Hill v. Comm'r of Internal Revenue

• Decision Date: 14 December 1976
• Docket Number: Docket No. 3942—76R.
• Citation: 1 Employee Benefits Cas. 2232,67 T.C. 411
• Court: U.S. Tax Court
• Parties: HILL, FARRER & BURRILL, A GENERAL PARTNERSHIP, PETITIONERv. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

1 Employee Benefits Cas. 2232

67 T.C. 411

HILL, FARRER & BURRILL, A GENERAL PARTNERSHIP, PETITIONERv. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 3942—76R.

United States Tax Court

Filed December 14, 1976.

Petitioner, a 19-member partnership engaged in the practice of law, adopted an employees' profit-sharing plan which meets all the requirements for qualification except certain ones applicable to plans which provide contributions or benefits for employees some or all of whom are ‘owner-employee(s)‘ as defined in sec. 401(c)(3)(B) IR.C. 1954. Petitioner's capital gains and one-third of its net profits are divided among its partners in proportion to their substantially equal capital contributions, and the other two-thirds of its profits are divided ‘on the basis that the total profit to the firm for services rendered by each partner during the calendar year bears to the aggregate total profit to the from for said period for all partners.’ At all relevant times at least one partner actually received a distribution of firm profits which exceeded 10 percent of the total firm profits. Held, at all relevant times at least one partner has been an ‘owner-employee’ within the meaning of sec. 401(c)(3)(B), I.R.C. 1954; therefore, since the owner-employee requirements for qualification of petitioner's profit-sharing plan have not been met, the plan is not a qualified one. Carl A. Stutsman, Jr., for the petitioner.

Harry Morton Asch, for the respondent.

OPINION

FEATHERSTON, Judge:

Petitioner has instituted this action pursuant to section 7476¹ for a declaratory judgment that its employees' profit-sharing plan adopted on June 27, 1975, and amended effective November 7, 1975, is a qualified one under section 401(a). The parties agree that all jurisdictional requirements have been met and, pursuant to Rule 217 of the Rules of Practice and Procedure of this Court, have filed with the Court so much of the administrative record as they deem necessary for a complete disposition of the action. No evidence other than the administrative record has been presented.

The qualification of the plan depends upon whether any one of the partners in petitioner, a law firm, is an ‘owner-employee’ within the meaning of section 401(c)(3)(B). Petitioner concedes that if this question is answered affirmatively, its plan does not meet all the applicable statutory requirements (e.g., sec. 401(a)(9), 401(a)(10)(B), and 401(d)). Respondent concedes that if none of the partners in petitioner is an ‘owner-employee’ within the meaning of section 401(c)(3)(B), the plan is a qualified one.

Petitioner Hill, Farrer & Burrill (hereinafter referred to as the partnership or the firm) is a general partnership with 19 full partners engaged in the practice of law in Los Angeles, Calif. Its partnership agreement, executed March 3, 1957, and amended in one respect, effective January 1, 1966, provides that the capital of the partnership shall consist of a cash contribution by each partner of $12,500 or such greater or lesser amount as may be fixed by a majority of the partners from time to time. An individual cash capital account is maintained for each partner, and the interests of the partners in the capital of the partnership, whether consisting of cash or other assets, are proportionate to their respective contributions.

The profits and losses of the firm are shared pursuant to clauses V and VI of the partnership agreement, which provide in part as follows:

V PROFITS AND LOSSES

The net profit of the partnership for each calendar year, determined as provided under Clause VI hereof, shall be distributed to each of the partners in the following ratio:

(1) Two-thirds thereof shall be divided among the partners on the basis that the total profit to the firm for services rendered by each partner during the calendar year bears to the aggregate total profit to the firm for said period for all partners, all as based upon the cost accounting records maintained by the firm; * * *

(2) The other one-third shall be allocated to the partners in proportion to their respective cash capital contributions.

Gains and losses on the sale of capital assets or income from sources other than fees for legal services rendered shall be allocated to the partners in proportion to their contribution to the cash capital.

Any losses of the partnership shall be borne by the partners in proportion to their cash capital contribution, save for losses incurred in maintaining any office other than the principal office of the firm. Such latter losses shall be deducted from total firm profits, if any, before the allocation of profit among the partners.

VI DETERMINATION OF NET PROFITS

The net profits of the partnership shall be determined in conformity with present accounting practices of the firm.

Each partner is given a drawing account, and his share of the partnership profits is credited to that account. All drawings of a partner during the year are charged to his account.

The policy of the firm with respect to clients produced by a partner or associate attorney, insofar as it is here pertinent, is as follows:

In the event a partner or associate produces a client who is not then nor previously has been a client nor referred by a client of the firm, of another partner or of an associate, then the partner or associate producing such client is entitled to an allocation of 20% (less the proportionate overhead) of the fees received for the services rendered to that client and to clients referred by or through that client, whether such reference be to the firm or any partner or associate therein. If a partner or associate assigns the work of such client to any partner or associate, the one who produced the original client is entitled to credit for all subsequent referrals to the one to whom the work has been assigned, thus maintaining an unbroken chain of referrals by or through the original client.

The one entitled to any 20% allocation may assign it or any interest therein or any portion of any of his fees to others to compensate for the otherwise uncompensated work of such others assigned to them and for expenditures in the interest of the firm, or for such other reason as to him may seem to benefit the firm.

In the event of the death, total permanent disability or permanent retirement from the practice of law of a partner or associate while a partner in or associate of this firm, the allocation of such 20% shall continue to him or to his estate or heirs, as the case may be, for a period of five years after such occurence (sic) commencing with the accounting date nearest to such occurrence.

Pursuant to these contract and policy provisions, at least one partner each year relevant hereto has actually received a distribution of partnership profits which exceeded 10 percent of the firm's total profits.

The determination of whether, under these contract and policy provisions, any one of petitioner's partners was an ‘owner-employee’ depends upon the definition of that term in section 401(c)(3), which, insofar as it is here pertinent, is as follows:

(3) OWNER-EMPLOYEE.—The term ‘owner-employee’ means an employee who—

(B) in the case of partnership, is a partner who owns more than 10 percent of either the capital interest or the profits interest in such partnership.

To the extent provided in regulations prescribed by the Secretary or his delegate, such term also means an individual who has been an owner-employee within the meaning of the preceding sentence.

Respondent concedes that none of the partners in petitioner owns more than 10 percent of the ‘capital interest’ in the firm. The issue, consequently, is narrowed to whether any one of them ‘owns more than 10 percent of * * * the profits interest’ in the partnership. Respondent's position is succinctly stated in the final adverse determination letter issued to petitioner on April 21, 1976, as follows:

Your proposed plan for division of profits, either through the partnership agreement or in actual operation, has resulted in partners owning and receiving more than 10% of the profits interest of the partnership as a result of their productivity. Thus, it is possible for any partner to have distributed to him in any year more than 10% of the firm's profits interest. Such partner has been in the past and would be an owner-employee. Your plan does not provide the necessary provisions for owner-employees required by Internal Revenue Code of 1954, Sections 401(a)(9), 401(a)(10)(B) and 401(d), and other applicable law.

Since, at all relevant times, at least one partner has actually received a distribution of firm profits which exceeded 10 percent of the total firm profits, respondent asks us to hold that such partner is or has been an ‘owner-employee’ within the meaning of section 401(c)(3)(B).

Petitioner pins its case on the precise language of section 401(c)(3)(B) which refers to a partner who ‘owns' more than a 10-percent ‘interest’ in a ‘partnership.’ The ownership of the profits interest in a partnership, the argument goes, is determined by the terms of the partnership agreement, and petitioner's agreement gives none of the partners a contractual right, in advance, to more than a 10-percent profits interest in the partnership. Rather, to a large extent the agreement keys the amount of the profits to which each partner is entitled each year to his productivity during the year. In such circumstances, petitioner argues, a partner may receive more than 10 percent of the profits in a given year, but this does not mean that he owns more than a 10-percent profits interest in the partnership.

While the issue is a close one, we think respondent has the better side of the argument, and we hold that petitioner's profit-sharing plan is not a qualified one under section 401(a).

The Internal Revenue Code provisions dealing with pension and profit-sharing plans provide tax benefits for both employers and employees. Generally, if a plan...