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A BRIEF LOOK AT THE ADVANTAGES
AND DISADVANTAGES OF PROFESSIONAL
INCORPORATION
M. H. Weinberg* INTRODUCTION Corporations are rapidly becoming a more popular organizational vehicle for medical, dental, veterinary, and legal group practices. Even though a large majority of professionals continue to operate in partnership form, the trend seems to indicate a definite surge toward incorporation. Obviously, the prudent practitioner should study the advantages and disadvantages of incorporation, so as to avail him- self of the most advantageous mode of business operation. The corporate form of organization has become more^ prevalent for two basic reasons. First, the number of states permitting the in- corporation of^ professional practices^ has^ increased^ dramatically^ in the last three years. In fact, with the passage of a Professional Serv- ice Corporation Act by Wyoming,' all^ fifty^ states^ now^ have^ on^ their books authority for professional persons^ to^ incorporate. Secondly, the Internal Revenue Service (Service) originally challenged professional corporations on the basis that they did not represent valid corporate entities. Taxpayers, however, were con- sistently successful in appealing such cases, and, as a result, the Service announced in August, 1969, that professional corporations would be recognized as^ valid^ entities^ for^ income^ tax^ purposes.^4 Fol- lowing this, in March of 1970, the Service issued a published rev- enue ruling which enumerated the states where professional cor- poration laws were acceptable., Eight revenue rulings followed, approving corporate status for associations, limited partnerships,
- B.A., Creighton University; J.D., Creighton University School of Law; B.S., Creighton University; LL.M., New York University. Lecturer^ in^ Law,^ Creighton^ Uni- versity School of Law; Professor, Business Law and Professional Corporations, Uni- versity of Nebraska at Omaha. Former Auditor and Attorney for the Internal Revenue Service. Member of the Omaha, Nebraska and American Bar Associations.
- WYo. STAT. ANN. § 34. 2. See e.g. NEB. REV. STAT. §§ 21-2201 to 21-2222 (Reissue 1970), as amended NEB. REV. STAT. Hi 21-2216, 21-2217 (Supp. 1971).
- Morrissey v. Comm'r, 296 U.S. 344 (1935) ; Kurzner v. U.S., 413 F.2d 97 (5th Cir. 1969) ; O'Neill v. U.S., 410 F.2d 888 (6th Cir.^ 1969)^ ;^ U.S.^ v.^ Empey,^406 F.2d^157 (10th Cir. 1969); U.S. v. Kintner, 216 F.2d 418 (9th^ Cir.^ 1954);^ Smith^ v.^ U.S., 301 F. Supp.^1016 (S.D.^ Fla.^ 1969)^ ; Van^ Epps^ v.^ U.S.,^301 F.^ Supp.^256 (D.^ Ariz.^ 1969)^ ; Williams v. U.S., 300 F. Supp. 928 (D.^ Minn.^ 1969);^ Cochrah^ v.^ U.S.,^299 F.^ Supp. 1113 (D. Ariz. 1969); Foreman v. U.S., 232 F. Supp. 134 (S.D. Fla^ 1964)^ ;^ Gait^ v.^ U.S., 175 F. Supp. 360 (N.D. Tex. 1959).
- Technical Information Release, 1019, August^ 8,^ 1969. 5. Rev. Rul. 101, 1970-1 CUM. BULL. 278.
CREIGHTON LAW REVIEW
and business trusts.'
Although the Service conceded the prime issue of professional
corporations, it did reserve the right to^ challenge^ them^ under^ special
circumstances, such as in the case of Jerome J. Roubik.^7 In^ that^ case,
the parties continued to operate their business as they had^ before
incorporation, using separate offices across town, distinct account-
ing records and separate staffs. The decision by the Tax Court up-
held the Commissioner's contention that the incorporation was^ a
mere sham, having no business purpose. This case has been fol-
lowed in Jack E. Morrison, 8 and thus it is imperative that, should in-
corporation be deemed advantageous,^ the form,^ as^ well^ as^ the^ sub-
stance, must be adopted.
Bearing in mind that professional corporations are^ now^ allowed
by the states and recognized by the Service, the professional is faced
with the problem of determining the best form of organization in
which to practice. In making this decision, the practitioner and^ his
advisors must consider not only the tax consequences of incorpora-
tion, but also the business and client-related implications thereof.
NON-TAX ADVANTAGES
The corporate form provides for a continuity of life that is not
available in partnerships, which usually must terminate when a
partner withdraws or dies. Also, stock in a^ corporation^ is^ readily
transferable, whereas a partnership interest can be transferred
only with the permission of one's fellow partners. Further, a cor-
poration is the only business form which allows^ centralized,^ pro-
fessional management, separate and^ apart^ from^ the^ shareholders.
In addition, a corporation provides tax certainty in its operation, as
the statutes on corporations are definite and certain. The^ profes-
sional corporation also provides limited liability^ as^ regards^ contract
obligations and personal injury not^ connected^ to^ professional^ serv-
ice.^8 In a partnership, however, every partner^ is^ jointly^ and^ severally
liable for a personal injury judgment against either a partner or an
associate. Furthermore, this^ liability^ is^ not^ limited^ to^ his^ partner-
ship interest,^ but^ extends^ to^ all^ his^ non-exempt^ assets."'
- Rev. Rul. 72-121, 1972 INT. REV. BULL. No. 11, at 18 (business trust) ; Rev. RuL 72-120, 1972 INT.^ REV.^ BULL.^ No.^11 at^17 (business^ trust)^ ;^ Rev.^ Rul.^ 72-75,^ INT.^ REV. BULL. No. 8 at 10 (business trust) ; Rev.^ Rul.^ 574,^ 1971-2^ CUM.^ BULL.^^432 (associations)^ ; Rev. 434, 1971-2 CuM. BULL. 430 (limited partnerships) ;^ Rev.^ Rul.^ 277,^ 71-1^ CUM.^ BULL. 422 (association) ; Rev. RuL 629, 1970-2 CuM. BULL.^228 (association.)
- 53 T.C. 365 (1969).
- 54 T.C. 758 (1970). 9. See e.g. NEB. REV. STAT. § 21-2210 (Reissue of 1970). 10. J. A. CRANE & A. R. BROMBERc., Law o1 Partnership, §^^64 (1968).
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CAPITAL ACCUMULATION COMPARISON
OBJECTIVE: (^) To accumulate $16,000 for the purchase of capital equipment by four professionals. Corporation Entity (^) Partnership $300,000 (^) Total Group Billings $300, Less ($100,000) General Overhead (^) ($100,000)
($178,892) Principals' Salaries ( 0)
$ 21,108 (^) Profit 0
4,644) Federal Income Tax ( 0)
$ (^) 16,464 Retained Capital * ***** * Distributable (^) $200,
Individual $ 44,723 Salary *** Distributable (^) $ 50, Less
($ 11,239)* Federal Income Tax ($ 13,712)*
0) Capital Contribution ($ 4,000)
Individual savings: $1,196 (^) ($33,484 - $32,288) X 4 Associates Total group savings: (^) $4,
*Illustrations (^) throughout assume five exemptions and $3,600 of
itemized deductions.
The corporation may thus be a vehicle (^) to aid the individual pro- fessional in lessening his tax burden. It is elementary (^) that the first $25,000 of corporate income (^) is subject to a very low 22 percent tax rate, though income earned by the corporation (^) over $25,000 is taxed at 48 percent. "^ Therefore, if a physician is in the (^) 50% bracket, it is far better to have the first $25,000 (^) taxed at the 22% level, since 78o on the dollar can then be reinvested, (^) as opposed to 50o otherwise.
15. INT. REV. CODE of 1954, § 11.
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PROFESSIONAL INCORPORATION
CURRENT EXPENSE COMPARISON
OBJECTIVE: To pay premiums in the amount of $1,450 and $450 for health and term life insurance respectively, for four professionals.
Corporation Entity Partnership
$300,000 Total Group Billings $300, Less ($100,000) General Overhead ($100,000)
5,800) Health Insurance ( 0)
1,800) Term Insurance ( 0)
($192,400) Principals' Salaries ( 0)
0 Profit * ***** * Distributable $200, 0 Federal Income Tax 0
Individual $ 48,100 Salary *** Distributable $ 50, Less ($ 12,800) Federal^ Income^ Tax^ ($^ 13,712)
0) Health Insurance ( 1,450)
0) Term Insurance ( 450)
$ 35,300 Spendible Income $ 34,
Individual savings: $ 912 ($35,300 - $34,388) X 4 Associates Total group savings: $3,
The total yearly savings in example 2 are further enhanced when one realizes that the proceeds of the group term life insurance are not subject to income tax on the death of the shareholder-em- ployee,'" nor to estate tax if the incidents of ownership are assigned at least three years before death.,, The Service has recognized such an assignment to be effective for the purpose of avoiding estate tax on group term life insurance.' 8 Also, under such insurance plans, the payments by the corporation of policy premiums are treated as corporate deductions,'" without any compensation being recognized by the employee.2 In effect, then, medical and life insurance ex- penses will be paid with pre-tax, as opposed to post-tax dollars.
16. Id. § 101. 17. Id. §§ 2042 and 2035. 18. Rev. Rul. 72-307, 1972 INT. REV. BULL, No. 25 at 9. 19. Note 12 supra.
- INT. REV. CODE of 1954, § 106.
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PROFESSIONAL INCORPORATION
Operating as a partnership, (^) the professional partners have only limited opportunities (^) to defer taxable income, to be compared shortly. Concededly, such (^) deferral can be extremely advantageous for an individual (^) who is nearing retirement, and who can foresee years in which his (^) taxable income will substantially decline. Be- cause of the graduated tax rate schedule it (^) is always preferable, if possible, to defer the recognition of salary income (^) until after re- tirement, when earnings are naturally reduced.
KEOGH PLANS V. (^) CORPORATE PLANS Attention will now be directed toward comparing (^) the allowable partnership plans with (^) the similar corporate endeavors. However, only a broad overview is permitted (^) due to the many nuances in- volved.", On October 10, 1962, President Kennedy signed (^) into law the Self- Employed (^) Individuals Tax Retirement Act of 1962. The Act permits employers (^) to establish retirement benefits for their employees by instigating annuity, profit sharing or pension plans."7 (^) Further, it in- cludes the self-employed taxpayer (^) within the term "employee," by acknowledging that realistically he is both the employer (^) and the employee. As a general rule, (^) however, these HR-10 (Keogh) Plans are much less attractive than qualified corporate plans. (^) And, even if the President's proposal allowing increased contributions (^) of $7,500, or 15 percent of earned income, were passed into law, the allowance would still not be as high as the deduction permitted (^) under a cor- porate combination of plans, which can go as high as (^30) percent of an individual's annual salary.8 For (^) a lawyer earning $60,000, this represents an additional accumulation of $9,000 a year. $9,000 (^) per year for thirty years could provide, at five percent simple interest, a distribution of well over one-half million dollars. Some additional comparisons are: (1) Under a corporate (^) profit sharing plan a contribution equal to 15 percent of employee compensation can be (^) made. Were the cor- poration to establish a pension plan (^) in addition to a profit sharing plan, a maximum (^) of 25 percent of an employee's compensation may be contributed to his account. If a pension plan alone isused, (^) the
26. For a more extensive (^) discussion of H.R. 10 plans see FISCHER, H.R. 10 Plans and Problems, 14th Ann. Wm. and (^) Mary Tax Conf. 29 (1968). 27. For a discussion of the elementary principles of the Act see Comment, (^) Self- Employed Individuals Tax Retirement (^) Act of 1962, §§ 1-8, 76 Stat. 809 - Tax Deduc- tions for Contributions to Pension Plans, Problems and Proposed Solutions, 58 Nw. (^) U. L. REV. 426 (1963). 28. INT. REV. CODE of 1954, § 404(a) (7).
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only limited percentage is determined by sound actuarial pension
calculations."
(2) The Keogh Plan has no provision for a deduction carryover
for excess contributions. Thus any excess contribtion would be
denied a present and a future deduction. However, a corporate
plan may carry over the deduction to a future year." The advantage
of an excess contribution carryover lies in the full deduction avail-
able in later years, while one receives tax-free income in the interim.
The excess contribution becomes, in effect, a tax shelter.
(3) Contributions for proprietors and partners can not be at a
higher percentage of earned income than that contributed for other
employees under the Keogh Plan. However, under a corporate
plan, where integration with Social Security is more freely allowed,
greater contributions can be made for higher-paid employees pro-
vided certain rather generous limits are adhered to.
(4) Under the Keogh Plan, withdrawals by proprietors or partners
are entitled to a five-year income averaging provision, but a seven-
year averaging provision is available for qualified corporate
plans.
(5) Under the Keogh Plan, death benefits in respect of a pro-
prietor or partner are not entitled to the $5,000 death benefit ex-
clusion from income tax, mentioned earlier."
(6) A further drawback in a Keogh-type plan becomes readily
apparent when one notices that every dollar placed into the Plan is
subject to federal estate tax, even if the payment goes to a bene-
ficiary other than the estate of the decedent.,, The estate tax on an
accumulation of $250,000 is of course quite large. There is, like-
wise, no gift tax exemption with respect to the account of a pro-
prietor or partner.,, This fact could have a significant effect on the
estate of an older partner, or even a younger partner viewing his
lifetime accumulations as being subject to the federal estate tax.
(7) The disability pay exclusion observed under example 2 is also
not applicable to distributions under the Keogh Plan." Obviously,
income tax liability piled on top of illness, injury, or disability may
be economically disastrous.
(8) Contributions under the Keogh Plan cannot be used in com-
puting net^ operating^ loss^ for^ income^ tax^ purposes.
7
29. Treas. Reg. § 1.404(a) **(6) (A) (3).
- INT.** REV. CODE of 1954, § 404(d). 31. Treas. Reg. § 1.401(11) (d) as qualified by § 1.401(10) (a). 32. INT. REV. CODE of 1954 §§ 72(n) (2) and 72(n) (4). 33. Id. § 101(b) (3).
- Id. § 2039(c). 35. Id. § 2517(b). 36. Id. § 105(g).
- Id. § 172(d) (4) (D.).
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in the clinic is not entitled to a disability payment for his partial
disability. Oftentimes, corporate profit-sharing plans provide for
withdrawals for college education of children, building or pur-
chasing of homes, as well as medical emergencies.
(16) The Keogh Plan must cover all full-time employees with at
least three years' service."^6 There is generally no integration with
Social Security under a Keogh Plan. Further, the amounts set aside
for other employees must vest immediately.,' A corporate plan has
greater flexibility in determining eligibility for participation, allows
integration with Social Security so as to permit higher-earning em-
ployees to receive a proportionately greater contribution, and lastly,
provides vesting schedules so that if a man leaves or terminates
early, only "X" percent of his contribution goes with him - the
rest goes either to reduce next year's pension contribution, or to
the other plan members to share proportionately.
(17) Under a Keogh Plan, integration with Social Security is not
permitted if more than one-third of the deductible contributions are
for owner-employees.
(18) If the Keogh Plan is a profit-sharing plan, it must have a
formula, although it may be flexibly designed, for contributions
on behalf of non-owner employees." A corporate profit-sharing plan
is much more flexible in that the Board of Directors could determine
a percent of contribution at the end of the corporation's tax year.
As long as contributions are made for the owner-employee in a
Keogh Plan, contributions must be made for other employees, even
those employees beyond normal retirement age. "
(19) The limitations on (after tax) voluntary contributions by
owner-employees are much stricter than in corporate plans. If the
Keogh Plan covers only owner-employees, no voluntary contribu-
tions can be made. 5 If the Keogh Plan covers both an owner-em-
ployee and other employees, voluntary contributions can be made
on a comparable basis up to 10 percent of compensation, or $2,500,
whichever is less.,-
(20) The trustee of a Keogh Plan must be a bank, unless the bene-
fits are funded solely by insurance or U. S. Government bonds."s
- Id. § 401(d) (3).
- Id. § 401(d) (2) (A).
- Id. § 401(d) (6) (A).
- Id. § 401(d) (2) (B) ; Rev. Rul. 115, 1968-1 CuM. BULL. 166. 50. Rev. Rul. 243, 1965-2 CUM. BULL. **139.
- TNT.** REV. CODE of 1954, § 4 0^ 1(e) (1) (A). 52. Id. § 401(e) (1) (B) (iii). 53. Id. §§ 401(d) (1) and 405(a) (1). However, "a person (including the employer) other than a bank may be granted, under the trust instrument, the power to control the investment of the trust funds. .. ."
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PROFESSIONAL INCORPORATION
(21) Insurance loans and assignments, or pledges by an owner-
employee, are treated as distributions subject to penalties51 The
plan itself may be disqualified if there is a prohibited transaction,
such as a loan to owner-employees, their families, or members of
the controlling group.^55 Many corporate plans provide for loans.
(22) If a lawyer contributed property, rather than cash, to a
Keogh Plan, the Plan could be disqualified because such a con-
tribution was a prohibited transaction.,
(23) The picture becomes even gloomier when one reads Revenue
Ruling 72-98, which holds that a Keogh Profit-Sharing Plan will not
qualify after March 5, 1972, if it permits owner-employees who
have not attained age 59 1/2, or become disabled, to withdraw their
voluntary contributions on any anniversary date of the plan. If a
prototype or master Keogh Plan is used, the date is extended to
March 5, 1973.
In this author's opinion, it is difficult to see how increasing the
deductible contribution rates under a Keogh Plan will ever fully
equalize the disparity between corporate and Keogh Plans. The
march toward professional service corporations will therefore
probably continue, for the possibility of both tax and procedural
benefits will remain very desirable.
DISADVANTAGES
So far we have discussed merely the pros of incorporation. A cor-
poration, and especially a professional corporation, does have many
undesirable features. Naturally, the ultimate choice as to whether or
not to incorporate depends upon whether the advantages outweigh
these disadvantages: whether the potential benefit is worth the
risk. This article will now attempt to enumerate these difficulties
and then suggest alternatives to minimize the risks.
INITIAL TRANSFER PROBLEMS
Some specialists suggest that in order to insure a tax-free incor-
poration, the partnership must be dissolved - only the assets are
transferred to the corporation, rather than transferring the total
partnership interest per se. However, according to Revenue Ruling
70-239, it makes no difference, for the partnership will be considered
to have transferred the assets regardless of the form actually em-
ployed.5 One must be wary, then, of the situation where, upon in-
- Id. §§ 72(M) (4) and 72(M) (5). 55. Id. § 503(g) (1) (A). 56. Id. § 5 0^ 3(g) (1) (D).
- Rev. Rul. 72-98, 1972 INT. REV. BULL. No. 10 at 7. 58. Rev. Rul. 239, 70-1 CuM. BULL. 74.
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PROFESSIONAL INCORPORATION
corporation has not been looked upon with complete disfavor. In
Revenue Ruling 72-4, for example, a pension plan for a sole em-
ployer-shareholder was upheld as not being discriminatory, subject
to the finding that there was a true corporation - not a sham as in
Roubik.^64 However,^ the^ Tax^ Court^ has^ disapproved^ medical^ re-
imbursement plans for one-man professional corporations."
KEOGH TRANSFER PROBLEMS
Large clinics, upon seeing the pitfalls of the Keogh Plan in recent
years, have been incorporating. When these clinics incorporate they
can either (1) terminate the old plan, (2) transfer the assets from
the Keogh Plan over to the corporate plan, or (3) "freeze" the
Keogh Plan and start a separate and distinct corporate plan. Any
termination of a Keogh Plan is unfortunately a premature distribu-
tion subject to tax. Obviously, this is disadvantageous.
If one merely transfers the assets from the Keogh Plan to a cor-
porate plan, the Keogh Plan accounts must be "walled off," and
they must still remain subject to the Keogh rules. "^ There will be no
premature distribution provided the assets are transferred intact.^67
But if the assets are converted to cash and then transferred, there
will be a premature taxable distribution. "
To my mind, alternative two, which walls off the Keogh assets,
is too costly, because a tailor-made plan must be set up. The best
alternative is approved in Revenue Ruling 69-157, where the Treas-
ury allowed the clinic to "freeze" the plan, and start a wholly
separate corporate^ plan.
TAx AVOIDANCE PROBLEMS
Section 269 of the Code provides, in effect, that if any person or
persons acquire control of a corporation, and the principal purpose
for such acquisition was the evasion or avoidance of federal in-
come tax, such as by securing the benefit of a deduction, credit, or
other allowance, then the Commissioner may disallow such deduc-
tion, credit, or other allowance. No case, however, has held that in-
corporation to obtain deductions for contributions to qualified fringe
benefit plans is within the ambit of Code section 269. In fact, in
Kurzner v. United States,' the court noted:
64. Rev. Rul. 72-4, INT. REV. BULL. No. 2 at 15.
65. E. D. Smithback, 38 P-H TAX CT. MEM. 69,136 (1969). 66. Rev. Rul. 541, 1971-2 CUM. BULL. 209. 67. Rev. Rul. 160, 1968-1 CuM. BULL. 167. 68. Rev. Rul. 254, 1969-1 CU'M. BULL. 129. 69. Rev. Rul. 157, 1969-1 CUM. BULL. 115. 70. 413 F.2d 97 (5th Cir. 1969).
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It may also be observed that the desire for pension and profit-
sharing plans is not purely a tax motive; insofar as the desire
is for economically feasible retirement and work-incentive
plans, it is clearly a non-tax motive. However, it is appropri-
ate to note that we intimate no view whatever as to the effect
of section 269 of the Internal Revenue Code of 1954 in regard
to professional service corporations."
"Business purpose" nevertheless can be found in a desire for cen-
tralized management -^ and limited liability.':
In this regard, Code section 482 enables the Commissioner to
distribute, apportion or allocate gross income, deductions, credits
or allowances between or among commonly controlled organizations
if necessary to prevent evasion of taxes or to clearly reflect the in-
come of such organizations. The effect of this section in the profes-
sional corporation context could be to reduce corporate income, by
imputing it to the former partnership and thereby lowering the
salaries of shareholder-employees and contributions to qualified
plans. Or, in the case of incorporation, receivables may have been
diverted from the partner to the corporation, and the government
may feel that these receipts should be taxed to the partners, and
not to the corporation. The analysis and illustration of Code section
482 and related problems can best be visualized in the instance of
a transfer of accounts receivable.
The Treasury can level three attacks upon the propriety of trans-
ferring accounts receivable to a corporation:
(1) The transfer is in reality an assignment of income from the
one who earned the income to a corporate entity who did not. The
resultant distortion of income is to be avoided at all costs.
(2) The corporation has not clearly reflected income under Treas-
ury Regulation 1.446-1 (a) (1) when it includes taxable receipts of the
partners.
(3) Under Code section 482, there is a distortion of income be-
tween two taxable entities caused by the transfer.
Note that until a few years ago, some cases have held that a
transfer of accounts receivable as a portion of the entire business
under Code section 351 (tax-free incorporation) would result in no
tax on the transfer of such accounts.. The receivables, however,
would have a zero basis in the hands of the corporation.,,
- Id. at 101. 72. 410 F.2d 888, 898 (6th Cir. 1969). 73. Holder v. U. S., 289 F. Supp. 160, 164 (N.D. Ga. 1968), ali'd per curiam, 412 F.2d 1189 (5th Cir. 1969).
- Birren v. Cornm'r, 116 F.2d 718 (7th Cir. 1940) ; Ezo Products Co., 37 T.C. 385 (1961) ; Pat!] H. Travis, 47 T.C. 502 (1967).
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CREIGHTON LAW REVIEW
incorporation of a fiscal year partnership, since a bunching of^ in- come problem will generally result.
Example: A partnership with a January 31, 1972, fiscal year in- corporates effective February 1, 1972. The distributive share of the partnership's 12 months' income (February 1, 1971 -^ January^ 31,
- will be included in the partner's 1972 calendar^ tax^ year.^ The partners, however, will also be receiving^ a^ salary^ for^ eleven^ months in 1972 from the corporation, and^ if^ the^ salary^ is^ equal,^ or^ nearly equal, to that which would have^ been^ his^ distributive^ share^ of^ part- nership profits, the result is inclusion of 23 months' income in one calendar year. Unfortunately, there is no ideal solution which will cure the problem; there are merely alternative means,^ each^ of^ which^ has its own drawbacks.^
(^87)
The alternative^ solutions^ are^ as^ follows: (1) Payment of reduced salaries for the first year of corporate existence. (2) Continuation of the partnership after incorporation plus pay- ment of low salaries. (3) Subchapter S^ election. There are many ways to pay reduced salaries. Some methods are: (1) Quarterly payment of salaries on the first day of the next succeeding quarter. (2) Payment of salaries once a year. (3) Spreading payment^ of^ salaries^ accrued^ in^ the^ first^ year^ over a period of several succeeding years. In regard to the second alternative, if the partnership were^ to retain the accounts receivable of the partnership, and^ the^ corpora- tion paid low salaries in the year of incorporation, the problem would be mitigated, since only the receivables actually collected, in addition to the smaller salary, would be income to^ the^ former partners. On the other hand, if one set up a Subchapter S corporation by electing a fiscal year which corresponds with that^ of^ the^ predecessor partnership's fiscal year, the bunching problem may be mitigated by paying low salaries and distributing^ all,^ or^ nearly^ all,^ of^ the^ cor- poration's income at the close of its taxable year. The Subchapter S election is perhaps the poorest alternative of the three because of the limitations on qualified pension and profit-sharing plans in- troduced by the Tax Reform Act of 1969.
- Lipoff, Organizing a^ Professional^ Service^ Corporation,^^28 N.Y.U.^ INST.^ ON^ FED. TAX. 1223, 1239-1240 (1970).
- INT. REV.^ CODE^ of^ 1954,^ §^ 1379.
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PROFESSIONAL INCORPORATION
All solutions (^) to the bunching problem have one thing in com- mon - low salaries. The individual would have little cash flow in the year of incorporation, and this would entail borrowing or living on one's savings. If the older professional has sufficient liquid sav- ings he is capable (^) of meeting this handicap. Since the salary will be eventually paid, he loses nothing except the return on his liquid investments which he must now use.
The younger professional is in a tougher situation. For example, the younger physician, already in debt, and just beginning to taste the good life after suffering through residency, internship, and medical school, either cannot borrow or does not desire to. He must, however, take part in the incorporation. While he can take greater advantage of income averaging generally, he must still borrow, knowing that eventually the same total salary will be paid to him. The low salary received in the first year of incorporation can be made more attractive by bonuses and/or a higher salary (^) in the following year. Other inducements might also be employed. Perhaps the other physicians can become accommodation endorsers at a local bank. Perchance an agreement for time payment of the tax liability can be
reached with^ the^ collection^ division^ of^ the^ Service.^ Perhaps^ a^ loan could be arranged from a pension or profit-sharing plan. Each situa- tion facing a young physician requires careful analysis. In the long run, the receivables earned will produce the same amount (^) of in- come, and, (^) the loan can be paid off. The yearly tax disadvantage caused by bunching of income in many cases (^) can be overcome by the yearly tax advantage gained through the tax shelters the cor- poration provides, such as (^) pensions, profit-sharing plans, sick pay, and group-term life insurance. But perhaps a feasibility study should simply be performed to determine whether the corporation is really advantageous or not for each man desiring to take part.
COMPENSATION PROBLEMS The major controversy in the professional corporation area deals with unreasonable compensation and the requirement for an automatic dividend. Until recently, most of us have assumed, under the authority of the Klamath" case, that compensation which does not exceed the amount of professional income of the practitioner before incorporation is probably safe from attack. Now, however, it seems that (^) there are two key issues that the Treasury might pursue on professional corporations:
89. Klamath Medical Service Bureau v. Comm'r, 261 F.2d 842 (9th Cir. 1958). cert. denied, 359 U.S. 966 (1959).
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PROFESSIONAL INCORPORATION
(1) Low capitalization to avoid a large dividend.
(2) Maintenance of a buy-sell agreement in the partnership and
the corporation to limit goodwill.
(3) Selection of Subchapter S status to avoid dividend treatment
if the corporation has ten or fewer shareholders. Or, in the alterna-
tive, the professional may even continue the partnership and lease
the names to the corporation at a set fee. If there are more than ten
shareholders, this approach seems best.
One additional lesson learned from the Nor-Cal Adjusters case
is that a bonus, to be deducted as salary, must not be paid from
available profits in the exact proportion of shareholdings, unless
related to performance.? A bonus can be deemed a disguised divi-
dend which would produce double taxation, once at the corporate
level as a dividend, and once at the shareholder level as ordinary
income.
MEDICAL REIMBURSEMENT PLAN PROBLEMS
We have seen that medical reimbursement plans under Code
sections 105 and 106 are deductible by the corporation and that the
recipient has no income. But, if the reimbursement is going to a
shareholder who is not an employee or to a sole shareholder-em-
ployer, then the deduction is denied. Instead, the reimbursement
is treated as a non-deductible dividend, again subject to double taxa-
tion."
This is not to say that the plan may not discriminate in favor of
employees who are also shareholdersy However, such discrimina-
tion, if not specifically provided for by the terms of the plan, may
be taken into account in determining whether the plan was "for
employees."
Payments under medical plans are not subject to the reasonable-
ness test applied to compensation under Code section 162 - because they are (^) considered business expenses deductible under Treas. Reg. I 1.162-10(a).1^9
ACCUMULATION PROBLEMS Since the Code gives a professional corporation a $100,000 leeway before finding an (^) unreasonable accumulation, and since the profes- sionals usually will want to receive as-high (^) a salary as possible,
- Id. 96. Samuel Levine, 50 T.C. 422 (1968). 97. Bogene, Inc., 37 P-H TAX CT. MEA. 68,147 (1968). 98. Larkin v. Comm'r, 394 F.2d 494 (1st Cir. (^) 1968). 99. Id.
CREIGHTON LAW^ REVIEW
capital accumulations in the corporation are^ rare.^ It is^ rather^ sur-
prising to^ find,^ however,^ that^ an^ item^ which^ might^ not^ be^ deductible for corporate income tax purposes^ may^ be^ used^ to^ reduce^ an^ un- reasonable accumulation.' ' For example, key man^ insurance^ and excess group term insurance over $50,000 may be so used^ to^ reduce an unreasonable accumulation. Some tax men suggest excess con- tributions to the qualified pension or profit-sharing plan, even though these excess contributions are non-deductible, due to the fact that unreasonable accumulation would^ thereby^ be^ reduced^ or eliminated. However, in^ Novelart^ Manufacturing^ Co.^ v.^ Commissioner,"" the court: (1) denied an income tax deduction on^ premiums^ for^ key^ man insurance;""' and (2) denied the taxpayer a specific deduction from taxable^ income to arrive at accumulated taxable income under Code section 535(b), because the Code does not specifically provide for such a deduc- tion;'" and (3) held that the^ payment^ of^ premiums^ on^ a^ sole^ or^ majority shareholder's life was not a reasonable need of the business, as re- quired in Code section 535(c), and thus the premiums could not^ be used to reduce the unreasonable^ accumulations."" The possibility still exists that pre-funding a buy-sell^ agreement may be a legitimate business need under Code section 535(c), be- cause the^ factual^ setting^ may^ so^ require.^ The^ basic^ test^ is^ whether a corporate business purpose is satisfied."" For example,^ redemp- tion or key man insurance is^ allowable^ for^ purposes^ of^ redeeming minority shares.'- The facts of each case will^ determine^ whether^ or not a business need is^ satisfied. There is an additional potential seventy^ percent^ penalty^ tax imposed on the "undistributed personal holding company income" of a professional corporation if: (1) more than^50 percent^ in^ value^ of outstanding stock^ is^ owned^ (directly^ or^ indirectly)^ by,^ or^ for,^ not more than five individuals, and (2) at^ least^^60 percent^ of^ the^ cor- poration's "adjusted ordinary gross income" for the^ taxable^ year consists of "personal holding company income.""' Such^ income^ is
100. TNT. REV. CODE of 1954 § 535(c) (1). 101. 434 F.2d 1011 (6th Cir. 1970), cert. denied, 403 U.S. 918 (1970).
- Id. at 1012. 103. Id.
- 1d. 105. Mountain State^ Steel^ Foundries^ v.^ Comm'r,^284 F.2d^737 (4th^ Cir.^ 1960).
- Mobile Stove & Pulley Mfg. Co. v. United States,^ 62-2^ U.S.T.C.^ f^9628 (S.D. Ala. **1962).
- TNT.**^ REV.^ CODE^ of^1954 §§^^541 and^ 542.
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