subch. C of the Internal Revenue Code. Empty shells like Keller have no assets or liabilities, and to the extent they are mere conduits, they will (aside from money in a pension trust) simply contain cash equal to the basis of the taxpayer’s stock. Assuming they are used as a conduit, and not to also shield income from progressive tax rates, the corporate tax problems are not really much greater than they are with any other bank account.

7 In Vnuk v. Commissioner, 621 F.2d 1318 (8th Cir. 1980), a physician partner (a radiologist) purported to be employed by a trust he created. The trust had other property and its reality was not challenged (although it was also held that the grantor trust rules applied). In holding the assignment of income doctrine applicable, the Eighth Circuit stated:

"Here, it is clear that the 'ultimate direction and control’ [over the earning of the compensation] rested in the taxpayer and not in the Trust. While the taxpayer may have conveyed, at least in form, his services to the Trust, he was not in substance a bona fide servant of the Trust. * * * [621 F.2d at 1320. Emphasis added.]”

See also Vercio v. Commissioner, 73 T. C. 1246 (1980). On the assignment of income issue alone, I find it very difficult to reconcile the line of decisions of which Vnuk and Vercio are a part with the decision of the majority herein. For in "substance” as opposed to "form” it is quite clear that the same can be said of Dr. Keller. He was not a bona fide employee of the corporation. The corporation did not supervise his employment (unless Dr. Keller, as sole shareholder, director, and president supervised himself), nor in any way control the amount of money earned by the collective efforts of the pathologists here involved or the pro rata portion thereof attributable to Dr. Keller. But as the majority has already told us, in this area form always equals substance.

8 Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943).

9 It seems very strange for this Court to follow the lead of the Second Circuit, which denigrated the assignment of income doctrine as one of the "common law principles of taxation.” Rubin v. Commissioner, 429 F.2d 650, 653 (2d Cir. 1970), revg. and remanding 51 T.C. 251 (1968), decided on remand 56 T.C. 1155 (1971), affd. 460 F.2d 1216 (2d Cir. 1972). Not only is it surprising to deal with a half century of Supreme Court decisions so cavalierly, but it is clear that Congress has, as is often the case, assumed that the assignment of income doctrine is a fundamental principle of tax law around which the statute is shaped. The trust and partnership provisions codify assignments of income principles, and Congress has often clearly stated in legislative history that it is predicating the law on these first principles. See secs. 671-678; sec. 704(e); H. Rept. 1337, to accompany H.R. 8300 (Pub. L. 591), 83d Cong., 2d Sess. 63 (1954); S. Rept. 1622, to accompany H.R. 8300 (Pub. L. 591), 83d Cong., 2d Sess. 86 (1954); H. Rept. 586, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 357, 380-381; S. Rept. 781, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 458, 485-487. See also sec. 1375(c) and the regulations thereunder. This integration of statutory provisions and judicial decisions is quite common to tax law — note, for example, the historical evolution of the tax benefit rule judicially and legislatively. See sec. Ill and Dobson v. Commissioner, 320 U.S. 489, 506 (1943); Alice Phelan Sullivan Corp. v. United States, 180 Ct. Cl. 659, 381 F.2d 399 (1967); Putoma Corp. v. Commissioner, 66 T.C. 652,664 n. 10 (1976), affd. 601 F.2d 734 (5th Cir. 1979).

10 The majority tells us (surely with tongue in cheek) that "The net effect of applying the assignment of income principles, thus, is the same, in this case, as applying section 482: petitioner is not directly taxable on all the income received by Keller, Inc.” Since, if the assignment of income doctrine applies, precisely the opposite is true — petitioner will be directly taxed .on all the income — this statement is patently false. And obviously for many reasons the results are not the same, but dramatically different, and that is what this case is all about.

11 And plainly, we will sooner or later be confronted with arrangements between professionals and corporations for which sec. 482 will be inadequate, and the decision today to so lightly discard the assignment of income doctrine will come home to roost.