Richlands Medical Association v. Commissioner
| Decision Date | 31 December 1990 |
| Docket Number | Docket No. 16595-86. |
| Citation | 60 T.C.M. 1572 |
| Parties | Richlands Medical Association v. Commissioner. |
| Court | U.S. Tax Court |
R. David Barbe and Joseph Anthony, 213 S. Jefferson St., Roanoke, Va., for the petitioner. Scott Anderson, for the respondent.
Respondent determined deficiencies in petitioner's Federal income tax as follows:
Taxable Year Additions to Tax Under Section1
Ended Deficiency 6653(a)(1) 6653(a)(2)
10/31/82 $637,376.44 $31,868.82 *
10/31/83 602,206.61 30,110.33 *
* 50 percent of the interest payable on the portion of the underpayment due to
negligence
The issues to be decided are: (1) whether petitioner is taxable as a corporation or as a partnership; (2) the amount of compensation to be allowed as a deduction to petitioner for payments to its owner-employees; and (3) whether petitioner is liable for additions to tax under sections 6653(a)(1) and (2).
Some of the facts are stipulated and are found accordingly. The stipulations and attached exhibits are incorporated herein by reference. At the time the petition in the instant case was filed, Richlands Medical Association was a professional association under the laws of the State of Virginia with its principal place of business in Richlands, Virginia.
In 1917, the Mattie Williams Hospital (the Hospital) began operations in Richlands, Virginia. The Hospital was owned by Dr. W.R. Williams until his death in 1961, at which time ownership passed to Dr. Williams' heirs (some or all of whom are referred to herein as "the Williams heirs"). The Hospital was a relatively small facility, containing 76 beds, and was located in a rural, mountainous area. The predominant business activity in the area of the Hospital was coal mining. The services provided by the Hospital included emergency room service, electrocardiography, sonography, radiology, obstetrics, surgery, intensive care, and pediatrics.
During 1962, Richlands Medical Association (petitioner) was organized pursuant to the Professional Association Act of Virginia, section 54-873 et seq., Code of Virginia (the Virginia Act),2 for purposes including the practice of medicine and the operation of a general hospital. In accordance with the Virginia Act, articles of association were adopted for petitioner. Between 1962 and 1964, petitioner operated the Hospital without a written lease from the Williams heirs. Between 1964 and 1986, petitioner operated the Hospital pursuant to a series of written lease agreements and a financing agreement entered into with the Williams heirs.
On October 26, 1981, petitioner's articles of association were amended. The amended articles of association (Articles) remained in effect throughout the years in issue, in addition to bylaws (Bylaws) governing the affairs of petitioner.
The owners, or "members," of a professional association organized under the Virginia Act are referred to as its "associates," and each associate is entitled to a "certificate of ownership" evidencing the proportional part of the association owned by him. Virginia Act sections 54-874(1), 54-888. The Virginia Act also provides that all associates of a professional association must be employees of the association and must be licensed to practice the profession for which the association is organized. Virginia Act sections 54-885, 54-888, 54-890.
Petitioner's Articles listed its associates as Doctors James H. McVey, William R. Strader, Ernest E. Moore, and Emile I. Khuri and listed those same individuals as petitioner's initial Board of Directors. Dr. Strader died during petitioner's taxable year ended October 31, 1982. Pursuant to the authority of section 54-889 of the Virginia Act, upon the death of one of petitioner's associates, the associate's certificate of ownership was to be returned to petitioner. Starting in mid-1982 and continuing for the remainder of the taxable years in issue, Doctors McVey, Moore, and Khuri were the sole associates of petitioner and were also the sole members of its Board of Directors.3 On various occasions, they were required to guarantee or endorse loans (including a line of credit) obtained by petitioner.
Under the Virginia Act, the board of directors of a professional association must be composed of at least three persons. Virginia Act section 54-882. The Bylaws provided that petitioner's Board of Directors could consist of between three and seven persons.4 Vacancies in the Board of Directors were to be filled by the Board of Directors, and the person elected to fill a vacancy would hold office until the next annual meeting of the associates at which directors were to be selected. A majority of the Directors in office were necessary to constitute a quorum for the transaction of business, and any question before the Board was to be determined by majority vote. Moreover, the Board could, by two-thirds vote, expel an associate.
The Bylaws provided that petitioner's Board of Directors could hold its meetings at such times and places as it might designate, but was required to hold at least one meeting per quarter. During the taxable years in issue, petitioner's Board of Directors held at least 26 meetings, the minutes of which were recorded by petitioner's Executive Secretary pursuant to responsibilities outlined in the Bylaws. At those meetings, a variety of matters relating to the operation of the Hospital were discussed and voted upon, including: hiring decisions with respect to nonowner physicians, collections, pay raises and other personnel matters, purchases and leases of property, pension matters, litigation involving petitioner, and retention of accountants. The meetings sometimes were called on very short notice, depending on the urgency of the matters requiring attention.
The Bylaws provided for the employment of a Hospital administrator who was to act as the representative of the Board of Directors in the management of the Hospital. The hospital administrator, however, was required to obtain approval from the Board of Directors for all expenditures not necessary to the everyday operation of the Hospital in excess of $1,000.
During the taxable years in issue, petitioner leased the Hospital from the Williams heirs under a seven year lease (the lease) commencing November 1, 1976, and ending October 31, 1983, for a monthly rental of $10,000. The lease provided that any fixtures, furniture, equipment or instruments purchased by petitioner, as well as any outstanding accounts receivable of petitioner, would become the property of the Williams heirs upon termination of the lease. The lease also provided that it would automatically terminate if, for any reason, petitioner had less than three members. The lease was signed by the President of petitioner solely on behalf of petitioner.
On November 1, 1977, petitioner, its associates, and the Williams heirs entered into an amendment to the lease and a financing agreement. The financing agreement provided that petitioner would be the maker of a note (the note), to be endorsed by petitioner's associates, evidencing a loan of up to $800,000, which amount was needed to finance construction necessary to maintain licensure and accreditation for the Hospital under standards prescribed by the Virginia State Health Department. Additionally, the Financing Agreement provided that the lease would be extended for a term coincident with the term of the note, and that a person mutually acceptable to the Williams heirs and to petitioner would serve as petitioner's Hospital administrator.
On February 18, 1978, the note, in the amount of $800,000 payable in eight annual installments, was executed by petitioner and endorsed by its associates, who assumed joint and several liability on the note. Because the last installment of the note was due on October 15, 1986, the lease was extended until that date. No further extensions of the lease occurred subsequent to October 1986, and petitioner ceased operations in December 1986. Petitioner's Articles provided that "the duration of the association is to be perpetual."
Petitioner consistently filed its Federal income tax returns as a corporation on Form 1120.
During the years in issue, petitioner paid its associates the following amounts, and deducted such amounts as compensation of officers (Schedule E, Form 1120):5
Year Ended Year Ended
Associate 10/31/82 10/31/83
Dr. James McVey ....... $977.778 $873,298
Dr. Emile Khuri ....... 702,524 672,871
Dr. Ernest Moore ...... 566,552 523,831
Respondent, in his notice of deficiency, allowed as a compensation deduction with respect to each associate an amount equal to 100 percent of the "collections" recorded by petitioner as attributable to medical services performed directly for patients by such associate. The following chart illustrates the amount of such "collections" allowed by respondent, in addition to the amounts recorded by petitioner as "billed" for the medical services of each associate during the years in issue:6
Year Ended 10/31/82 Year Ended 10/31/83
Associate Billings Collections Billings Collections
Dr. James McVey ......... $622,260.36 $397,556.12 $592,470.60 $324,759.38
Dr. Emile Khuri ......... 363,641.51 241,014.39 426,434.13 231,435.84
Dr. Ernest Moore ........ 310,204.46 191,713.62 302,641.13 162,467.94
A comparison of the compensation paid to each associate with "billings" and "collections" indicates that each associate was paid, during the years in issue, not only substantially more than the collections recorded for his services but also substantially more than the billings for his services. For example, Dr. McVey's pay for the year ended 10/31/82 was approximately 157 percent of his billings...
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