Wallace v. United States

• Decision Date: 31 October 1968
• Docket Number: No. LR-67-C-14.,LR-67-C-14.
• Citation: 294 F. Supp. 1225
• Parties: Deane D. and Frances M. WALLACE, Alex T. and Miriam S. Gillespie, and James O. and Jean B. Porter, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Eastern District of Arkansas

294 F. Supp. 1225

Deane D. and Frances M. WALLACE, Alex T. and Miriam S. Gillespie, and James O. and Jean B. Porter, Plaintiffs, v. UNITED STATES of America, Defendant.

No. LR-67-C-14.

United States District Court E. D. Arkansas, W. D.

October 31, 1968.

William H. Bowen and Jerry T. Light of Smith, Williams, Friday & Bowen, Little Rock, Ark., for plaintiffs.

Jerry A. Wells, Atty., Dept. of Justice and W. H. Dillahunty, U. S. Atty., Eastern District of Arkansas, for defendant.

Memorandum Opinion

HENLEY, Chief Judge.

This is a suit for refunds of federal income taxes brought by Drs. Deane D. Wallace, Alex T. Gillespie, and James O. Porter of Little Rock, Arkansas, who are stockholders in and employees of a professional service corporation known as the Wallace, Gillespie & Porter Professional Association, hereinafter called the "Association," organized in 1962 under the provisions of the Arkansas Medical Corporation Act.¹ The tax year involved is calendar 1965. With respect to each of the taxpayers the Commissioner of Internal Revenue assessed deficiencies which were paid. Claims for refunds have been denied administratively. Federal jurisdiction is established. The facts are undisputed, and the case has been submitted on the pleadings, stipulations of fact, discovery material, documentary exhibits, and memorandum briefs.

While the Court is directly concerned with the individual tax liabilities of the respective taxpayers, the underlying issues relate to the status of the Association as a corporation and to the status of a profit-sharing plan and trust fund set up by the Association for its employees, including the individual taxpayers, during the fiscal year ending June 30, 1963.

As to the status of the Association, the question is whether it is entitled to be recognized as a corporation for federal income tax purposes in view of the restrictive provisions of Federal Tax Regulations, § 301.7701-2, as amended in 1965, which regulation deals in general with the classification for tax purposes of certain types of organizations under statutory definitions appearing in section 7701 of the Internal Revenue Code of 1954, 26 U.S.C.A., § 7701.

As to the status of the plan and the fund, the question is whether they qualify for favorable tax treatment under the provisions of sections 401 et seq. and 501 et seq. of the Internal Revenue Code. It has been stipulated that the Government's sole objection to the qualification of the plan and the related trust is that the provisions of section 19 of the plan, hereinafter quoted, do not meet the requirements of section 401(a) (2) of the Code.

The advantage of corporate recognition is that if the Association is a corporation within the meaning of the federal tax laws, and if the plan is a qualified plan, the compensation paid to plaintiffs and to other employees of the Association may be deducted as ordinary business expenses of the corporation; further, contributions made by the Association to the profit-sharing plan are deductible as ordinary business expenses and are not taxable to the recipients, including plaintiffs, as income until they actually begin to receive benefits under the plan. Another benefit is to be found in the fact that the corporation has elected to be taxed as a partnership as provided by section 1371 et seq. of the Code.

As indicated the plan and trust were established in 1963. Section 19 of the plan is as follows:

"The contributions by the Company to the trust pursuant to this Plan shall be irrevocable, subject, however, to the approval of the Plan in its original form, or as amended, by the Internal Revenue Service and the allowance of a deduction for all of said contributions by reason thereof. In the event the Plan is not approved by the Internal Revenue Service, all contributions and accumulated income shall be returned to the Company and the rights of all participants shall be deemed forfeited."

During 1963 and 1964 the Association made contributions under the plan. Those contributions were deducted as expenses by the Association when it filed its returns for fiscal 1963 and fiscal 1964. The amounts of the contributions to the fund were not reported as income by plaintiffs when they filed their returns for calendar 1963 and calendar 1964. The same course was followed with respect to the Association's return for fiscal 1965 and with respect to plaintiffs' individual returns for calendar 1965.

The Commissioner took no exception to the returns for 1963 and 1964. However, on the basis of the 1965 amendment to FTR § 301.7701-2 the Commissioner challenged the 1965 returns and this suit followed.

I.

It is clear that Arkansas adopted the statutes which have been mentioned for the express purpose of permitting professional people, such as doctors, lawyers, and dentists, to practice within the framework of corporations so as to gain the tax benefits which have been outlined. Williams, Medical and Dental Corporations; a Step Toward Tax Equality, 15 Univ. of Ark. Law Review 366 et seq. Many other States have taken the same course. 7 Merten's Law of Federal Income Taxation, Zimet and Barton Revision § 38A.32; Re Florida Bar, Fla., 133 So.2d 554, 4 A.L.R.3d 375, and Annotation beginning at page 383; Empey v. United States, D.C.Colo., 272 F.Supp. 851.

Section 2 of the Arkansas statute permits any two or more licensed physicians to form a corporation to study, diagnose, and treat human ailments and injuries and to promote medical, surgical, and scientific research and knowledge, provided that medical and surgical treatment, consultation, and advice may be given only by licensed physicians. Section 3 of the Act provides in general that medical corporations are to be governed by laws applicable to ordinary business corporations. However, other sections of the Act make it clear that a doctor employed by a medical corporation does not lose his professional standing nor is he relieved of professional responsibilities and discipline merely because he is working for a corporation.

No contention is here made that the Association is not a "corporation" as far as Arkansas law is concerned. It was organized as provided by the Act. All of its shareholders and officers are doctors, who are also corporate employees. The corporation has articles of incorporation and by-laws; its affairs are managed by a board of directors; there are regular meetings of stockholders and directors. The Association has an employer's identification number supplied by the District Director of Internal Revenue at Little Rock; federal income taxes and the employees' share of social security taxes are withheld from wages paid by the Association; the Association pays social security and unemployment compensation taxes with respect to each of the plaintiffs. The Association carries workmen's compensation, group life, medical and disability income insurance covering the plaintiffs and other employees. Stock interest in the Association can be owned by a licensed doctor only; if a shareholder dies, retires, or desires to withdraw from the Association his stock is to be purchased by the Association at book value after appropriate adjustments. It does not appear that a stockholder has a right to sell his stock to any doctor outside the Association.

The Regulation relied on by the Government prescribes a number of criteria by which it is to be determined whether a business organization is to be considered a corporation for federal tax purposes. The Government argues that the question of whether an organization is entitled to be treated as a corporation for income tax purposes is a federal question, and that State law is not controlling; that the regulation in question is a valid one, and that the Association does not meet the regulatory criteria. Hence, the Government contends, the Association is not entitled to corporate tax treatment and must be considered to be a partnership not entitled to the tax advantages sought to be gained.

Plaintiffs contend that the regulation is invalid. Alternatively, they argue that even if the regulation is valid, the Association meets the criteria thereof.

II.

As is well known, there are certain types of business organizations which, though not incorporated, closely resemble corporations, and the statutory definition of a "corporation" includes "associations, joint-stock companies, and insurance companies." 26 U.S.C.A., § 7701 (a) (3). And unincorporated business organizations have been taxed as corporations if they have sufficient resemblances to corporations. Morrissey v. C. I. R., 296 U.S. 344, 56 S.Ct. 289, 80 L.Ed. 263; Wholesalers Adjustment Co. v. C. I. R., 8 Cir., 88 F.2d 156; Pelton v. C. I. R., 7 Cir., 82 F.2d 473.

In 1948 it turned out to be to the tax advantage of a group of Montana doctors, practicing as a clinic, to be treated as a corporation for federal tax purposes; the Internal Revenue Service took the position that the organization was a partnership. The Court of Appeals held that the clinic had more of the characteristics of a corporation than of a partnership and should be taxed as a corporation. United States v. Kintner, 9 Cir., 216 F.2d 418.

The Treasury announced that it would not follow the Kintner decision, Rev. Rul. 56-23, 1956-1 Cum.Bull. 598, and in 1960 the Treasury adopted regulations designed to offset the effect of Kintner "and to make it as difficult as possible for unincorporated organizations to be taxable as corporations." Empey v. United States, supra, 272 F.Supp. at 852.

The fear of professional people that the 1960 Regulation would render the Kintner decision valueless to them from a tax standpoint and the belief that the problem could be solved by securing legislation permitting doctors, lawyers, and the like to incorporate led to the agitation for and the adoption of appropriate State legislation. Williams, op. cit., at 369-370; Empey v. United States, supra, 272 F.Supp. at 852.

Such legislation prompted the...