Reinhardt v. Comm'r of Internal Revenue

• Decision Date: 30 September 1985
• Docket Number: Docket No. 14506-83.
• Citation: 85 T.C. 511,6 Employee Benefits Cas. 2417,85 T.C. No. 29
• Parties: JULES REINHARDT AND MARILYN D. REINHARDT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

6 Employee Benefits Cas. 2417

85 T.C. 511

85 T.C. No. 29

JULES REINHARDT AND MARILYN D. REINHARDT, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14506-83.

United States Tax Court

Filed September 30, 1985.

P was a physician and a shareholder-employee of C, a professional corporation that renders medical care and treatment through duly licensed physicians. As such, P was covered by C's qualified profit-sharing and pension plans that were available only to physicians who were shareholder-employees. P sold his C stock, divested himself of all his economic interests related to C, and terminated his employee relationship with C. Shortly thereafter, P entered into an independent contractor relationship with C and continued to provide the same services as a physician. Upon terminating his employee relationship, P received a distribution from C's qualified plans.

HELD: P's change in employment status from that of an employee to that o6 an independent contractor did not constitute a ‘separation from the service‘ within the meaning of section 402(e)(4)(A)(iii). Therefore, the distribution to P was not a lump-sum distribution, and P is not entitled to use the 10-year averaging method provided by section 402(e)(1) in determining the tax on that distribution. GREGORY K. WISE, for the petitioners.

TIMOTHY S. MURPHY, for the respondent.

OPINION

PARKER, JUDGE:

Respondent determined a deficiency in petitioners' 1979 Federal income tax in the amount of $43,671. The issue for decision is whether petitioners properly reported a distribution from qualified profit-sharing and pension plans under the 10-year averaging method provided by section 402(e)(1). ¹ Resolution of this issue depends on whether petitioner Jules Reinhardt's change of employment status from that of employee to that of independent contractor was a ‘separation from the service‘ within the meaning of section 402(e)(4)(A)(iii) even though he continued to perform exactly the same services as a physician after the change.

This case was submitted fully stipulated. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

Petitioners Jules Reinhardt and Marilyn D. Reinhardt resided in Lapeer, Michigan, at the time the petition was filed in this case. Petitioners timely filed their 1979 joint Federal income tax return (Form 1040) with the Internal Revenue Service Center in Covington, Kentucky. Petitioner Marilyn D. Reinhardt is a party in this case solely because she filed a joint tax return with her husband for the year in issue. All references to petitioner in the singular will be to petitioner Jules Reinhardt.

Knollwood Clinic (the Clinic) is a Professional Corporation (P.C.) organized under the laws of the State of Michigan. The Clinic renders medical care and treatment through duly licensed physicians. All physicians at the Clinic practice medicine under either a standard association agreement or a standard employment agreement. Physicians who practice under association agreements are independent contractors, and physicians who practice under employment agreements are employees of the Clinic. Only those physicians who are shareholders in the Clinic are eligible to practice at the Clinic under employment agreements and thus eligible to participate in the Clinic's pension and profit-sharing plans. Except for eligibility in the Clinic's pension and profit-sharing plans, the other fringe benefits provided by the Clinic are essentially the same for all physicians regardless of their employment arrangement. ²

Consistent with the Clinic's employment policy, petitioner and the Clinic executed a one-year, renewable employment agreement on July 1, 1978. From that date until June 30, 1979, petitioner was a practicing physician and a shareholder-employee of the Clinic. Petitioner also served as an officer and director of the Clinic. The Clinic paid petitioner a salary pursuant to the employment agreement and properly deducted and withheld the appropriate Federal, state, and local taxes from petitioner's wages. Petitioner's employment agreement was identical in all material respects to other employment agreements between the Clinic and other employee-physicians. As a shareholder-employee, petitioner was eligible to participate and did participate in the Clinic's pension and profit-sharing plans.

Petitioner had other economic interests indirectly related to the operations of the Clinic. Petitioner held stock in Doc Development, a corporation that owns the building in which the Clinic is located. Petitioner also held stock in Lapeer Apothecary, a corporation that operates the pharmacy associated with the Clinic.

Petitioner desired to establish his own office in the Lapeer area. Petitioner first explored the possibility of establishing his own office in the Lapeer County area on or about January 1, 1979. Petitioner terminated his employment agreement ³ with the Clinic on June 30, 1979, in anticipation of establishing his own office in the area. However, pursuant to paragraph 14 of petitioner's employment agreement, petitioner was prohibited from practicing medicine within a 12-mile radius of the Clinic for 90 days from the date of termination. Violation of this noncompetition provision would have obligated petitioner to pay the Clinic liquidated damages in the amount of $10,000.

On or before the date petitioner terminated his employment agreement with the Clinic, petitioner divested himself of all of his economic interests related to the Clinic. On June 30, 1979, petitioner sold all of his stock in the Clinic and all of his stock in Doc Development, the corporation that owns the Clinic's building. ⁴ In addition, prior to July 1, 1979, petitioner resigned as officer and director of the Clinic. As of July 1, 1979, petitioner's only interest in the Clinic was that of a creditor for the balance due for the sale of his stock.

While making arrangements to open his own office, petitioner needed a source of income and needed facilities to continue caring for his patients. If he wanted to practice within a 12-mile area of the Clinic, petitioner's only option, other than paying the $10,000 in liquidated damages, was to enter into an association agreement with the Clinic. Since petitioner was no longer a shareholder of the Clinic, petitioner was not eligible to enter into an employment agreement with the Clinic. Consequently, on July 2, 1979, petitioner entered into an association agreement with the Clinic for a 5-year term. Thereafter, petitioner served the Clinic as an independent contractor. The Clinic treated petitioner as an independent contractor and paid petitioner fees for performing services. The Clinic no longer deducted withholding taxes, and petitioner was given a Form 1099 to report these fees. Petitioner's association agreement with the Clinic was identical in all material respects to the agreements between the Clinic and all of its other nonemployee physicians. For Federal employment tax purposes, the Clinic treated petitioner as an employee during the first half of 1979 and as an independent contractor during the second half. However, petitioner rendered the same services as a physician under the association agreement as he had previously rendered under the employment agreement.

On January 20, 1981, petitioner was one of the incorporators of Metamora Medical, P.C. Pursuant to his association agreement with the Clinic, petitioner gave the Clinic a 6-month notice of termination. After terminating his association agreement, petitioner waited 90 days to begin practicing medicine at Metamora Medical, P.C. to avoid the $10,000 liquidated damages provision in the association agreement. ⁵ As of April 1, 1981, petitioner had severed all relations with the Clinic and was a full-time employee of Metamora Medical, P.C.

After petitioner terminated his employment agreement with the Clinic on June 30, 1979, petitioner received a distribution in July of 1979 from the Clinic's pension and profit-sharing plans in the amount of $150,744. He reported the distribution on his 1979 return using the special 10-year averaging provision for determining the tax on that distribution. Petitioner did not deduct any auto expenses on his return. ⁶

By statutory notice of deficiency dated March 24, 1983, respondent determined that the distribution petitioner received from the Clinic's qualified profit-sharing and pension plans did not qualify for the special 10-year averaging method provided by section 402(e)(1) because petitioner had not ‘separated from the service‘ of his employer within the meaning of section 402(e)(4)(A)(iii). This lawsuit ensued.

Petitioner argues that the termination of his employment agreement with the Clinic on June 30, 1979 constituted a ‘separation from the service‘ of the Clinic as of July 1, 1979. ⁷ Petitioner further argues that the distribution on account of that separation from the service was properly reported on his 1979 return using the special 10-year averaging method provided by section 402(e)(1). We must decide whether the termination of petitioner's employment agreement amounted to a ‘separation from the service‘ within the meaning of section 402(e)(4)(A)(iii).

Generally, distributions made from a qualified pension or profit-sharing plan are taxable to the recipient as ordinary income under section 72 (relating to annuities). Sec. 402(a)(1). ⁸ However, Congress has accorded preferential tax treatment for reporting distributions where the recipient receives his entire interest from a qualified plan in a lump-sum distribution. Section 402(a)(2) allows capital gains treatment for lump-sum distributions attributable to pre-1974 active participation in a qualified employee trust. ⁹ Section 402(e)(1) provides a special 10-year averaging method for reporting the ordinary income portion of a lump-sum distribution. ¹⁰ The term ‘lump- sum distribution,‘ as defined in section 402(e)(4)(A),...