Schneer v. Commissioner

*643 Respondent, by means of separate notices of deficiency, determined deficiencies in Federal income *644 tax for petitioners' 1984 and 1985 taxable years in the amounts of $ 49,708 and $ 25,252, respectively. Respondent, in both years, also determined additions to tax under section 6653(a)(1) ¹ and an additional 50-percent interest on $ 45,437 of the 1984 deficiency and on $ 25,252 of the 1985 deficiency under section 6653(a)(2). Respondent also determined additions to tax under section 6661 and increased interest under section 6621(c) for both taxable years. By agreement, the parties have resolved the *109 additions to tax under section 6661 and increased interest under section 6621(c). The parties have also resolved the additions to tax under section 6653(a)(1) and (2) in connection with the adjustments concerning the Coal Venture II tax shelter for both taxable years. There remain for our consideration issues concerning: (1) Whether fees received from petitioner husband's prior law firm (where he was not a partner) are taxable to petitioner husband or the partners of his new law firm (where he is a partner); and (2) whether petitioners are liable for additions to tax under section 6653(a)(1) and (2) with respect to any portion of the deficiencies in income tax attributable to issue (1).

FINDINGS OF FACT

The parties' stipulations of facts and referenced exhibits are incorporated herein by this reference.

Petitioners*110 resided at Croton-On-Hudson, New York, at the time the petition was filed in this case. Stephen B. Schneer (hereinafter petitioner, when used in the singular, shall refer to Stephen B. Schneer), was a practicing attorney during the years 1983, 1984, and 1985. Until February 25, 1983, petitioner was an associate with the law firm of Ballon, Stoll & Itzler (BSI). BSI was a partnership. Petitioner was not a partner in BSI and he did not share in general partnership profits. Petitioner's financial arrangement with BSI consisted of a fixed or set salary and a percentage of any fees which arose from clients petitioner brought or referred to the firm.

*645 BSI did not have a written partnership agreement, and no written agreement existed in connection with petitioner's relationship as an associate with BSI. When petitioner left BSI he had an understanding that he would continue to receive his percentage of fees which arose from clients he had referred when he was an associate with BSI. Petitioner was expected to consult regarding clients he referred to BSI and whose fees were to be shared by petitioner. Petitioner would have become entitled to his percentage of the fees even if he had*111 not been called upon to consult.

After petitioner left BSI and while he was a partner of two other law partnerships (other than BSI) he consulted on numerous occasions concerning BSI clients. Most of the 1984 and 1985 fees received under this agreement were attributable to Terri Girl and Prince, clients that petitioner had brought to BSI. Neither the remaining BSI attorneys nor petitioner had contemplated whether petitioner would receive the fees if he refused to consult concerning the clients referred by petitioner. For the years under consideration, petitioner consulted with BSI attorneys on each occasion his services were requested. The services provided by petitioner to BSI consisted of legal advice and consultation on legal matters.

Late in February 1983, petitioner became a partner in the law firm of Bandler & Kass (B&K), and on August 1, 1985, petitioner became a partner in the law firm of Sylvor, Schneer, Gold & Morelli (SSG&M). BSI, B&K, SSG&M, and petitioner, at all pertinent times, kept their books and reported their income on the cash method of accounting. Neither B&K nor SSG&M had written partnership agreements. The agreement between the partners of B&K was that*112 each partner would receive a percentage of the partnership profits derived from all fees received beginning the date the partner joined the partnership. In addition, petitioner agreed to turn over to the partnership all legal fees received after joining the partnership, regardless of whether the fees were earned in the partnership's name or from the partnership's contractual relationship with the client. The same agreement existed between the partners of SSG&M, including petitioner.

*646 During 1984 and 1985, BSI remitted $ 21,329 and $ 10,585 to petitioner. The amounts represented petitioner's percentage of fees from BSI clients that he had referred to BSI at a time when he was an associate with BSI. With the exception of $ 1,250 for the 1984 taxable year, all of the fees received during 1984 and 1985 were for work performed after petitioner left BSI. Petitioner, pursuant to his agreements with B&K and SSG&M, turned those amounts over to the appropriate partnership. B&K and SSG&M, in turn, treated the amounts as partnership income which was distributed to each partner (including petitioner) according to the partner's percentage share of partnership profits.

BSI's 1984 records *113 reflect that of the $ 21,329 total, $ 944 was attributable to Prince and $ 17,060 was attributable to Terri Girl. The remainder of the $ 21,329 remitted for 1984 ($ 3,325) was attributable to BSI clients for which petitioner had not consulted since leaving BSI during February 1983. The 1985 records of BSI reflect that the entire amount ($ 10,585) was attributable to Prince. BSI records reflect that billings and fees were made and received from BSI clients at various times during the year, but that petitioner received one annual aggregate payment.

OPINION

We consider here basic principles of income taxation. There is agreement that the amounts paid to petitioner by his former employer-law firm are income in the year of receipt. The question is whether petitioner (individually) or the partners of petitioner's partnerships (including petitioner) should report the income in their respective shares.

The parties have couched the issue in terms of the anticipatory assignment-of-income principles. See Lucas v. Earl, 281 U.S. 111, 74 L. Ed. 731, 50 S. Ct. 241 (1930). Equally important to this case, however, is the viability of the principle that partners may pool their earnings and report partnership*114 income in amounts different from their contribution to the pool. See sec. 704(a) and (b). The parties' arguments bring into focus potential conflict between these two principles and compel us to address both.

First, we examine the parties' arguments with respect to the assignment-of-income doctrine. Respondent argues that *647 petitioner earned the income in question before leaving BSI, despite the fact that petitioner did not receive that income until he was a partner in B&K and, later, SSG&M. According to respondent, by entering into partnership agreements requiring payment of all legal fees to his new partnerships, petitioner anticipatorily assigned to those partnerships the income earned but not yet received from BSI.

Respondent also raises the question of petitioner's method of accounting -- the cash method. Respondent notes that the cash method requires taxpayers to postpone reporting income until received, whether or not earned prior to receipt. See secs. 1.446-1(c)(1), 1.451-1(a), Income Tax Regs. While the concepts of recognition, receipt, and accounting method are sometimes necessary for a complete analysis of an assignment-of-income case, respondent here appears primarily*115 concerned with the possibility that petitioner's method of accounting will obscure our perception of when petitioner earned the income in question. ²

Petitioner contends that the income in question was not earned until after he left BSI and joined B&K and SSG&M. He argues that the income received from BSI is reportable by the partners of the B&K and SSG&M partnerships (including petitioner) in their respective shares. Petitioner also points out that partnership agreements, which like the ones in issue allocate and redistribute partners' income, have received the approval of respondent in Rev. Rul. 64-90, 1964-1 (Part 1) C.B. 226. Petitioner argues that he was obligated to consult with BSI in order to be entitled to the BSI fees. Petitioner concedes that, for some of the income in question, no consultation was performed or requested. He emphasizes, however, that *116 a substantial amount (about 90 percent) of the fees involved clients of BSI for whom consultation was performed. Finally, petitioner believes that his failure to consult would have resulted in loss of the fees.

The principle of assignment of income, in the context of Federal taxation, first arose in Lucas v. Earl, supra, where the Supreme Court, interpreting the Revenue Act of 1918, held that income from a husband-taxpayer's legal practice was taxable to him, even though he and his wife had *648 entered into a valid contract under State law to split all income earned by each of them. In so holding, Justice Holmes, speaking for the Court, stated:

There is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. [281 U.S. at 114-115.]

From that pervasive and simply stated interpretation, a plethora of cases and learned studies have sprung forth. Early cases reflected the use of the assignment-of-income principle only with*117 respect to income not yet earned. The theory behind those interpretations was that income not yet earned is controlled by the assignor, even if assigned to another. Such income is necessarily generated by services not yet performed. Because the assignor may refuse to perform services, he necessarily has control over income yet to be earned. See Matchette v. Helvering, 81 F.2d 73 (2d Cir. 1936); Helvering v. Horst, 311 U.S. 112, 118, 85 L. Ed. 75, 61 S. Ct. 144 (1940). ³ This early rationale left open the possibility of successful assignments, for tax purposes, of income already earned. That possibility was foreclosed in Helvering v. Eubank, 311 U.S. 122, 85 L. Ed. 81, 61 S. Ct. 149 (1940), where the Supreme Court held that income already earned would also fall within the assignment-of-income doctrine of Lucas v. Earl, supra.

Respondent contends*118 that Helvering v. Eubank, supra, is controlling in this case because petitioner had already earned the income in question at the time he entered into the partnership agreements. In that case, the taxpayer was an insurance agent who switched jobs and then assigned the future renewal commissions from policies already written. The taxpayer had written the policies and completed all work on them before leaving that job. The renewals and commissions were realized by the taxpayer solely due to the initiative and action of policyholders. "'At the time of assignment there was nothing contingent in the * * * [taxpayer's] right'" to collect the money. See Helvering v. Eubank, supra at 126 (McReynolds, J., dissenting and quoting the lower court at 110 F.2d 737, 738 (2d Cir. 1940)).

*649 In this case, petitioner was not entitled to the referral fees unless the work for the referred clients had been successfully completed. On the other hand, petitioner would be entitled to the fees if the work was completed or if at the time of the assignment there was nothing contingent in petitioner's right to collect his percentage of the fees. Additionally, the majority of*119 the services had not been performed prior to petitioner's leaving BSI. In this regard services had been performed with respect to $ 1,250 prior to 1984. With respect to $ 3,325 of the $ 21,329 of fees received in 1984, petitioner did not consult and was not required to do anything subsequent to leaving BSI to be entitled to those fees. With respect to the remainder of the $ 21,329 for 1984 and all of the 1985 fees, petitioner was called upon to and did consult while he was a partner of B&K or SSG&M.

We must decide whether petitioner had earned the fees in question prior to assigning them to the B&K or the SSG&M partnerships. Although petitioner was on the cash method, the principles that control use of the cash method are not suited to this inquiry. For purposes of the assignment-of-income doctrine, it must be determined whether the income was earned prior to an assignment. The principles underlying the cash method do not focus upon when income is earned, the focus is upon when income is actually or constructively received. The accrual method, however, involves a question of when income is earned, rather than when it is received. We accordingly consider the principles underlying*120 the accrual method for the purpose of determining whether petitioner had "earned" the income in question prior to the time he agreed to turn it over to the B&K or SSG&M partnerships.

Income is said to accrue where the right to receive it becomes fixed, that is when there is an enforceable liability. See, e.g., Spring City Foundry Co. v. Commissioner, 292 U.S. 182, 184-185, 78 L. Ed. 1200, 54 S. Ct. 644 (1934); Commissioner v. Hansen, 360 U.S. 446, 463-464, 3 L. Ed. 2d 1360, 79 S. Ct. 1270 (1959). This principle has evolved into a more specific test to determine whether income is includable under the accrual method -- the all-events test. Under that test income is includable (earned) when: (1) All events have occurred which fix the right to receive the income, and (2) *650 the amount can be determined with reasonable accuracy. See sec. 1.451-1(a), Income Tax Regs.

To meet the requirements of the all-events test, there can be no substantial contingency to a taxpayer's right of receipt or as to the certainty of the amount to be received. Under the accrual method, income may not be subject to taxation at a time when payment remains subject to the discretion of the employer, Kinkead v. Commissioner, 35 T.C. 152, 155-156 (1960),*121 or there is some other factor of uncertainty, Commissioner v. Brown, 54 F.2d 563, 567-568 (1st Cir. 1931). See also Parkford v. Commissioner, 45 B.T.A. 461 (1941), affd. 133 F.2d 249 (9th Cir. 1943); Leedy-Glover Realty & Insurance Co. v. Commissioner, 13 T.C. 95, 104-106 (1949), affd. per curiam on other grounds 184 F.2d 833 (5th Cir 1950).

The transaction under consideration is one where petitioner had an agreement under which he would receive a percentage of fees received by BSI from clients who were referred by petitioner while he was an employee of BSI. Inherent in petitioner's unconditional right to payment is the condition precedent that billable services have been performed for the referred client. Additionally, petitioner's right to payment may also be subject to a second condition precedent that he may be required to consult and be involved in performing the services to be billed. Finally, there is the conditional aspect of payment. If the referred client does not pay for services rendered, then petitioner will not receive his percentage.

The possibility that the client might*122 not pay his obligation once services are performed is insufficient to cause the deferral of income for an accrual method taxpayer. Key Homes, Inc. v. Commissioner, 30 T.C. 109, 112-114 (1958), affd. per curiam 271 F.2d 280 (6th Cir. 1959); First Savings & Loan Association v. Commissioner, 40 T.C. 474 (1963). On the other hand, the prerequisite of performance of the services prior to any liability on the part of the obligor is an essential to satisfying the all-events test. The right to receive income cannot become fixed before the obligor has an obligation to pay. McDonald v. Commissioner, 217 F.2d 475 (6th Cir. 1954), revg. on other grounds a Memorandum Opinion of this Court. See also Berger Engineering Co. v. *651 Commissioner, T.C. Memo. 1961-292. Recognition of liability by the obligor is the essence of accrual. Maryland Shipbuilding & Drydock Co. v. United States, 187 Ct. Cl. 523, 409 F.2d 1363, 1367-1368 (1969).

The record in this case reflects that, with the exception of $ 1,250 of services performed in prior years, the billings and payments in *123 question were performed and collected subsequent to the time of assignment of the income. The requirement that petitioner may have been called upon to consult is part of the contingency relating to the performance of the work prior to liability being established or fixed. The absence of consulting by petitioner is not decisive in the setting of this case. Additionally, as a corollary to the income principles, under section 461(h) a taxpayer is not entitled to a deduction under the accrual method unless there has been economic performance, i.e., the services have been performed or the property delivered.

With these principles as our guide, we hold that petitioner had not earned the fees in question prior to leaving BSI, with the exception of the $ 1,250 received for services performed in an earlier year. More specifically, we hold that petitioner earned the income in question while a partner of a partnership to which he had agreed to pay such income. With respect to substantially all of the fees in issue, BSI records reflect that clients were billed and payment received during the years in issue. ⁴ Moreover, if petitioner had refused a request for his consultation, it was, at*124 very least, questionable whether he would have received his share of the fee if the work had been successfully completed without him. Petitioner was requested to and did provide further services with regard to clients from which about 90 percent of the fees were generated. We note that BSI did not request consultation with respect to $ 3,325 remitted during 1984. However, that amount was not earned as of the time of the assignment because the work had not yet been performed for the BSI clients (irrespective of whether or not *652 petitioner would be called upon to consult). Accordingly, with the exception of $ 1,250 for petitioner's 1984 taxable year, we hold that petitioner had not earned the income in question prior to leaving BSI and did not make an anticipatory assignment of income which had been earned.

*125 Two additional related questions remain for our consideration. First, respondent argues that irrespective of when petitioner earned the income from BSI, "there was no relationship * * * [between] the past activity of introducing a client to * * * [BSI], and the petitioner's work as a partner with * * * [B&K or SSG&M]." According to respondent, petitioner should not be allowed to characterize as partnership income fees that did not have a requisite or direct relationship to a partnership's business. In making this argument, respondent attempts to limit and modify his longstanding and judicially approved position in Rev. Rul. 64-90, 1964-1 C.B. 226 (Part 1). See also Bufalino v. Commissioner, T.C. Memo. 1976-110; Brandschain v. Commissioner, 80 T.C. 746 (1983), both involving partnership agreements similar to the one described in Rev. Rul. 64-90. ⁵ Second, while we generally hold that petitioner did not make an assignment of income already earned, the possibility that this was an assignment of unearned income was not foreclosed.

*126 These final two questions bring into focus the true nature of the potential conflict in this case -- between respondent's revenue ruling and the assignment-of-income doctrine. Both questions, in their own way, ask whether any partnership agreement -- under which partners agree in advance to turn over to the partnership all income from their individual efforts -- can survive scrutiny under the assignment-of-income principles.

Rev. Rul. 64-90, 1964-1 (Part 1) C.B. at 226-227, in pertinent part, contains the following:

Federal income tax treatment of compensation received by a partner and paid over to a partnership where the partner, who uses the cash receipts and disbursements method of accounting, files his returns on a *653 calendar year basis and the partnership, which also uses the cash method, files its returns on a fiscal year basis.

I.T. 3824, C.B. 1946-2, 37, and Revenue Ruling 54-167, C.B. 1954-1, 152, amplified.

Advice has been requested regarding the Federal income tax consequences of a change in the terms of a partnership agreement to provide that all compensation received by the partners will be paid over to*127 the partnership immediately upon receipt.

In the instant case, several individuals formed a partnership for the purpose of engaging in the general practice of law. Aside from the partnership business, each of the partners has performed services from time to time in his individual capacity and not as a partner. The several partners have always regarded the fees received for such services as compensation to the recipient as an individual.

The partnership which was formed in 1954 and uses the cash receipts and disbursements method of accounting files its Federal income tax returns for fiscal years ending January 31, and the partners file their individual returns on the cash method for calendar years. Each partner reports his distributive share of the partnership income, gain, loss, deduction or credit for the partnership fiscal year ending within the calendar year for which his individual return is filed. All compensation received by each partner for services performed in his individual capacity is reported in that partner's return for the calendar year when received.

It is proposed to amend the partnership agreement as of the beginning of the partnership's next fiscal year to*128 provide that all compensation received by the partners be paid over to the partnership immediately upon receipt.

The question in the instant case is whether compensation remitted to the partnership pursuant to this provision will constitute partnership income.

Similar inquiries were previously considered by the Internal Revenue Service. * * * In both instances, it was pointed out that a partnership could not exist for the purpose of performing the services for which the compensation and allowances were received, and, thus, the recipient partner would be required to report the taxable portion of the compensation and allowances in his individual return, even though these items were pooled with partnership earnings. * * *

In the instant case, the general practice of the partnership consists of rendering legal advice and services. Consequently, fees received by a partner for similar services performed in his individual capacity will be considered as partnership income if paid to the partnership in accordance with the agreement. Those fees need not be reported separately by the partner on his individual return. However, the partner's distributive share of the partnership's taxable*129 income which he must report on his individual return will include a portion of such fees. [Emphasis supplied.]

A key requirement of this ruling is that the services for which fees are received by individual partners must be similar to those normally performed by the partnership. See *654 also Rev. Rul. 80-338, 1980-2 C.B. 30 (enforcing same requirement); Rev. Rul. 54-223, 1954-1 C.B. 174 (same). Cases dealing with similar partnership agreement situations have also enforced this requirement. See Hamm v. Commissioner, 683 F.2d 1303 (10th Cir. 1982), affg. T.C. Memo. 1980-154; Brandschain v. Commissioner, supra; Philbin v. Commissioner, 26 T.C. 1159, 1167 (1956); Bufalino v. Commissioner, supra.Respondent now attempts to add to this requirement by arguing that the fees here in question were earned through activity, which was admittedly legal work, but was not sufficiently related to the work of petitioner's new partnerships. In other words, respondent argues that the income here was earned in BSI's business activity and not B&K's or*130 SSG&M's business activity.

In Hamm v. Commissioner, T.C. Memo. 1980-154, Mayes v. United States, 207 F.2d 326 (10th Cir. 1953), affg. per curiam 106 F. Supp. 961 (E.D. Okla. 1952), was cited for the proposition that "Where a partner earns income for services performed outside of the scope of his partnership duties * * * the income is taxed to him even though he assigns it to the partnership." 40 T.C.M. 284, 285; 49 P-H Memo T.C. par. 80,154 at 748. In Mayes, an accountant and his son, who was a mechanic, were held to have anticipatorily assigned personal service income when they pooled their income in accord with a partnership agreement. Their partnership was formed to engage in real estate activity and to perform accounting services. See also Mayes v. Commissioner, 21 T.C. 286 (1953) (mechanic-son pursuing same issue in Tax Court). The courts deciding both the father's and the son's cases held that the services producing the income were performed not by the partnership, but by the individuals involved. Hence, the income had to be reported by those individuals. Neither