Brief for the United States — United States v. Basye

reum ent:

I. Payments made by Health Plan pursu-

aant to its agreement with Medical

Group, including both payments made

directly to the partnership and those

made to the trust, constituted partner-

Ye

eS:

AL. Each partner in Medical Group, includ-

at

ship income

ing the present respondents, should

have included in his gross income for

the years in question his distributive

share of partnership income

The decision below effectively circum-

vents the limitations upon qualified

pension trusts established by the Inter-

nal Revenue Code of 1954

ey, Gar

35 CITATIONS

3 “Allen Commissioner, 410 F. 2d 398, af-

. firming per curiam 50 T. C. 466 14, 15

Beck Chemical Equipment Corp. v. Com-

missioner, 27 T.C. 840 20

Bell v. Commissioner, 219 F. 2d 442 20

Bingler v. Johnson, 594 U.. 741 16, 17

Bourne v. Commissioner, ms F. 2d 648,

N certiorari denied, 290 U og 20

Canada) v. Guitteau, 86 F 14

Comer v. Davis, 107 F. 2d 355 Se Sage

Commissioner v. Bonwit, 87 F. 2d 764,

certiorari denied, 802 U.S. 694 14

Commissioner v. Culbertson, 337 U.S.

783 11, 15

nei v. First Security Bank, No.

70-805, decided March 21, 1972 15

Commissioner v. Goldberger’s Estate, 213

F. 2d 78 20

Commissioner v. Harmon, 323 U.S. 44. 15

Commissioner v. Laughton, 113 F. 2d

103 a 14

Commissioner v. LoBue, 351 U.S. 243— 16

Commissioner v. Sunnen, 383 U.S. 591__ 11, 15

deCousser v. Commissioner, 16 T. C. 65. 20

Earl v. Commissioner, 80 F. 2d 888 13

20

20

Galt v. 9 216 F. 2d 41, cer-

ti.'/borari denied, 348 U.S. tei

fa e v. Commissioner, 308 U.S. 355. 14

os

Continued Page

_Halkias v. Commissioner, 12 T.C. 1091 20

Heiner v. Mellon, 304 U.S. 271 9, 19

_ Helvering v. Eubank, 311 U.S. 122 14

Helvering v. Horst, 311 U.S. 112 15, 16

_ Hicks v. United States, 314 F. 2d 180 14

Hogle v. Commissioner, 132 F. 2d 66. 14, 22

Hulbert v. Commissioner, 227 F. 2d 399. 20

Jones v. Page, 102 F. 2d 144 14, 22

Lucas v. Earl, 281 U.S. 111 9, 11, 12, 13, 14,

15, 16, 17, 21, 22, 24

Mayes v. United States, 207 F. 2d 326 14

Megiboto v. Commissioner, 218 F. 2d 687. 14

Miller v. Commissioner, 144 F. 2d 287. 14

Poe v. Seaborn, 282 U.S. 11! 15

Saenger v. Commissioner, 69 F. 2d 631. 14

Schlude v. Commissioner, 372 U.S. 128. 17

Starr v. Commissioner, 267 F. 2d 148 20

Strauss v. Commissioner, 168 F. 2d 441,

certiorari denied, 335 U.S. 858, rehear-

ing denied, 335 U.S. 888 16

Teschner v. Commissioner, 38 T.C. 1003. 15

United States v. Baker, 233 F. 2d 195 20

United States v. Joliet & Chicago R. Co.,

315 U.S. 44 15

VPillere v. Commissioner, 133 F. 2d 905. 14

Income Tax Act of 1913, e. 16, 38 Stat.

114, 166, Sec. II, D 18-19

Internal Revenue Code of 1954 (26

U.S. C.):

Sec. 61 26

Sec. 61(a) 11, 16, 18, 19, 21, 26

Sec. 401 23, 24

Sec. 401(a) 23, 26-27

Iv. age

, Sec. 404 24, 27-28

Sec. 672 (a) g 16

‘See. 672 (-b — po 15

Secs. 674-678 16

Sec. 701 19

Secs. 701-704 is

Sec. 702 : 28

See. 702 (a) 19, 21, 28-29

Sec. 708 - 19, 29

Sec. 704 19, 29

Sec. 705 (a) f 19

Sec. 731 (a) 19

Sec. 733 19

Sec. 6031 19

Revenue Act of 1918, c. 18, 40 Stat. 1057,

Sec. 218(a) : 19

Self-Employed Individuals Tax Retire-

ment Act of 1962, P.L. 87-792, 76 Stat.

809 23

Miscellaneous:

H. Rep. No. 1387, 88d Cong., 2d Sess., p.

65 (3 U.S.C. Cong. & Adm. News

(1954) 4017, 4091)

Lyon and Eustice, Assignment of Income,

17 Tax L. Rev. 295 (1962)

0.D. 187, 1 Cum. Bull. 174 (1919)

S. Rep. No. 1622, 88d Cong., 2d Sess., p.

89 (3 U.S.C. Cong. & Adm. News

(1954) 4621, 4721-4722) _

Wolfman, Level for Determining Charac-

ter of Partnership Income—“Entity” v.

“Conduit” Principle in Partnership

Traæation, 19 N. V. U. Institute on Fed-

then 287 (1961) —_

Supreme Court of the Antted States

OcToBer TERM, 1972

No. 71-1022

UNITED STATES or AMERICA, PETITIONER

_ James A. Basye and Eve.yn E. BASYE, ET AL.

o WRIT OF CERTIORARI TO THE UNITED STATES

"COURT OF APPEALS FOR THE NINTH CIRCUIT

BRIEF FOR THE UNITED STATES

* *

OPINIONS BELOW

The opinion of the district court (Pet. 15-29)" is

Teported at 295 F. Supp. 1289. The opinion of the

court of appeals (Pet. 31-42) is reported at 450 F. 2d

JURISDICTION

: The judgments of the court of appeals (Pet. 43-

_ 48) were entered on September 16, 1971. By order

“Pet.” references are to the petition for certiorari.

(1)

dated December 10, 1971, Mr. Justice Douglas ex-

tended the time for filing a petition for a writ of

certiorari to and including February 12, 1972. The

petition was filed on February 9, 1972, and certiorari

was granted on April 3, 1972 (R. 220). The juris-

diction of this Court rests on 28 U.S.C. 1254(1).

QUESTION PRESENTED

Whether compensation for services rendered by a

medical partnership, made payable by contract, and

paid, to a trust, is income of the partnership, and

therefore taxable to the partners, as the United States

contends, or whether, as the courts below held, such

compensation is not partnership income and will con-

stitute income to the beneficiaries of the trust only

when distributed to them.

STATUTES INVOLVED

The pertinent provisions of Sections 61, 401, 404,

701, 702, 708 and 704 of the Internal Revenue Code

of 1954 are set forth in the Appendix, infra, pp. 26-

29. 7 )

STATEMENT

Respondents are physicians and partners in a

medical partnership, Permanente Medical Group

» hespondents“ refers collectively to James A. Basye,

Carol L. Cook, Maurice C. Fishler, Henry Donald Grant, Wil-

klum 8. Hunter, Jessamine 8. Hunter, and Nadia Sorokowski,

.

8

eo

tical Group”), which was organized in 1949 for

wactice of medicine in California. In 1960 the

rship had over 200 physician-partners, 41

ian-employees, and an unstated number of other

ple (R. 82-83). Under the partnership agree-

nt (R. 101-113), the partners had drawing ac-

ounts varying with responsibility and seniority, but

dere to share equally in net earnings in excess of

rawing accounts (R. 105-106). The partnership

d its income on the accrual basis, and for a

year ending June 30th (R. 80-81, 82, 83, 105-

1959, Medical Group entered into a detailed

ritten agreement (R. 114-154) with Kaiser Foun-

dation Health Plan, Ine. (“Health Plan“), an or-

ganization supplying prepaid medical care and hos-

tal service to its members, of whom there were

pro: y 359,000 in its Northern California Re-

gion. This agreement, which succeeded earlier agree-

ents between the two organizations, was for a period

| two years from July 1, 1959, through June 30,

61, and from year to year thereafter, subject to

rmination or renegotiation upon written notice

ren by either party ninety days prior to the end of

of whom was a physician and partner during the years

ved. Evelyn E. Basye, Jack J. Cook, Phyllis H. Fishler,

M. Grant, and George W. Sorokowski are parties to these

as only because they filed joint income tax returns with

respective spouses, and, in the case of Jean M. Grant

he year 1960, because she reported one-half of the com-

income in a separate return.

.

ae

7

any year, Under its terms, Medical Group agreed to

provide to all members of Health Plan within its

Northern California Region all medical services re-

quired: by or incident to membership contracts. (R.

82-88, 121-122, 123, 124-125, 188.)

‘With; respect to compensation, the agreement pro-

vided (R. 187): “As base compensation to Medical

Group for Medical Services to be provided by Medical

Group hereunder, Health Plan shall pay to Medical

Group the amounts specified in this Article H.” Ar

ticle H (R. 187-189) then set forth the two items

_ constituting base compensation. The first, payable

directly to Medical Group, was a stated amount (orig-

inally $2.61329) per member per month, subject to

adjustments as provided in Sections H-2 and H-3.

The second item of base compensation called for the

payments that have given rise to this litigation. It

was to be made up Of payments required (R. 139)

“In the event that Medical Group establishes a sav-

ings and retirement plan or other deferred compensa-

tion plan approved by Health Plan *.” Though

establishment of this plan was thus stated to be

contingent, and was deferred for several months, it

was agreed that Health Plan’s contributions there-

under (later agreed to be 12 cents per member per

month) should commence as of July 1, 1959 (the

effective date of the agreement), and that Health

Plan's obligation to make such contributions should

continue only so long as the agreement or any con-

_ tinuation or extension generally similar to the agree-

‘ment should remain in effect. (R. 83, 187-139, 162.)

5 The plan contemplated by the agreement was es-

ished later in 1959 by a trust agreement executed

Medical Group, Health Plan, and a bank serving

1 trustee (R. 158-199). Under it, Health Plan made

payment of $200,000 to the trust at the outset, and

agreed to make further payments on a per-member,

per- basis during the period in which the agree-

went between Medical Group and Health Plan re-

‘mained in effect. The funds paid to the trust, less

fees and expenses, were to be paid over to an insur.

ance company in order to pay retirement benefits to

partners and physician-employées of Medical Group,

computed on a complex of factors such as age, years

of service, and compensation level. Tentative alloca-

1 8 to potential beneficiaries were made when funds

were received, but no interest vested prior to retire-

ment, and potential benefits might be lost prior to,

or after, retirement by withdrawal from Medical

Group for practice other than with another group

serving Health Plan’s members. In that event,

amounts allocated to a participant’s tentative account

e re-allocated to the tentative accounts of other

participants. Upon retirement of a partner or a

physician-employee qualified by age and years of

bervice, the amounts credited to his tentative account

s to be applied to purchase a retirement income

In addition to the items of base compensation, it was

ed that Health Plan should also pay to Medical Group

contract. The trust was subject to amendment at

a eee an rep ee Grog, (R.

88, 92-97, 162-168, 164-170, 182.)

e ot. this agree

ment was to create an incentive for physicians to

remain with Medical Group, and thus to insure Health

Plan that it would have a stable and reliable group

of physicians providing services to its members with

a minimum of turnover, However, as the respondents

asserted in their claims for refund, it served also the

independent, and in some respects conflicting, in-

terests of Medical Group and the participating phy-

sicians. (R. 11, 22, 47, 51, 55, 59, 83-84.)

The agreement between Medical Group and Health

Plan contemplated that membership in the partner-

ship would change from time to time, and provided

that the agreement should continue in effect regard-

less of the withdrawal from Medical Group of indi-

vidual partners or the addition of new partners as

long as most physicians than partners continued

their association as then organized or as reorganized

through voluntary action. The. partnership agree-

ment constituting Medical Group provided that the

partnership should continue despite the death, retire-

ment, or withdrawal of partners; it provided also

for the addition of new partners, and for the method

of termination of the partnership. The trust agree-

ment also provided for its continuation as long as

fifty percent of the participants continued in associa-

tion or in reorganized form. In case of dissolution

of the partnership or a reorganization not qualifying

within the provisions for continuity, then the assets

_ held under the trust agreement were to be promptly

_ liquidated, and the net proceeds distributed by lump-

zum payments to the participants then entitled there-

to. (R. 97, 110, 113, 135, 174, 175.) N

Health Plan paid to the trust, on a monthly basis,

an aggregate of more than $2,000,000 during the

period from its first payment in Medical Group’s

fiscal year ending June 30, 1960, until it discontinued

payments at a point in Medical Group’s fiscal year

ending June 30, 1968. Medical Group did not in-

elude these payments in its returns of taxable in-

eome, and they were not included in the partners’

distributive shares of gross or taxable income. The

Commissioner of Internal Revenue assessed defici-

encies against the respondent partners for 1960 and

1961 on the ground that the compensation for serv-

_ lees of the partnership constituted gross income of

the partnership, deflected to the trust through con-

tractual arrangement with Health Plan; and, there-

fore, that the partners were taxable on their distrib-

utive shares of such income. Respondents paid the

taxes in dispute and, after their claims for refund

were denied, brought these actions for refund. (R.

5 In the case of the respondents George W. Sorokowski and

‘Nadia Sorokowski, the assessments, claims for refund, and

‘of Internal Revenue on his own initiative made an adminis-

rative determination that Dr. Sorokowski was entitled to a

auction for 1968 equal to the sum of the amounts that had

Ven the basis for deficiency assessments made against her

81, 84-86.)

hak Sais obit e eee

and were heard upon an agreed statement of facts

(R. 80-88), accompanied by an Appendix (R. 89-

100), and documentary Exhibits A through F (R.

101-204).

Both courts’ below held that the partnership re-

alized no gross income from the payments made by

Health Plan to the trust because the partnership

“never had the right to receive them. They further

held that the partnership should be considered merely

the agent of the partners, and should otherwise be

disregarded in determining their tax liabilities, Treat-

ing the partners merely as contingent trust bene-

ficiaries, the lower courts concluded that they would

be taxable on payments to the trust only at such

times as distributions were made by the trust. (Pet.

15-29, 31-42.)

for 1960, 1961, 1962, and 1968, and computed an overpay-

ment of the Sorokowskis’ income taxes for 1968 in the amount

9

SUMMARY OF ARGUMENT

The government’s position in this case involves

two steps, each grounded upon a fundamental income

tax decision of this Court.

~ 1, The first principle of income taxation was es-

"tablished by this Court's decision in Lucas v. Earl,

- 281 U.S. 111, that income must be taxed to him who

earns it, and that anticipatory arrangements to de-

fleet payment elsewhere will not serve to avoid re-

15 ‘sponsibility for the tax on income from services.

- Accordingly, when Health Plan agreed to pay, and

paid, compensation for medical services rendered by

_ Medica] Group to Health Plan's members, the entire

amount of that compensation constituted partnership

gross income to Medical Group, though part of it was

paid, as agreed, to a trust rather than directly to

Medical Group. The fact that the form of the pay-

ment served to advance the interests of Health Plan

macde it none the less income to Medical Group.

2. This Court held in Heiner v. Mellon, 304 U.S.

271, that each partner in a partnership must take

into his current income his proportionate share of

partnership income despite the fact that distribution

Was necessarily held in abeyance. Accordingly, the

fact that part of Medical Group’s partnership income

was to be held in trust did not serve to avoid the

partners liability for taxation of their proportionate

shares. The court below simply disregarded this

fundamental aspect of the taxation of partnerships

and partners, and viewed the case as involving taxa-

10

tion of contingent beneficiaries of a trust. But

partners are liable to taxation upon their propor-

tionate shares of partnership income without refer-

ence to whether they, or others, are beneficiaries of

a trust created to receive and hold partnership in-

8. The effect of the decision below is to circumvent

the limitations that Congress has imposed upon quali-

fied pension trusts. Such trusts combine the tax bene-

fits of current deductibility for employers with de-

ferred taxation of employees. But their availability,

both in the years here in question and subsequently,

is restricted by a number of limitations, such as

those against discrimination, that the trust in this

case clearly does not meet. Nevertheless, the decision

below affords to a clearly unqualified pension trust

tax benefits that Congress has restricted to trusts

meeting the rigorous standards established by the In-

ternal Revenue Code. The effect is therefore to invite

partnerships large and small, in any business or pro-

fession, to defer the taxation of as much partnership

income as they may choose by the device of having

such income paid directly to a trust that meets none

of the requirements of qualified pension trusts.

_ |. -PAYMENTS MADE BY HEALTH PLAN PURSUANT

T0 ITS AGREEMENT WITH MEDICAL GROUP, IN-

... CLUDING BOTH PAYMENTS MADE DIRECTLY TO

_ THE PARTNERSHIP AND THOSE MADE TO THE

_ RUST, CONSTITUTED PARTNERSHIP INCOME.

}

tes

: _* Section 61(a) of the Internal Revenue Code of

1954, Appendix, infra, defines gross income to in-

dude, among other items: (1) Compensation for

_- Services, including fees, commissions, and similar

= tbs ”

More than forty years ago, in a decision that has

_ stood without question as one of the foundations

upon which the structure of the graduated income

oe tax has been built, this Court held in Lucas v. Earl,

281 U.S. 111, that a taxpayer who has earned com.

aoe pensation for services must include that compensation

in his gross income even though, by effective assign-

ment, payment has been deflected and channeled to

“5

another. The Court has subsequently described that

deeision as embodying “the first principle of income

a taxation: that income must be taxed to him who

~~ earns it.” Commissioner v. Culbertson, 337 U.S. 733,

739.740. See also Commissioner v. Sunnen, 333 U.S.

5591, 604.

The statements that the Court made in Lucas v.

Furl set forth the basis of its decision with concise-

ness and clarity (281 U.S, at 114-115):

There is no doubt that the statute could tax

salaries to those who earned them and provide

12

that the tax could not be escaped by anticipatory

arrangements and contracts however skilfully

devised to prevent the salary when paid from

vesting even for a second in the man who earned

fit. That seems to us import of the. statute

before us and we t that no distinction can

be taken accordit e

the arrangement by which the fruits are attri-

ere ee fem See ne which

„% e thin

ease with as much directness and force as they did

upon Lucas v. Earl. Though “anticipatory arrange-

ments and contracts” may have prevented Health

Plan's payments to the trust “from vesting even for

à second” in Medical Group, they can not serve to

‘eliminate this element of the compensation for Medi-

cal VVV taxable

income.

eee eee

Plan's payments to the trust, as well as its payments

directly to the partnership, were, and were intended

to be, compensation for the services rendered by the

partnership under the Medical Service Agreement

(Ex. B, R. 114.157). They surely were not gifts,

and they were made as a direct part of the employ-

ment arrangement. The agreement called for medical

‘services by the partnership, and explicitly included

(R. 137) in “base compensation” therefor the pay-

‘ments to be made to the trust as well as those to be

made directly to the partnership, all as detailed in

mele Bch. 187-139) of e Additional

13

contingent compensation was provided for in Article

(R. 139-141). In Section C-8 (R. 126), in Article

1 (R. 189), and in Article J (R. 141), reference is

Made to the compensatory arrangements set forth in

Article H. The trust agreement itself (Ex. C, R.

158-199) refers to Health Plan's obligation to con-

tribute to the trust as being derived from the service

agreement with the partnership, and indicates the

compensatory nature of the payments by providing

that they will be coterminous with the effectiveness

of the agreement with the partnership (R. 162).

: Despite the patent parallelism between this case

and Lucas v. Earl, the court below thought that that

_ decision was not controlling here because (Pet. 39)

= “a crucial element is missing here. Permanente

~~ never had the right itself to receive the payments

made into the trust as current income.“ But that

was equally true in Lucas v. Earl, and the same court

“made much the same point when that case was be-

‘fore it. See Earl v. Commissioner, 30 F. 2d 898,

899 (C. A. 9). Mr. Earl made the effective assign-

‘ment in 1901, and the income there in question con-

sisted of fees and salary earned in 1920 and 1921,

2 ‘0 that he also, “never had the right * * * to receive

be escaped by anticipatory arrangements and

contracts however skilfully devised to prevent the sal-

ary when paid from vesting even for a second in the

u who earned it.” It has been equally true in

s cases following Lucas v. Earl, where de-

14

3 flecting arrangements were made prior to the rendi- .

tion of services, that the taxpayer “never had the

right itself to receive the payments. * And this

Court's decision in Helvering v. Eubank, 311 U.S. 122, ö

makes it clear that an attempted deflection of earned

income is ineffective to avoid tax liability whether the

_ deflecting arrangement is made before the income is

7 eee ebe y. Earl, or after, as in Helvering

v. Eubank,

8 The controlling fact here, as in Lucas v. Earl, is

ee eee ee

personal services rendered, and those services were

rendered, pursuant to the agreement, by the partners

and employees of Permanente Medical Group. For

more than 40 years, it has been established and ac-

cepted in our tax law that the result of these facts

is that the income is taxable to the entity individual

or partnership which rendered the services, regard-

less of any arrangement, anticipatory or otherwise,

designed to deflect it elsewhere.

Ts Allen v. Commissioner, 410 F. 2d 398 (C. A. 8), affirming

per curiam, 50 T. C. 466; Hicks v. United States, 314 F. 2d

VVV 218 F. 2d 687 (C. A.

8): Mayes v. United States, 207 F. 2d 826 (C. A. 10); Miller

v. Commissioner, 144 F. 2d 287 (C. A. 4); Villere v. Commis-

sioner, 188 F. 2d 905 (C. A. 5); Hogle v. Commissioner, 132

F. 2d 66 (C. A. 10); Comer v. Davis, 107 F. 2d 865 (C. A. 5); :

Jones v. Page, 102 F. 2d 144 (C. A. ö); Commissioner v. Bon-

wit, 87 F. 2d 764 (C. A. 2), certiorari denied, 302 U.S. 694:

E dag v. Cittean, 86 F. 2d 808 (C. A. 6); Saenger v. Com-

the phrasing of the Court’s opinion in Lucus v.

. 466, affirmed per res 410 F. 2d 398 (CA.

If a contractual arrangement to insulate a tax-

yer from receipt of compensation he earned could

mul him from taxation, the force of Lucas v.

would be reduced to wavering admonition.’

Court long ago differentiated between consensual or

etual arrangements for the deflection and division of

me (Commissioner v. Harmon, 825 US. ee

ided March 21, 1972.

In Teschner v. Commissioner, 88 T. C. 1008, relied upon by

both courts below, the majority stressed a factor not here

present the fact that the taxpayer had no part in negotiating

establishing the terms of the contest of which he was the

Otherwise, the majority in Teschner wrote of de-

flection of income, as did the court of appeals in this case, in

terms of the discussion of control in Helvering v. Horst, 811

8. 112. While Horst is, of course, a leading decision on

eee e ere eee dee

x property, or control of the flow of income, are the

2» determinants. But with regard to the deflection

e must be taxed to him who earns it” ( Commissioner v.

ertson, supra, 387 U.S. at 789-740), so that “compensa-

16

the fact that the formal arrangements nade for

payment to the trust of part of the partnership’s com-

pensation advanced the interests of Health Plan does

not make the payments any the less compensation, or

remove them from the broad sweep of the definition

of gross income in Section 61 (a). Commissioner v.

TLoßue, 351 U.S. 248. This Court has only recently

held that increased compensation paid with a view to

reducing turnover and increasing stability in em-

_ ployment is not for that reason any the less taxable

_ income, Bingler v. Johnson, 894 U.S. 741. “[N]o dis-

_ tinction can be taken according to the motives leading

to the arrangement Lucas v. Earl, 281 U.S.

at 115. The view of the court of appeals (Pet. p. 40)

dat payments to the trust were not “compensation for

tion for the continued, long-term services of indivi-

dual physicians” is difficult to reconcil ile not only with

the partnership obligation but also with the facts

chat payments varied from month to month with the

number of Health Plan’s members in the same fashion

that direct payments to the partnership varied, that

17 Tax L. Rev. 256 888 (1962). Ses Strauss v. Commissioner,

168 F. 2d 441 (C. A. 2), certiorari denied, 885 U.S. 858, re-

ſoes. Even by the Horst standards of control. applicable to in-

eome from property, there would be basis for attributing to

administration of the trust. (R. 166-168, 170, 175, 176-178.)

Tuer had complete power to amend the trust. (R. 182.) Cf.

participant in these powers, was a non-adverse party within

17

‘were to be made while, but only while, the

cal service agreement with the partnership was

ect, and that membership in the partnership

was subject to change (R. 108, 112, 113, 129-130,

35). But even if the court were correct in that

w, the monthly payments, whether for current or

"anticipated services, would be no less current in-

é to the partnership. Bingler v. Johnson, 894 U.S.

757; Schlude v. Commissioner, 372 U.S. 128.

I Health Plan's wish to create or encourage sta-

lity in the group of physicians who served it were

‘the philosopher’s stone that would convert payments

concurrent with service into something other than

. e we should undoubtedly find marked

nges in employment patterns throughout the na-

deere who professed to seek enhanced sta-

b ty in employment would undoubtedly soon be mak-

example, educational trusts for the benefit of em-

‘ployees’ children. Grateful employees would find sat-

faction in the prospect of tax deferred (or possibly

tax-free) dollars being devoted to their families’ fu-

155 welfare. Only the revenues would suffer.

In sum, if Lucas v. Earl is to retain the unques-

ioned authority that it has had for forty years,

‘then all of Medical Group’s “base compensation” for

services, including that part paid to the trust as

ell as that part paid directly, must be included in

18

II.

EACH : PARTNER IN MEDICAL GROUP, INCLUDING

_ THE PRESENT RESPONDENTS, SHOULD HAVE

INCLUDED IN HIS GROSS INCOME FOR THE

~ YEARS IN QUESTION HIS DISTRIBUTIVE SHARE

f PARTNERSHIP INCOME.

If, as we believe we have shown, the payments

made by Health Plan to the trust as well as those

made directly to the partnership were includable in

partnership income, then each partner, including the

Present respondents, should have included in his gross

income his proportionate share of the increased part-

nership income. Internal Revenue Code, Section 61

() (18). 5

“Though Subchapter K of Chapter 1 of the Internal

Revenue Code of 1954 greatly expanded the detail

wen,

ctural scheme now embodied in Sections 701

ee came i ok has remained

unchanged since the enactment of Section II, Dye of

H. Rep. No. 1887, ssd Cong., 2d Sess., p. 65 (8 U.S.C.

News (1954) 4017, 4091); 8. Rep. No. 1622,

Cong., 2d Sess., p. 89 BURG Cong. & Adm. News

(1954) 4621, 4721, 4722).

: * Provided further, That any persons carrying on

business in partnership shall be liable for income tax only in

their individual ‘capacity, and the share of the profits of a

partnership to which any taxable partner would be entitled if

the same were divided, whether divided or otherwise, shall be

returned for taxation and the tax paid, under the provisions

he Income Tax Act of 1913, e. 16, 38 Stat. 114, 166:

he partnership itself is not taxed,” but it prepares

d files a return in much the same manner that is

sired of an individual taxpayer," and the partners

e required to take into their income their distribu-

ive shares of partnership income.“ In Heiner v.

Mellon, 304 U.S. 271, this Court held that “distri

tive share” meant “proportionate share”, rather al

“distributable share”, and that partners are required

to take into their individual income their distribu-

tive, or proportionate, shares of partnership income

wen though applicable state law ‘prevented distribu-

© tion, In so holding, it referred with approval (304

at 281, n. 8) to O.D. 187, 1 Cum. Bull. 174

19), in which the Treasury had held that partner-

» income was currently taxable to the partners

n the amount of their distributive shares although

2 contract it could not be distributed until later

Secs. 708, 6031.

un Secs. 61 (a) (18), 702 (a), 704. The phrase “distributive

e” originated in Sec. 218 (a) of the Revenue Act of

e. 18, 40 Stat. 1057.

The correlative of these provisions is that amounts dis-

_ tributed are not taxed to a partner upon distribution unless

te amount of money distributed is in excess of the partner’s

basis in his partnership interest. Sec. 781 (a) (1). That basis

increased by the partner’s distributive share of partner-

ip income, and decreased by distributions to him, and by

is distributive share of partnership losses. Secs. 705 (a), 733.

SA a an

comes their proportionate shares of partnership in-

It follows that if, Gi a ate iho cana Health

Plan’s payments to the trust constituted partnership

income, then the respondent partners were required

to take into their income their increased distributive

shares of the partnership income, despite any con-

tractual arrangement, by trust or otherwise, to hold

_ distribution in abeyance. Contrary to the court of

— understanding (Pet. 37, 41), the govern-

| por jon that the payments to the trust con-

eee e fs and consequently

eee gere

| or “conduit” theory of partnerships. Those

concept cali conte ide play ‘ily where there. is a

e ot ‘characterizing Income for special treat-

f 18 Starr v. Commissioner, 267 F. 28148 (C. A. 777 United

States v. Baker, 288 F. 2d 195 (C. A. 10); Hulbert v. Commis-

„27 F. 2d 399 (C. A. 7); Bell v. Commissioner, 219

442 (C. A. 5) Commissioner v. Goldberger s Estate, 218

m. 1 v. E e 27 T. C. 840; deCousser

um ner, 16 T. C. 65; Halkias v. Commissioner, 12 T. C.

1001; Face ‘Commissioner, 10 T.C. 775.

1 and to a partner. See Sections

10 888 and 702 (a) (9). With respect to the pay-

TTT

e. But the fact that the partners were also

gent beneficiaries of the trust is quite irrele-

| ian-employees, who were equally contingent

tiaries. It has not sought, arid does not seek,

8 of the partnership’s largesse. It .can hardly

sh the partners’ liability for tax on their shares

See Wolfman, Level for Determining Character of Part-

ship Income—“Entity” v. “Conduit” Principle in Partner-

Taxation, 19 N.Y.U. Institute on Federal Taxation 287

of partnership income that they were the principal

contingent beneficiaries of the trust.

The court of appeals persisted in this error when

it concluded (Pet, 86) that had respondents “con-

tracted individually with * * * [Health Plan] for

payments into a retirement trust subject to the same

conditions involved here, they would not be subject

to taxation in the years the payments were made.”

Under Lwoas v. Earl, an individual physician (or,

for that matter, a corporation) contracting with

Health Plan, with similar provisions for payments

to a trust for himself and his employees, or for rela-

tives or others, would be taxed currently on amounts

irrevocably paid to the trust because, as to him, such

payments would be no more than deflected compen-

sation for services rendered. Cf. Hogle v. Commis-

sioner, 182 F. 2d 66 (C. A. 10); Jones v. Page, 102

F. 2d 144 (C. A. 5). The cases upon which the court

below relied (Pet. 36) would be relevant, irre-

spective of whether an individual, a corporation, or

a partnership contracted with Health Plan, only if

the government looked to the trust as a source of in-

come to berieficiaries, such as employees, who might

never receive payment. They are of no relevance

where, as here, the contracting party (the partner-

ship) was irrevocably compensated by the bargained-

for payments to the trust, and where we are con-

cerned only with the tax liabilities of the individual

partners, whether they were or were not beneficiaries

of the trust.

28

. m.

THE DECISION BELOW EFFECTIVELY CIRCUM.-

VENTS

THE LIMITATIONS UPON QUALIFIED PEN-

SION TRUSTS ESTABLISHED BY THE INTERNAL

compensated employees, Section 401 (a) (4).

of these conditions, there could be no quali-

ing 1960 and 1961. Though that restriction has been

Telaxed somewhat in later years by amendments to

the Code effected by the Self-Employed Individuals

Tax

fits only for professional physician- employees, could

not qualify under either the standards of 1960 and

1961 or those of later years. Yet, contrary to the

explicit statutory limitations on qualified pension

trusts, the decision below produces for the partner.

ship and the the principal tax benefits of

ch.a trust, and thus openly invites partnerships to

umvent ‘requirements carefully devised by

$s conditions to obtaining thee, dere

(RN. 116, 121-122, 129-180, 188, 155, 156.)

: „it ths trast had constituted a pension trust for employees

qualified under Section 401, the payments to the trust by

Health Plan would still have constituted gross income to the

Medical Group partnership but would, at the same time, have

given rise to an offsetting deduction by Medical Group. How-

ever, since, on several grounds, including the fact that it was

es icles Goats wedi Mel eee

pension trust under Section 401, the offsetting de

25

CONCLUSION

For the reasons stated, the judgments of the court

appeals should be reversed.

APPENDIX |

Internal Revenue Code of 1954 (26. USC):

Sc. 61, Gross INCOME DEFINED. |

9 General Definition. Except as -other-

wise provided in this subtitle, gross income

; means all income from whatever source derived,

Re e ese not nes to) a following

5 0 0 ae 8 for pervices, including

ge 3 ö

been, aun. ot partner

N

8 3 0

S850. 401. n PENSION, PRorIT-SHAR-

wi ma, AND ST00K Bonus PLANS.

NS (a) Requirements for Qualification—A trust

created or organized in the United States and

: _ forming part of a stock bonus, pension, or profit-

_ sharing plan of an employer for the exclusive

‘benefit of his employees or their beneficiaries

Beall constitnte s qualified trust under this sec

(1) if. contributions are made to the

N ‘trast by such employer, or employees, or

: both, or by another employer who is entitled

do deduet his contributions under section

Me Ee (relating. to deduction for

. ee plans), for the purpose of distribut-

e eee

15

*

7

27

the corpus and income of the fund accumu-

lated by the trust in accordance with such

plan;

(2) if under the trust instrument it is im-

possible, at any time prior to the satisfac-

tion of all liabilities with respect to em-

ployees and their beneficiaries under the

trust, for any part of the corpus or income

to be (within the taxable year or there-

after) used for, or diverted to, purposes

other than for the exclusive benefit of his

employees or their beneficiaries;

* * * *

a :

= (4) if the contributions or benefits provided

under the plan do not discriminate in favor

of employees who are officers, shareholders,

persons whose principal ‘duties consist in

supervising the work of other employees, or

highly compensated employees.

81x. 404. DEDUCTION FOR CONTRIBUTIONS oF

: AN EMPLOYER TO AN EMPLOYEES’ TRUST OR

ANNUITY PLAN AND COMPENSATION UNDER A

DEFERRED-PAYMENT PLAN.

(a) [as amended by Sec. 24, Technical Amend-

ments Act of 1958, P. L. 85-866, 72 Stat. 1606]

Senerul Rule.—If contributions are paid by an

employer to or under a stock bonus, pension,

: (5) Other plana in the taxable year

When paid, if the plan is not one included

in paragraph (1), (2), or (3), if the em-

ployees’ rights to or derived from such em-

ployer’s contribution or such compensation

are nonforfeitable at the time the contri-

bution or compensation is paid.

* * * *

SC. 701. PARTNERS, Nor PARTNERSHIPS, SUB-

or To Tax.

| A partnership as such shall not be subject: to

the ineome tax imposed by this chapter. Persons

‘carrying on business as partners shall be liable

dor income tax only in their separate or indi-

vidual: capacities.

‘Sec. 702. INCOME AND CREDITS OF PARTNER.

dea) General. Rule.—In determining his in-

come tax, each partner shall take into account

aie separately his deere share of the partner-

oo |

* * * *

29

(9) taxable income or loss, exclusive of

items requiring separate computation under

other paragraphs of this subsection.

* 2 * *

Sec. 703. PARTNERSHIP COMPUTATIONS.

(a) Income and Deductions.—The taxable in-

come of a partnership shall be computed in the

Same manner as in the case of an individual

except that—

(1) the items described in section 702(a)

shall be separately stated, and

4 * „ „

SEc. 704. PARTNER’s DISTRIBUTIVE SHARE.

(a) Effect of Partnership Agreement.—A

partner’s distributive share of income, gain, loss,

deduction, or credit shall, except as otherwise

provided in this section, be determined by the

partnership agreement.

* * * *

* as. GOVERNMENT PRINTING OFFICE; 1972 470203 863