Klamath Medical Service Bureau v. Commissioner

Klamath Medical Service Bureau, Petitioner, v. Commissioner of Internal Revenue, Respondent Klamath Medical Service Bureau v. Commissioner Docket No. 60345 United States Tax Court 29 T.C. 339; 1957 U.S. Tax Ct. LEXIS 34; November 22, 1957, Filed *34 Decision will be entered under Rule 50. Petitioner is engaged in the business of providing medical, surgical, and hospital services upon contract. It contracts with its stockholders, who are physicians and surgeons, to render such services and to bill the petitioner therefor upon the basis of a fee schedule. During the years at issue petitioner paid such doctors in excess of the amounts so billed and sought to deduct the amounts paid as ordinary and necessary business expenses under section 23 (a) (1) (A), I. R. C. 1939. Respondent has disallowed a portion of such payments as distributions of earnings or, in the alternative, as unreasonable in amount. Held, to the extent of 100 per cent of the billings of the physicians, such payments represent compensation for services rendered and are reasonable in amount. Held, further, that such payments in excess of 100 per cent of physicians' billings are distributions of the earnings of petitioner. Richard B. Maxwell, Esq., for the petitioner. Wendell M. Basye, Esq., for the respondent. Withey, Judge. WITHEY *340 The Commissioner has determined deficiencies in income tax against petitioner in the amounts and*35 for the fiscal years as follows: Year ended June 30 Income tax deficiency [1951] $ 56,314.19 [1952] 48,644.87 [1953] 55,219.34 The sole issue for our determination is whether the Commissioner erred in disallowing as ordinary and necessary business expenses a portion of the fees of petitioner's member-stockholder physicians paid them during the years at issue. FINDINGS OF FACT. Most of the facts have been stipulated and are found accordingly. The corporation income tax returns have been filed by petitioner for the years at issue with the appropriate officer and within a lawful period at Portland, Oregon. The city of Klamath Falls lies within Klamath County in the State of Oregon near the southern border of the county. The county is approximately 20 miles wide by 90 miles long. Klamath Falls is the only municipality of any size within its boundaries. In 1939 a number of local doctors in the vicinity of Klamath Falls, feeling that under existing circumstances adequate medical, surgical, and hospital services were not being rendered the population of the county and city and some of them having contracted with various employers for medical services to be rendered their respective*36 employees, decided to pool their contract medical practice and agreed to form a corporation which would furnish adequate medical and hospital service. To that end the petitioner was incorporated under the laws of Oregon on December 16, 1939, as a hospital association, its articles stating the corporate purposes to be to carry on the business of furnishing medical, surgical, nursing, hospital, ambulance, dental, or other services necessary, contingent upon sickness or accident, and to own, lease, and operate hospitals, wards, and dressing stations, and otherwise perform and operate as a hospital association under the laws of Oregon. At that time the only hospital facilities available in Klamath County were privately owned by physicians. The articles also provided for an authorized capital stock consisting of 50 shares of common stock with a par value of $ 100 each and 50 shares *341 of preferred stock with a par value of $ 100 each, the preferred shares having a fixed dividend return of 8 per cent but no voting rights unless the petitioner became delinquent upon two semiannual dividends. Stock ownership of petitioner was limited to members in good standing of the Klamath County*37 Medical Association, and the medical and surgical services which petitioner was organized to furnish to its subscribers were to be performed by member or participating physicians (hereinafter both are sometimes referred to as staff doctors or physicians) who were its stockholders. From January 1940 to April 1943, petitioner was operated solely as a service bureau and its income was solely from premiums on the contracts for prepaid medical and surgical care. In April 1943, the petitioner purchased the Hillside Hospital and financed this purchase by a bond issue secured by a mortgage on the hospital property. All of the bonds which were issued were subscribed and paid for at par value by the member physicians and by the public. The total amount of this bond issue was $ 110,000 and the issue was retired by the end of 1953. In 1946 petitioner purchased the Klamath Valley Hospital and Valley Hotel. This purchase likewise was financed by a bond issue in the total amount of $ 200,000. Beginning in 1943 and from then throughout the taxable years here involved, the income of petitioner from premiums on its contracts was supplemented by income from operation of the two hospitals, together*38 with income from the operation of the hotel which was an annex to the Klamath Valley Hospital building. In 1950 petitioner began a complete corporate reorganization which was consummated in January 1951. Prior to the reorganization all of the stockholder members of petitioner had purchased for $ 100 one share of the common stock of petitioner which was no-par-value voting stock, except for 2 shares which had been issued to so-called participating doctors who were new to the community and "who are on a one-year probation with petitioner." Their stock was of $ 100 par value and nonvoting. After the lapse of 1 year such doctors could surrender their par-value stock for par and purchase a share of no-par-value voting stock at its then book value. During the years ended June 30, 1951, 1952, and 1953, 39 shares of common stock were held by 39 physicians who were called "member doctors." Such doctors, together with the two holding $ 100-par-value stock, constituted all of the practicing physicians within Klamath County. Subsequent to the reorganization and throughout the tax years involved, each stockholder-member doctor was required to own at least $ 1,000 worth of the bonds of petitioner. *39 The $ 100-par-value nonvoting stock issued to probationers carried with it no right to receive dividends. *342 Under petitioner's bylaws, no individual member physician could make a contract for his services with any other hospital association except that such contracts already in existence at the time of adoption of the bylaws could be performed, extended, and renewed from time to time. By virtue of the stock purchase agreement between petitioner and its member physicians, such members were entitled to sell their stock to petitioner at any time at its book value, and they obligated themselves on ceasing the practice of medicine in Klamath County and obligated their estates upon their death to sell their stock to petitioner for its book value. The stock purchase agreement also provided generally that in case any member sought to dispose of or encumber any part of his stock, he could not do so without the written consent of petitioner's board of directors or until 30 days' notice to the petitioner of his intention to sell, during which time petitioner agreed to purchase all such stockholders' stock at its book value as determined by the last regular audit of petitioner's books. *40 It further provided that in determining such book value the unpaid medical service charges on the part of petitioner's member physicians were to be valued at 100 per cent of the billings of such physicians. The petitioner from its inception maintained a schedule of rates for certain surgical and medical procedures which was altered and amended from time to time in order to more nearly bring such rates to a level with rates for the same services charged by physicians and surgeons in Klamath Falls in their private practices. The schedule was used for the purpose of differentiating between medical and surgical procedures and to insure that member physicians would receive like compensation for like services. Beginning on January 2, 1940, and throughout the tax years involved, all member and participating doctors had agreed with petitioner to furnish professional services to the subscribers of petitioner who might be accepted for treatment in accordance with the terms and limitations of the contracts between the petitioner and its subscribers. Each doctor agreed to submit to petitioner complete information on services rendered to subscribers by the 10th of the month following the performing*41 of the service. The charges to be made by each physician for services to subscribers were to be based initially on the amounts provided by the fee schedule of petitioner then in effect. Petitioner agreed to pay such percentage of each physician's base fees charged and approved during each 6-months' period, prior to June 30 and December 31 of each year, as the total net income of the petitioner for such period, less such amount as the board of directors of petitioner determined should be retained for corporate purposes, might bear to the total base fees of all of the physicians during said period. Fifty per cent of petitioner's member physicians' bills were paid monthly. For *343 some pay periods prior to the years at issue member physicians had received less than 100 per cent of their billings. How much less and for which years are not shown by the record. The total billings of the member and participating physicians of petitioner for the taxable years ended June 30, 1951, 1952, and 1953, based on the set fee schedules, amounted to $ 169,173.40, $ 165,045.15, and $ 171,544.98, respectively. Petitioner made payments to member and participating physicians in excess of the*42 billings for those taxable years. The total payments made to such doctors during those years by petitioner were $ 197,793.71, $ 190,996.17, and $ 230,449.25, respectively. Percentagewise the actual payments to physicians for the 3 taxable years involved amounted to approximately 116.9 per cent, 115.7 per cent, and 134.3 per cent of physicians' billings, respectively. The services represented by billings were rendered by the staff doctors who presented the bills. Petitioner's fee schedule for the years at issue is unreasonably low when compared to like services and procedures and the compensation charged therefor by physicians engaged in private practice. It is equitable and fair when the lessened costs to doctors rendering services, which lessened costs are attributable to petitioner's operation, are considered. The fee schedule does not provide fees which are unreasonable in amount for those years. The payments in excess of billings were made in pursuance of respective resolutions of petitioner's board of directors for each year at issue. Below are excerpts from the minutes of the meetings of the board of directors of petitioner for the years indicated, by virtue of which*43 such payments were made to staff doctors: 6/29/51 President Dr. Black explained that the purpose of the adjourned meeting was to await the conclusion of the audit in order to fix the fees for the past six-months' period, and after going over the fiscal records the following resolution was unanimously approved: Resolved, that the Bureau pay 135% of the fees of member physicians for the six-month period ending June 30, 1951 and the manager is instructed to make such payments forthwith. 6/19/52 President Dr. Black stated that the purpose of the meeting was primarily to have Mr. Zamsky review the financial status of the Bureau for the purpose of determining the six-months distribution, and after considerable explanation and discussion, it was moved by Dr. Currin, seconded by Dr. Adams, that the management be empowered to distribute fees to members which they have earned, as reflected by the Bureau's books, the exact figure to be ascertained by Rollin Rodolph. 6/23/53 President Dr. Black brought up the matter of fee distribution for the past six-months, and after a report from Mr. Zamsky as to present financial status of the Bureau, the following resolution was unanimously adopted: *44 Resolved, that the officers of the Bureau be and they are hereby directed to pay on or before June 30, 1953, 165.759% of the base fees charged by each participating physician during the period December 31, 1952, to June 30, 1953. *344 Petitioner's corporate income tax returns and its books and records upon which the same are based have been prepared and maintained on the cash basis and for the entire corporation as a business unit; however, for statistical purposes throughout the taxable years involved, it has maintained a rather elaborate cost accounting system wherein its operation has been treated as being divided into various departments or divisions so that the income and cost of operation of each might be at any time determined. One of such divisions was the "bureau division," the purpose of which was to carry on the business of contracting with employers for their employees and with individuals and families for the furnishing of medical, surgical, and hospital care for a prepaid sum which it terms "a premium." Another division is the hotel division and another the hospital division. Under its subscriber contracts, such medical, surgical, and hospital services were*45 to be furnished, except in emergency cases, by petitioner's stockholder-member physicians and the hospital services were to be furnished in and by the Hillside and Klamath Valley Hospitals. Subscribers who might suffer injury or emergency illness were to be entitled to the services of licensed doctors of medicine and to necessary hospital services from other than a staff physician of petitioner or a hospital owned by the petitioner, in which case the subscriber was bound to give proper notice to petitioner and petitioner agreed to bear the expense of such service to the extent that it did not exceed its own established rates and charges set forth in its fee schedule. On the face of petitioner's two individual coverage contracts appears the following: Witnesseth: That, subject to all terms and conditions hereinafter set forth, which are made a part of this certificate, Klamath Medical Service Bureau, sometimes hereinafter called K. M. S. B., an Oregon Corporation having offices situated at Klamath Falls, in the State of Oregon, and being licensed to conduct the business of an hospital association under the laws of the State of Oregon, hereby agrees to bear the expense of the hereinafter*46 stipulated services to the following person or persons, specified hereinafter as "member" or "members": * * * * (Member Physicians of the Klamath Medical Service Bureau have agreed to accept K. M. S. B. Fees as full payment for Services for all eligible persons or employes actually employed and receiving wages or salary and/or family whose net family income is less than $ 5,000.00 per year. When the net family income of such person or employe is in excess of $ 5,000.00 per year, the member should make his own arrangements with the doctor, in advance if possible, regarding fees for service. Benefit payments made to the member by K. M. S. B. will act as a credit to total charges. BENEFITS ARE THE SAME FOR ALL PERSONS REGARDLESS OF INCOME. CLAIMS FOR SERVICES MUST BE MADE WITHIN NINETY (90) DAYS.) KLAMATH MEDICAL SERVICE BUREAU (sgd) L. A. Brown Manager. *345 Included in the gross receipts reported on the corporate income tax returns of petitioner are the following amounts attributable to premiums received from its contracts and hospital and hotel revenues: Tax year ended June 30 [1953] Premiums from contracts $ 298,107.26 $ 286,511.13 $ 306,708.25 Hospital revenue 512,511.08 538,059.66 561,711.22 Hotel revenue 17,311.00 18,241.29 19,396.93 *47 Under petitioner's internal system of cost accounting the profits (and losses) of its divisions, after apportionment of overall costs and income taxes, for the years in question were as follows: Tax year ended June 30 Division [1953] "Bureau" (contracts) $ 14,666.79 $ 24,862.04 $ 4,446.42 Klamath Valley Hospital 25,649.27 5,840.81 34,804.89 Hillside Hospital (10,191.48) (10,690.78) (20,180.95) Valley Hotel (2,496.38) (3,963.30) (2,197.51) Total 27,628.20 16,048.77 16,872.85 Petitioner's statistical records establish that certain amounts of regular hospital charges which were attributable to member patients who were covered by contracts of petitioner were never transferred from the bureau department's bank account to the hospital department's bank account. This permitted payments to member physicians which, in the years in question, were in excess of their billings without showing a deficit to the bureau department. In its regular statistical audit, this procedure was presented in two ways, either as a decrease in both hospital departments' gross earnings or as a special allowance charged against such earnings. The amounts*48 not so transferred in the taxable years in question were as follows: Tax year ended June 30 Hospital [1953] Klamath Valley Hospital $ 48,893.42 $ 53,314.07 $ 64,061.55 Hillside Hospital 50,457.21 42,085.50 20,303.94 Total 99,350.63 95,399.57 84,365.49 The petitioner is managed by an unpaid board of directors, consisting of member doctors, and by committees, consisting of members. Only two executives, a "Bureau" manager in charge of corporate *346 and contract activities and a business manager of hospitals, receive compensation. Such compensation for business is distinguished from professional services rendered to petitioner by its member doctors and participating doctors. From the time of its incorporation petitioner has formally declared and paid but one dividend, consisting of a $ 1,000, eight per cent hospital bond of the petitioner declared and paid as of September 27, 1949. The payments to doctors and physicians performing services for petitioner are not proportionate to the equal interest in the stock of petitioner owned by its stockholders. Each of its member-stockholder doctors has a substantial private practice from which*49 he derives professional income. The book value of each share of petitioner's common stock has risen from $ 972.95 as of June 30, 1950, to $ 2,410.28 on June 30, 1953. From 1941 through the tax years involved herein, the relationship between petitioner's premium income and the total amount paid to member physicians was as follows: Premium Expenses Interdivision Total amount Year income less other expenses not paid member income paid physicians [1941] $ 44,986.17 $ 21,714.50 $ 23,079.67 [1942] 80,931.36 32,873.48 47,845.88 [1943] 116,545.33 42,873.33 72,735.01 [1944] 130,264.12 50,784.71 84,587.41 [1945] 145,481.56 55,937.12 94,809.97 [1946] 163,001.32 65,426.80 72,671.45 [1947] 218,615.33 112,427.07 138,588.82 [1948] 272,851.16 158,981.57 158,227.20 [1949] 309,396.84 148,165.93 168,744.42 [1950] 305,225.40 101,587.45 $ 54,988.21 171,275.08 [1951] 298,107.26 85,646.76 99,350.63 197,793.71 [1952] 286,511.13 70,652.92 95,399.57 190,996.17 [1953] 308,033.45 73,137.78 84,365.49 230,449.25 Total 2,679,950.43 1,020,209.42 334,103.90 1,651,804.04 One hundred per cent of the billings of staff doctors represents reasonable*50 compensation for the services for which petitioner was billed. The deficiency herein has arisen because for the taxable years ended June 30, 1951, 1952, and 1953 respondent has refused to allow as a business expense deduction respective portions of payments made by petitioner to staff physicians in the amounts of $ 73,364.35, $ 65,034.51, and $ 73,453.23. Insofar as the amounts rejected as deductions represent an excess of 100 per cent of staff doctors' billings for services, such excess is distribution of petitioner's earnings and is not compensation for services rendered. Insofar as such rejected deductions are included within 100 per cent of billings, such amounts were reasonable as compensation to staff doctors for their services. *347 OPINION. Petitioner claims section 23 (a) (1) (A) of the Internal Revenue Code of 1939 permits the deduction of the amounts here involved as ordinary and necessary business expenses. Respondent contends such amounts are in reality mere distributions of earnings to petitioner's stockholders or, in the alternative, that should such payments be held to constitute compensation for services rendered, they are in any event nondeductible because*51 they are unreasonable in amount for such services. The controversy presents primarily a question of fact. Our ultimate findings are dispositive of both contentions. We have found no decided case directly in point upon these facts. It is true that this Court has approved, as indicating payment of compensation as distinguished from distributions of earnings, instances where the method of computing compensation was agreed upon retrospectively. Streckfus Steamers, Inc., 19 T. C. 1; Glenshaw Glass Co., 13 T. C. 296; California Vegetable Concentrates, Inc., 10 T. C. 1158; Draper & Co., 5 T. C. 822; Vancoh Realty Co., 33 B. T. A. 918. However, as indicated by those cases, such arrangements, as is the case here, must be given close scrutiny in order to insure that earnings are not distributed under the guise of compensation for services rendered. That the payments here in controversy may have been in amounts which were reasonable is not dispositive of respondent's primary contention for, even though reasonable, unless such payments *52 were compensation for services and not distributions of earnings, they would not be deductible as compensation for services. We think it must be concluded from this record that, with respect to that portion of the payments here involved which exceeds 100 per cent of the billings of petitioner's staff doctors, such payments were distributions of petitioner's profits and earnings. We are led to this conclusion because of the contract under which petitioner was bound to pay its member doctors for their services rendered. That instrument is ambiguous with respect to the compensation for such services. It does not specifically provide for the payment of over 100 per cent of the billings for such services but does provide specifically that the billings be in accordance with its fee schedule. It also provides specifically that staff physicians will furnish professional services to petitioner's subscribers in accordance with the terms and limitations of the contract between petitioner and such subscribers. It is also noted therein that the individual member physician has read such contracts. We assume therefrom that he was fully aware of the terms thereof when executing his employment*53 contract with petitioner. Two of the contracts by which petitioner sells its services to subscribers provide on their face that petitioner's member physicians accept petitioner's fees as payment in full for services to persons or employees or their families whose net *348 income is less than $ 5,000 per year. It is provided further that, when the family income is in excess of $ 5,000 per year, the subscriber must make his own arrangements with the physician regarding fees in which event "[benefit] payments made to the member by K. M. S. B. [petitioner] will act as a credit to total charges." It seems clear from this that petitioner has contracted with its member physicians that they will render their services to petitioner for fees equal to its fee schedule regardless of the fact that such fees may be in some instances below reasonable compensation therefor. This is not unrealistic when it is considered that staff doctors do not bear certain office administrative expense in their rendition of services to petitioner's subscribers which would be borne by them with respect to private patients. One hundred per cent of the billings of staff doctors for services rendered constitute*54 the total expense for such services for which petitioner is liable under its employment contract. There is no express contract requirement that they be paid in excess of 100 per cent of billings for their services. That petitioner intended to distribute earnings under the guise of payment for services rendered seems clear to us in the light of the testimony of the president of petitioner's board of directors during the years at issue. He testified relating to the computation of payments to be made to petitioner's member physicians as follows: Q. Doctor, you testified as to the methods of arriving at the proportion of billed amounts, and you testified that in some cases that proportion was less than 100 per cent and upon occasion it was more than 100 per cent. Now, how was it determined how much more than 100 per cent was to be paid? A. Well, as I described our method, each month we paid the doctors' billings which are based on this fee schedule, yardstick, or whatever you want to call it, and we paid 50 per cent of the billings. Then we hold in reserve and at the end of the six month period, after we meet our obligations, business-wise, for all of our expenses, we're obligated*55 to accept on a proportionate basis what is there. Q. You mean, in other words, that everything over expenses is distributed for the payment of the remaining 50 per cent of the billings? A. No, that isn't exactly correct.Q. What is correct? A. Well, we retire our obligations. We improve our hospitals. We get new equipment in and see if we can do a better job in practice, and we set aside something in anticipation of such things as, you might call it a medical catastrophe, an epidemic, and then we take our proportionate basis of what is left, whether it be 80, 100 or perhaps somewhat more. Q. I see. In other words, the entire remainder amount is distributed upon the remaining unpaid billings -- A. Yes. Q. -- over and above the expenses you have named? A. Yes. It seems clear from this testimony that under its contract with member physicians petitioner intended that all of its earnings in *349 excess of amounts necessary for its operation, planned expansion, and reserves were to be distributed to its member-stockholder physicians. Viewed in that light the contract provides not only a method of computation for services rendered but also a method for distribution of its profits*56 to its stockholders. We are convinced from this record that petitioner, after attaining its objective of providing adequate medical, surgical, and hospital facilities for the people of Klamath County, fully intended its earnings and profits should be distributed to its stockholders and that the method of doing so, was that with which we are here concerned. We are strengthened in this conviction by the fact that in determining the book value of its stock for purposes of transferring shares thereof only 100 per cent of staff doctors' billings is to be treated as accounts payable by petitioner. Nothing in the record leads us to believe that payments to staff doctors in excess of 100 per cent of their billings are authorized by the employment contracts either as compensation for other periods when payments were less than 100 per cent of billings or that the contracts authorize such excess payments to be made for services under any circumstance. Respondent has rejected as a deduction more than the excess of payments to physicians over 100 per cent of billings. Why he has done so is not clear from his notice of deficiency or the pleadings. On brief, however, he contends that the*57 portion of the deductions which he has disallowed has close relationship to the amounts shown by petitioner's internal bookkeeping to have been owed by its contract division to the hospital division but retained and not paid by the former; that this fact tends to characterize those unpaid amounts as distribution of hospital profits which latter division was not obligated to pay staff doctors because they had rendered no services to it. We are unable to agree that the amounts "retained" by the contract division have the claimed relationship to the disallowed portion of proposed deductions. They are not the same and the variation is considerable. Nor are we able to agree that the hospital division was under no obligation to pay for staff doctors' services. As an integral part of the corporate entity which is petitioner, it was as surely obligated to do so as any other so-called division of petitioner. Surely nothing in petitioner's articles or bylaws provides otherwise. It is not true either that the doctors did not render services to the hospitals. In a very real sense, but for the services they rendered to hospital patients, there would have been little, if any, hospital income. *58 It is reasonable to conclude petitioner would otherwise have been unable to utilize hospital facilities and would not have acquired them. Even though we have found the amount of payments equal to 100 per cent of billings to be compensation for services, to the extent *350 they might be unreasonable they would not be deductible as such. See Miller Mfg. Co. v. Commissioner, (C. A. 4) 149 F. 2d 421. Respondent relies heavily for support of his position that they are unreasonable upon the existence in Oregon of a Statewide organization of like character with petitioner and the fact that, although petitioner's last revision of its fee schedule was largely in line with that organization's fee schedule, to some extent it provided higher compensation for listed services. We agree that this evidence is worthy of consideration upon this issue, but do not find it to be conclusive in this case. Three physicians in good standing and reputation, two member stockholders of petitioner and one who was not related to petitioner in any way, testified that even the payments here involved in excess of 100 per cent of billings were below those to be expected *59 in the private practice of medicine and surgery. We do not find this fact to be controlling here, but must give it some weight. The physicians did however testify in effect, two of them expressly, that such payments were unreasonably low for the services rendered even when the advantages of petitioner's bearing a portion of the costs which private practitioners would otherwise be forced to defray were taken into consideration. This testimony remains uncontradicted upon the record and we see no reason to give it less than its full weight. There is ample evidence that the services billed for were rendered and respondent does not claim to the contrary. We have therefore found as a fact that, to the extent of 100 per cent of the billings of staff doctors, payments to them by petitioner during the years at issue are reasonable in amount and are properly deductible as a business expense. Decision will be entered under Rule 50.