Klamath Med. Serv. Bureau v. Commissioner of Int. Rev.

• Decision Date: 26 January 1959
• Docket Number: No. 16025.,16025.
• Citation: 261 F.2d 842
• Parties: KLAMATH MEDICAL SERVICE BUREAU, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Ninth Circuit

261 F.2d 842 (1958)

KLAMATH MEDICAL SERVICE BUREAU, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 16025.

United States Court of Appeals Ninth Circuit.

December 15, 1958.

Rehearing Denied January 26, 1959.

Mautz, Souther, Spaulding, Denecke & Kinsey, James R. Moore, William H. Kinsey, Portland, Or., for petitioner.

Charles K. Rice, Asst. Atty. Gen., Grant Wiprud, Helen A. Buckley, Lee A. Jackson, Attorneys, Department of Justice, Washington, D. C., for respondent.

Before STEPHENS, Chief Judge, and BONE and BARNES, Circuit Judges.

BARNES, Circuit Judge.

This is a petition for review of federal income taxes for the years 1951, 1952 and 1953. Timely petition to this Court was made after decision in the Tax Court. This Court has jurisdiction under Int. Rev.Code of 1954 § 7482, 26 U.S.C. § 7482.

The question presented is whether the Tax Court's determination that those amounts distributed by taxpayer to its stockholder physicians in excess of their billings for services rendered were nondeductible distributions of corporate income, rather than compensation for personal services within the meaning of § 23(a) of the Int.Rev.Code of 1939.¹ The corporation took the latter position and accordingly filed returns on this basis during the years in question. The Commissioner rejected this and determined deficiencies.

I — Facts

The case was submitted on a stipulation of facts supported by exhibits and some oral testimony. The facts must be understood. As found by the Tax Court, they may be summarized briefly as follows:

Petitioner is an Oregon corporation, organized in 1939, largely engaged in the business of selling prepaid medical, surgical and hospital plans or contracts in Klamath County, Oregon, and providing the medical and surgical services and hospitalization required under the plans and contracts. A primary source of petitioner's income is the premiums paid on the plans and contracts sold. Some other income is also received by petitioner from noncontract patients using the hospital facilities owned by petitioner. Stock ownership is limited to members of the Klamath County Medical Association. To provide this service which it contracts to supply, petitioner entered into contracts with all members of the County Medical Association, whereby they agreed to perform the services necessary. Under these contracts the doctors agreed to a schedule of base fees for each service which they performed and were to be paid according to a complex formula. The formula provides that when a doctor bills the Medical Service Bureau for a service he has rendered a patient, within thirty days the Bureau is to pay him fifty per cent of the base fee. Then every six months the petitioner is to pay him (less the fifty per cent already paid) a percentage of the base fees billed by the doctor, determined by the ratio which the total net income of petitioner (less certain amounts determined by the board to be necessary for corporate purposes) bears to the total fees billed by all the physicians during that six month period. In short, the petitioner determines what its net profit will be, deducts amounts necessary for retiring bonds, etc., and then pays out a percentage of its profits to the doctors, regardless of what the fee schedule amount would be, since the latter is only a base fee. During the years in question these payments amounted to 116.9, 115.7, and 134.3 per cent of each physicians' billings for the three years, so that in each year the excess over 100 per cent represented payments in excess of the fee schedule.

The Tax Court specifically found that while the fee schedule was unreasonably low when compared to like services and procedures and compensation charged therefor by physicians in private practice, it was equitable and fair when the lessened costs to doctors rendering services under the plan (which lessened costs are attributable to taxpayer's operation) were considered. None of the fees set were unreasonable in amount, and it was held that 100 per cent of the billings of physicians constituted reasonable compensation for the services for which taxpayer was billed.

From 1940 to 1943 petitioner operated solely as a service bureau and its income was solely from premiums on the contracts for medical care. However, in 1943 taxpayer bought the Hillside Hospital and in 1946 bought the Klamath Valley Hospital, and the Valley Hotel. Since that time, part of its income has come from the operation of these facilities.

Under its subscriber contracts services are furnished, except in emergency situations, by taxpayer's physician-stockholder-members and hospital services by the petitioner's hospitals. Subscribers away from Klamath in emergency cases may seek local care and petitioner will bear the cost of the services up to the limit of the fee schedule. Two individual contracts with subscribers exist under which the physician members agree "to accept K.M.S.B. Fees as full payment for Services for all eligible persons" whose family net income is less than $5,000 per year, and when the income exceeds this amount, then as to the amount charged by a physician, "Benefit payments made to the member by K.M.S.B. will act as a credit to total charges. Benefits Are the Same for All Persons Regardless of Income." There was testimony to the effect that use was not made of the clause pertaining to those earning over $5,000.

Finally, all members of the petitioner obligated themselves to resell their stock in petitioner if they left the area or retired. They agreed that no member could sell his share without the written consent of taxpayer's board of directors, and within thirty days after notice to taxpayer of intention to sell, the taxpayer agreed to purchase all such stock at book value. In determining book value, the unpaid medical service charges on the part of taxpayer's member-physicians were to be valued at 100 per cent of the billings of such physicians.

The taxpayer's fee schedule was altered and amended, generally upward, from time to time to bring it more nearly level with charges by physicians in private practice. The schedule was used for the purpose of differentiating between medical and surgical procedures and to ensure that member physicians would receive like compensation for like services.

The Commissioner and the Tax Court disallowed as deductions by petitioner, for compensation to member doctors, all sums paid in excess of 100 per cent of the base fee schedule fees billed and approved for each doctor.

II — The Law

The sole issue is: May petitioner deduct as "compensation," payments to its stockholder-member-physicians in excess of 100 per cent of base fee billings by its members?

Petitioner specifies as the primary error the finding and conclusion of the Tax Court that the excess over the 100 per cent of base fee billings was distribution of profits rather than compensation for services. Further error is urged in the subsidiary findings and conclusions that underlie the alleged primary error, to wit: that the contracts with the doctors were ambiguous when interpreted as obligating the doctors to perform their services for no more than the base fee schedule amounts; that this was part of a method of paying out earnings rather than compensating the doctors for their services; and that the fact that in some earlier years the doctors may have received less than 100 per cent of the base fees may not be taken into consideration here.

Petitioner's argument is based on three factors drawn from reading and interpreting Reg. 118, § 39.23(a)-6, promulgated under the Int.Rev.Code of 1939.² Petitioner claims that in this area all cases based on the said regulation have established three tests: (1) Do the payments made bear any relation to the stockholdings? (Here, the answer is no, since all doctors have one share each, but are paid amounts differing by reason of the services performed); (2) Are the payments made in proportion to services rendered? (Here, that fact is undenied.); and (3) Are the payments reasonable in amount? (The Court held that they were reasonable up to 100 per cent, and indicated that it felt they would also be reasonable up to the amounts actually paid.) Thus, says petitioner, since there is no case to be found where all of these things were answered properly and the amounts denied as deductions for compensation, the Tax Court must be wrong. Furthermore, the amounts were always intended and characterized as compensation for services. Petitioner cites many cases to the effect that if one element or another be missing, the courts will disallow the deduction; and many cases showing that where the compensation was reasonable it is allowable as such, even though this may mean that the corporation has no profits. Compare, however, e. g., Am-Plus Storage Battery Co. v. C. I. R., 7 Cir., 1929, 35 F.2d 167, 168-69. Furthermore, petitioner argues that the findings and conclusions of the Tax Court on the subsidiary holdings are not justified by the evidence, primarily because petitioner seems to think the court places too much emphasis on the fact that the compensation of the doctors was based on a percentage of the net...