Haag v. Commissioner

*605 The Commissioner determined deficiencies in petitioner's Federal income tax as follows:

The issues we must decide are (1) whether certain income reported by petitioner's closely held corporation during the years in issue is taxable to petitioner pursuant to section 61 ¹ and the assignment of income doctrine; and (2) whether such income is allocable to petitioner pursuant to section 482.

FINDINGS OF FACT

All of the facts have been stipulated and, except as noted (see notes 2 and 3 infra), are so found. Petitioner Stanley W. Haag, resided at Adel, Iowa, when he filed his petition*35 in this case. Petitioner timely filed Federal income tax returns for the taxable years 1979, 1980, and 1981.

Petitioner is a physician licensed to practice medicine in the State of Iowa. Prior to March 16, 1976, petitioner was a general partner in the Hilltop Medical Clinic (Hilltop), a partnership organized on January 1, 1967, under the laws of the State of Iowa. Petitioner joined the partnership no later than June 1971. Although the partnership agreement provides for amendment, it has not been amended to reflect the retirement or resignation of the original partners or the *606 addition of new partners. Petitioner's name, therefore, does not appear on any written partnership agreement.

On March 16, 1976, petitioner organized Stanley W. Haag, M.D., P.C. (the P.C.), under the Iowa Professional Corporation Act, Iowa Code, ch. 496C (1986). The P.C. subsequently adopted bylaws, opened bank accounts in its name, caused a board of directors to be elected, elected officers, and held shareholder and director meetings. Petitioner was the sole director of the P.C. Petitioner and John L. Henss ² were the officers of the P.C., and petitioner and an employee stock ownership plan*36 were the sole shareholders. The P.C. at all times has been a validly organized and operated professional corporation under Iowa law. The P.C. is not a sham or dummy corporation and is an entity taxable apart from its owners and employees. A business purpose for the formation of the P.C. was to continue the medical practice and other businesses of petitioner. The P.C. adopted an employee stock ownership plan ("ESOP") and a medical reimbursement plan.

On or about March 16, 1976, petitioner assigned his interest in Hilltop to the P.C. Hilltop employed all of the partnership's nonprofessional employees and paid office, lab, medical, and rent expenses. Hilltop also issued checks for malpractice insurance *37 covering each partner, but charged the amounts paid to the partners' drawing accounts. The P.C. thus paid for petitioner's malpractice insurance.

Hilltop issued Schedules K-1 to the P.C. for Hilltop's 1979, 1980, 1981, and 1982 taxable years showing the P.C.'s distributive share of Hilltop income and its withdrawals and distributions as follows:

*607 Petitioner entered into an employment agreement with the P.C. on March 16, 1976. The agreement provides, in relevant part:

1. EMPLOYMENT

(a) The Corporation hereby employs the Employee to perform professional services on behalf of the Corporation and to render such services as are necessary for the Corporation to operate and maintain an establishment for * * * the practice of medicine.

* * * *

(d) The Employee agrees to devote his entire time, attention, knowledge and skill to such employment and shall at all times maintain and enhance the reputation of the Corporation, its shareholders and employees and the profession, generally.

Compensation for *38 petitioner's services was left to the discretion of the board of directors after taking into account the P.C.'s and petitioner's cash-flow needs.

In addition to the partnership interest in Hilltop, petitioner contributed farms and a dog kennel and breeding operation to the P.C. on March 16, 1976. In exchange for the partnership interest, professional equipment, land, the farms, and the kennel and breeding operations, the P.C. assumed certain indebtedness of petitioner ($ 123,500 owed to the West Des Moines State Bank), issued to petitioner 100 shares of stock with no par value but valued at the time of the transfer at $ 10 each, and a non-interest bearing note in the face amount of $ 56,085.66. The transaction qualified for nonrecognition treatment under section 351(a).

The P.C. acquired two farms from petitioner totaling 280 acres, portions of which were used for grain farming and portions for the kennel operations and related activities. At all relevant times, the P.C. owned 30 to 70 dogs. The P.C. trained hunting dogs, boarded dogs, and bred dogs. The P.C. was known for its German shorthaired pointers and German wirehaired pointers and some of its dogs were of "national quality." *39 Petitioner is a recognized national expert on these breeds. The P.C. also ran a shooting club on the farm property and hunters paid a fee to hunt. The farm was stocked with game birds and the P.C. operated the farm in such a way as to increase the game bird population.

The P.C.'s income from the farm, kennel, and breeding operations for the fiscal years ending February 29, 1980, *608 February 28, 1981, and February 28, 1982, was as follows:

On November 28, 1978, Doc's Renowned Restaurant, Ltd. (the Restaurant), was incorporated as a wholly owned subsidiary of the P.C. During all relevant periods, the P.C. and the restaurant filed consolidated Federal income tax returns. The P.C.'s net income from the restaurant for the fiscal years ending February 29, 1980, February 28, 1981, and February 28, 1982, was as follows:

*40 The P.C. entered into separate written agreements in 1978 to provide medical services to the Mitchellville Girls Training School (the Training School) and the Mitchell Village Care Center (the Care Center). The P.C. received the following income from those contracts for the fiscal years ending February 29, 1980, February 28, 1981, and February 28, 1982:

Petitioner made an unknown number of cash advances to the P.C. between March 16, 1976, and February 28, 1979. As of February 28, 1979, the P.C.'s books reflected that it owed petitioner $ 105,243.59. During the years in issue, the P.C. repaid that amount in full and transferred to petitioner additional amounts so that on February 28, 1982, petitioner had taken out of the P.C. $ 27,400.02 more than the $ 105,243.59 of cash he had advanced.

Petitioner's "loans" to the P.C. initially did not state any interest, but beginning on March 1, 1980, 10-percent interest was accrued on the average annual balance outstanding. Petitioner reported interest income from the P.C. of $ 5,765.03 and $ 1,130.22, respectively, *41 on his 1981 and 1982 *609 tax returns. A promissory note was issued for petitioner's initial $ 56,085.66 loan to the P.C. in 1976, but no promissory notes were issued for any of petitioner's subsequent advances to the P.C. or the P.C.'s payments to petitioner. No security was given for any of the loans between petitioner and the P.C.

The P.C. paid petitioner no salary from March 1, 1979, through January 31, 1982. In February 1982, the P.C. paid petitioner an $ 18,000 bonus for the fiscal year ending February 28, 1982, and contributed $ 2,700 to the ESOP on petitioner's behalf. Petitioner also received the following amounts from the P.C. as tax-exempt medical reimbursements:

The P.C. reported its distributive share of Hilltop income on its corporate tax returns. Petitioner reported only his salary from the P.C. on his individual tax returns. During the years in issue, petitioner reported the following income from the P.C. and the P.C. reported the following income from Hilltop:

*42 In 1979, 1980, and 1981, petitioner withdrew $ 5,635, $ 7,906, and $ 8,558, respectively, from Hilltop without recording the withdrawals on the P.C.'s books. Petitioner did not report the withdrawals as income on his individual income tax returns for those years.

The nature of the medical services that petitioner provided to patients at Hilltop was not changed by the existence of the P.C. Neither petitioner nor the P.C. made any effort to notify patients treated at Hilltop before or after March 16, 1976, that the P.C. existed and had assumed petitioner's medical practice.

*610 The following schedule summarizes the P.C.'s income and expenses as reported on its tax returns for the years in issue:

In his notice of deficiency dated November 18, 1983, respondent allocated the P.C.'s Hilltop income to petitioner.

OPINION

The first issue we must decide is whether petitioner or the P.C. earned the income from the Hilltop Medical Center partnership during the taxable years 1979, 1980, and 1981, and thus whether such income is taxable to petitioner pursuant to section 61 and the assignment of income doctrine. The principle that income is taxed to the one who earns it is basic to our system of income taxation. Commissioner v. Culbertson, 337 U.S. 733, 739-740 (1940); Lucas v. Earl, 281 U.S. 111 (1930). The generally accepted test for resolving who is to be taxed requires us to *611 determine who actually earned the income. In the corporate context, *44 however, the actual earner test may be inadequate because a corporation can earn income only through the personal services of its employees and agents. Johnson v. Commissioner, 78 T.C. 882, 890-891 (1982), affd. without published opinion 734 F.2d 20 (9th Cir. 1984), cert. denied 469 U.S. 857 (1984). This Court, therefore, has applied a more refined test which looks to who controls the earning of income. See Vercio v. Commissioner, 73 T.C. 1246, 1254-1255 (1980). In Johnson v. Commissioner, we set out the two requirements that must be met before a corporation, rather than its service-performer employee, will be considered the controller of the income and taxable thereon:

First, the service-performer employee must be just that -- an employee of the corporation whom the corporation has the right to direct or control in some meaningful sense. Second, there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position. [78 T.C. at 891.*45 Emphasis added. Citations and fn. ref. omitted.] ³

Petitioner contends that section 61 and the assignment of income doctrine are inapplicable in this case because the parties have stipulated that the P.C. is validly organized and operated and is not a sham or dummy corporation. The assignment of income doctrine is an essential tool for preventing a taxpayer from assigning income to a corporation (or other person) to avoid tax liability. A finding that the P.C. is not a sham does not preclude application of the assignment of income doctrine because a taxpayer *46 can assign income to a corporation with real and substantial businesses to avoid tax liability. Wilson v. United States, 530 F.2d 772, 778 (8th Cir. 1976). We nevertheless find that the P.C.'s Hilltop income is not allocable to petitioner pursuant to section 61 or the assignment of income doctrine because the P.C. controlled the earning of the income.

The first element of the control test is satisfied if petitioner was an employee over whom the P.C. could exercise control in a meaningful sense. The employment *612 agreement that petitioner and the P.C. entered into on March 16, 1976, provides in relevant part:

1. EMPLOYMENT

(a) The Corporation hereby employs the Employee to perform professional services on behalf of the Corporation and to render such services as are necessary for the Corporation to operate and maintain an establishment for * * * the practice of medicine.

* * * *

(d) The Employee agrees to devote his entire time, attention, knowledge and skill to such employment and shall at all times maintain and enhance the reputation of the Corporation, its shareholders and employees and the profession, generally.

Respondent contends that*47 this agreement did not give the P.C. any real control over petitioner's services because, as the P.C.'s sole director and one of only two shareholders (the other being the ESOP), petitioner could modify or rescind the agreement or could, and did, ignore it. We find respondent's argument to be without merit. There is nothing in the record to indicate that petitioner ignored the employment agreement. The ability of a majority or sole shareholder to ignore, rescind, or modify an agreement entered into with his corporation exists in every closely held corporation. A holding that such ability precludes a corporation from exercising control over its employee's earning of income, and thus being taxable on that income, would violate the longstanding recognition of corporations as entities independent of their shareholders. See Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943). We find that the employment agreement effectively gave the P.C. the right to control petitioner's medical practice.

The second element of the control test requires that there exist a contract or similar indicium recognizing the corporation's controlling position*48 entered into between the corporation and the entity to whom it provides services. There was no written agreement between Hilltop and the P.C. Petitioner assigned his interest in Hilltop to the P.C., but Hilltop did not amend its partnership agreement to reflect the assignment. It is nonetheless evident that Hilltop recognized the P.C. as a partner because it listed the P.C., and not petitioner, as the partner on Schedules K-1, Partner's Share of Income, Credits and Deductions, for each *613 of the years in issue. Moreover, it should be noted that Hilltop did not amend its partnership agreement to reflect petitioner's admission to the partnership in 1971. Although there was no formal contract between Hilltop and the P.C., Hilltop recognized the P.C. as the entity who controlled the provision of medical services by petitioner, and therefore the earning of income.

Respondent cites two cases in which this Court has upheld reallocations of income under the assignment of income doctrine from a validly organized and operated corporation to its shareholder/employees. See Jones v. Commissioner, 64 T.C. 1066 (1975); Roubik v. Commissioner, 53 T.C. 365 (1969).*49 Both cases are distinguishable. In Jones v. Commissioner, supra, the taxpayer, an official court reporter, formed a personal service corporation to loan out his services despite the legal requirement that a court reporter be an individual and not a corporation. In addition, the taxpayer never entered into an employment agreement with the corporation and remained under the direct control of the judge to whom he was assigned. Although we found that the corporation was not a sham, we held that the taxpayer assigned his income from court reporting to the corporation because by law the corporation could not perform such services.

In Roubik v. Commissioner, supra, four radiologists formed a corporation and entered into employment agreements with it. The corporation was validly organized under State law. We nonetheless held that the corporation did not have any right to control the professional activities of its "employees" and that the radiologists had assigned their income to the corporation. The corporation did not enter into any agreements with third parties to provide medical services and agreements between the physicians*50 acting in their individual capacities and third parties persisted after the corporation was formed.

In the present case, in contrast, an effective employment agreement existed between petitioner and the P.C.; Hilltop recognized the P.C. as the entity through which petitioner provided medical services; and the medical partnership interest could be transferred to a corporation under Iowa*614 law. We, therefore, hold that the P.C., and not petitioner, earned the income from Hilltop in 1979, 1980, and 1981.

Our determination that the P.C. earned the income from Hilltop does not, however, end our inquiry. Next we must decide whether respondent properly allocated the Hilltop income for the taxable years 1979, 1980, and 1981, from the P.C. to petitioner pursuant to section 482. Section 482 permits respondent to reallocate income actually earned by one member of a controlled group to other members of that group if (1) there are two or more trades, businesses, or organizations, (2) the enterprises are owned or controlled by the same interest, and (3) reallocation of income among the enterprises is necessary to clearly reflect income or to prevent the evasion of taxes. Wilson v. United States, 530 F.2d 772, 777 (8th Cir. 1976).*51 Respondent's section 482 allocation will be sustained unless petitioner establishes that it is arbitrary, capricious, and unreasonable. Pacella v. Commissioner, 78 T.C. 604, 618 (1982); Keller v. Commissioner, 77 T.C. 1014, 1022 (1981), affd. 723 F.2d 58 (10th Cir. 1983).

This Court has held that section 482 applies in the one-man personal service corporation context. Keller v. Commissioner, supra.⁴ The purpose of section 482 is to place a controlled taxpayer in the same position as an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer in accordance with the standard of an uncontrolled taxpayer dealing at arm's length. Sec. 1.482-1(b)(1), Income Tax Regs.; Hospital Corp. of America v. Commissioner, 81 T.C. 520, 593 (1983).

*52 *615 The requirement that there be two or more trades, businesses, or organizations for a section 482 allocation is to be construed broadly. Wilson v. United States, 530 F.2d at 777; Keller v. Commissioner, 77 T.C. at 1022. Petitioner and the P.C. satisfy the dual business requirement. Petitioner is in the business of providing medical services as an employee of the P.C., and the P.C., as a partner in Hilltop, is in the business of providing medical services through petitioner. See Keller v. Commissioner, 77 T.C. at 1024. ⁵ Petitioner's business and the P.C.'s business are also under common control. At issue, is whether a reallocation of income is necessary to clearly reflect income or to prevent the evasion of taxes. To determine whether a reallocation is necessary to clearly reflect income or to prevent the evasion of taxes, we must decide whether the agreement between the taxpayer and the corporation reflected arm's-length dealing.

*53 We note that, in general, petitioner did not engage in transactions with the P.C. at arm's length. Numerous "loan" transactions between petitioner and the P.C. evidence a lack of arm's-length dealing. On March 16, 1976, when the P.C. was formed, petitioner loaned the P.C. $ 56,085.66 without interest. Between March 16, 1976, and February 28, 1979, petitioner made an unknown number of additional cash advances to the P.C. totaling $ 49,157.93. Between February 28, 1979, and February 28, 1982, the P.C. repaid these cash advances to petitioner and made an unknown number of additional cash advances to petitioner totaling $ 27,400.02.

Whether a withdrawal of funds by a shareholder from a corporation or an advance made by a shareholder to a corporation creates a true debtor-creditor relationship is a factual question to be decided based on all relevant facts and circumstances. J.S. Biritz Construction Co. v. Commissioner, 387 F.2d 451, 453 (8th Cir. 1967), revg. a Memorandum Opinion of this Court; Haber v. Commissioner, 52 T.C. 255 (1969), affd. 422 F.2d 198 (5th Cir. 1970). For disbursements *616 *54 to constitute true loans there must have been, at the time the funds were transferred, an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment. Haber v. Commissioner, supra at 266; Saigh v. Commissioner, 36 T.C. 395, 419 (1961). Because direct evidence of a taxpayer's state of mind is not generally available, courts have focused on certain objective factors to distinguish bona fide loans from disguised dividends, compensation, and contributions to capital. ⁶