Comparison of Keogh Plans and Corporations: Tax Advantages for Professionals, Lecture notes of Law

Download Comparison of Keogh Plans and Corporations: Tax Advantages for Professionals and more Lecture notes Law in PDF only on Docsity! 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.2 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. 1. 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). 3. 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). 4. 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."' 6. 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.) 7. 53 T.C. 365 (1969). 8. 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). (Vol. 6 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 $300,000 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 $200,000 0 Federal Income Tax 0 Individual $ 48,100 Salary *** Distributable $ 50,000 Less ($ 12,800) Federal Income Tax ($ 13,712) 0) Health Insurance ( 1,450) 0) Term Insurance ( 450) $ 35,300 Spendible Income $ 34,388 Individual savings: $ 912 ($35,300 - $34,388) X 4 Associates Total group savings: $3,648 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. 20. INT. REV. CODE of 1954, § 106. 1972) CREIGHTON LAW REVIEW Finally, a widow could receive a $5,000 tax-free death benefit from the corporation,! ' and a certain amount of disability benefits can be excluded from income tax by an employee." LONG RANGE TAX SHELTER COMPARISON OBJECTIVE: To put aside $8,000 for each associate's family security and retirement. Corporation Entity Partnership $300,000 Total Group Billings $300,000 Less ($100,000) General Overhead ($100,000) 32,000) Qualified Plan ( 0) 168,000) Principals' Salaries ( 0) 0 Profit * * * Distributable $200,000 0 Federal Income Tax 0 Individual $ 42,000 Salary *** Distributable $ 50,000 Less ($ 10,035) Federal Income Tax ($ 13,712) 0) Savings and Life Insurance ( 8,000) $ 31,965 Spendible Income $ 28,288 Individual savings: $ 3,677 ($31,965 - $28,288) X 4 Associates Total group savings: $14,708 Corporations may make temporary investments with the excess funds generated by this example. If these investments are made in dividend paying stock, the Code permits an 85 percent dividends re- ceived deduction.", Thus, the corporation is subject only to tax on 15 percent of the dividend income received, making the maximum effective rate a mere 7.2 percent. 4 An individual cannot take ad- vantage of such a dividend deduction beyond $200 on a joint return.2 5 21. Id. § 101. 22. Id. § 105. 23. Id. § 243. 24. 15%, the amount subject to tax, times 48%, the maximum corporate tax rate. 25. INT. REV. CODE of 1954, § 116. (Vol. 6 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). 1972) CREIGHTON LAW REVIEW 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.48 (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 46. Id. § 401(d) (3). 47. Id. § 401(d) (2) (A). 48. Id. § 401(d) (6) (A). 49. Id. § 401(d) (2) (B) ; Rev. Rul. 115, 1968-1 CuM. BULL. 166. 50. Rev. Rul. 243, 1965-2 CUM. BULL. 139. 51. 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 . .. ." (Vol. 6 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, 1973.11 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- 54. Id. §§ 72(M) (4) and 72(M) (5). 55. Id. § 503(g) (1) (A). 56. Id. § 5 0 3(g) (1) (D). 57. Rev. Rul. 72-98, 1972 INT. REV. BULL. No. 10 at 7. 58. Rev. Rul. 239, 70-1 CuM. BULL. 74. 1972) CREIGHTON LAW REVIEW corporation, stock is transferred to associates of the partnership, for such a transfer may be treated as an assumption of the liabilities of the old partners. 9 Also, if one transfers property subject to a depreciation recapture under Internal Revenue Code of 1954 sections 1245 or 1250, and if no "boot" is transferred, then, as a general rule, there is no recap- ture."' Boot would include cash or other property, but not the stock which the transferee receives for his property. If one has property which would create an unrealized loss when transferred, the loss cannot be recognized under Code section 351, the tax-free exchange provision. In addition, one must be careful of Code section 267, which disallows certain losses, expenses, and interest with respect to transactions between related taxpayers. If loss property is involved, one should first sell the property to an un- related taxpayer, take the loss and then transfer the proceeds. In this manner one would not only get the benefit of tax loss, but also a tax-free transfer of the proceeds under Code section 351. Another important point to remember is that if liabilities are transferred, and the liabilities exceed the basis of the remainder of the property transferred in a 351 exchange, then gain will be recognized to the extent of the difference between the liabilities assumed and the basis of the remaining property transferred.,, These "initial transfer problems" are not peculiar to professional incorporation; they extend to all incorporations regardless of size or type. Hence, if, a corporate form of existence is desired, care must be taken so that such transfers do not result in needless tax liabilities. There are still several open issues, because the Treasury has not yet published its proposed new rules to replace the old Kintner Regulations on professional associations taxed as corporations. The promised promulgations will settle many issues including, per- haps, the question of whether a professional corporation can escape tight control by incorporating under the state's general incorpora- tion statute, rather than under the special professional incorpora- tion statute."2 But one thing is clear. With the exception of the one-man pro- fessional corporation, the professional corporation has been ac- cepted per se by the Treasury. 3 But even the one-man professional 59. Treas. Reg. § 1.351(1) (b) (1). 60. INT. REV. CODE of 1954, §§ 124S(b) (3) and 1250(d) (3). 61. Id. § 357(c) (1). 62. See State Electro-Medical Institute v. Platner, 74 Neb. 23, 103 N.W. 1079 (1905) as an example of allowable incorporation under a general state statute. 63. WORTHY, I.R.S. Chief Counsel outlines what lies ahead for professional corpora- tions, 32 J. OF TAX.88 (1970). (Vol. 6 PROFESSIONAL INCORPORATION But in 1966, the Tax Court decided Peter Raich,75 wherein it was determined that the receivables were not taxable except where the adjusted basis of the property transferred is exceeded by the liabili- ties assumed." But, in Nash v. United States,77 a recent Supreme Court case, the bad debt reserves on the accounts receivable were not considered income to the transferors when transferred. Now many conservative tax practitioners feel that a transfer of accounts receivable will be initially tax-free. If the problem of a potential reallocation of income under Code section 482 arises, the Treasury will undoubtedly rely on Rooney v. United States" and Brown v. Commissioner ' to uphold the realloca- tion. The Brown case held that when an attorney assigned receiv- ables (legal fees) to a corporation which had no assets other than the transferred receivables, tax to the attorney resulted.8" There is contra authority in Thomas W. Briggs" and Arthur L. Kniffen.2 As of this date the issue is unresolved. Until this controversy under Code section 482 is resolved, it is best to obtain a Service ruling, commonly called a closing agree- ment, before a decision to incorporate is acted upon. Chief Counsel Worthy has indicated that closing agreements will be given where both accounts receivable and accounts payable have been trans- ferred.' But even if the accounts receivable will not be reallocated, one must still be careful not to incorporate where the liabilities are in excess of the basis of the property transferred.1 Finally, the warning in Robert L. McCoy"5 points to the fact that the partnership should be "cleaned up" before incorporation, by paying off all liabilities. Those accounts payable which are trans- ferred to and paid by the corporation will not be deductible by the new enterprise."" The best solution is to pay off the accounts pay- able before incorporating, or to keep enough property in the hands of the former partners to cover these payables. INCOME BUNCHING PROBLEMS The toughest problem, which as yet remains unresolved, is the 75. 46 T.C. 604 (1966). 76. The Service acquiesced in Rev. Rul. 442, 1969-2 CuM. BULL. 53. 77. 398 U. S. 1 (1970). 78. 305 F.2d 681 (9th Cir. 1962). 79. 115 F.2d 337 (2d Cir. 1940). 80. Id. at 339. 81. 25 P-H TAX CT. MEM. 56,086 (1956). 82. 39 T.C. 553 (1962). 83. Worthy, I.R.S. Chief Counsel outlines what lies ahead for professional corpora- tions, 32 J. OF TAX, 88, 90 (1970). 84. INT. REV. CODE of 1954, § 35 7(c) (1). 85. 40 P-H TAX CT. MEM. 71,034 (1971). 86. 46 T.C. 604; Velma W. Alderman, 55 T.C. 662 (1971). 1972) 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, 1972) 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. 8 7 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 1969.88 87. Lipoff, Organizing a Professional Service Corporation, 28 N.Y.U. INST. ON FED. TAX. 1223, 1239-1240 (1970). 88. INT. REV. CODE of 1954, § 1379. (Vo 1. 6 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). 1972) 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). 102. Id. at 1012. 103. Id. 104. 1d. 105. Mountain State Steel Foundries v. Comm'r, 284 F.2d 737 (4th Cir. 1960). 106. Mobile Stove & Pulley Mfg. Co. v. United States, 62-2 U.S.T.C. f 9628 (S.D. Ala. 1962). 107. TNT. REV. CODE of 1954 §§ 541 and 542. (Vol. 6 PROFESSIONAL INCORPORATION generally dividends, interest, royalties, rents and "income derived from personal service contracts.""', To constitute personal holding company income, income from personal service contracts must be: (1) derived from a "contract" under which the corporation is to furnish personal services, (2) a person other than the corporation must have the right to designate (by name or description) the in- dividual who will perform the services, and (3) the individual who performs, or who may be designated, owns, directly or indirectly, 25 percent or more in value of the outstanding stock of the corpora- tion at "some time" during the taxable year.' 9 The Committee reports recognize that: the (client's right of designation) will prevent this rule from applying in general to operating corporations engaged pri- marily in rendering personal services .... Thus corporations which let out the services of architects, engineers, and ad- vertisers would not as a general rule be required to report such income as personal holding company income.' "' (Emphasis supplied) The Service has taken the position that "contract" includes oral as well as written agreements,"' and therein might be included an agreement for professional services with one who holds a 25 percent interest in the professional association. The simplest solution lies in barring the client's right to designate who will perform the services desired. In the S. 0. Claggett, Inc." - case, the Tax Court held that the "mere expectation" that a certain person will perform services is insufficient to amount to a designation. That case in- volved a one-man corporation. Unfortunately, a case by case ap- proach is necessary to determine whether there is either a designa- tion or there exists a right to designate.1:1 Under Code section 341(a), the gain from the sale or exchange of the stock of a collapsible corporation, or a distribution in partial or complete liquidation of a collapsible corporation, will be taxed at ordinary income rates. CONCLUSION The most difficult problem in professional corporations is caused not by the law but by people. There is so much coffee-room hearsay that many professionals hear only conflicting points of view. Con- 108. Id. § 543. 109. Treas. Reg. § 1.543(1) (b) (8). 110. H.R. Rep. No. 1546. 75th Cong., 1st Sess., 5-6 (1937). 111. Rev. Rul. 299, 1969-1 CuM. BULL. 165. 112. 44 T.C. 503 (1965). 113. Rev. Rul. 172, 1959-1 CuM. BULL. 144; Kurt Frings Agency, Inc., 42 T.C. 472 (1964), afI'd per curiam, 351 F.2d 951 (9th Cir. 1965). 1972) CREIGHTON LAW REVIEW fusion abounds. The only way to settle this confusion is to do a dol- lars and cents analysis for each professional to determine the year- ly mathematical advantage of incorporation. A conference should then be scheduled with each professional to resolve his doubts and to show his gain or loss on incorporation. In that way it will be easier to dispel any doubt. If a feasibility study is made by a professional who knows the problems of other professionals, very few practices will regret their choice to incorporate. If problems do develop, they will develop be- fore incorporation, at a time when they can be resolved to the sat- isfaction o'f all parties through pre-incorporation agreements. After the feasibility study is complete, one can accurately weigh the benefits against the potential cost, and the risk inherent in a government determination that there was no professional service corporation. It is this author's belief that the benefits in most cases outweigh the cost and the risk. In short, one has everything to gain and nothing to lose. Prospects The aura of tax reform is in the air again. Surprisingly this air of reform will aid the professional corporation. As the tax shelter loopholes are closed, the efforts of most professionals to achieve tax parity wil turn more toward the professional corporation. The professional will see his corporate executive neighbor with his fringes protected by tax shelters and will desire the same advantages. One would think that President Nixon's proposal to (1) raise the Keogh deduction to 15% with a maximum of $7,500 and (2) to allow individual retirement plans with yearly contributions of up to $1,500 on top of the Keogh plan might cut down on the race to incorporate. Not so, because most knowledgeable professionals realize that every dime in the Keogh plan is subject to estate tax, while em- ployer contributions to qualified corporate plans are not subject to estate tax under Code section 2039(c). Not only will the estate tax savings attract doctors and lawyers to the professional corporation, but also the increase in net spendible income, realized when the corporation pays for such things as health insurance, educational meetings, and life insurance. This net in- crease in spendible income is welcomed by both the older and the younger professional. When the advantages of the professional corporation are further and fully explained in terms of a well-managed investment, having both tax shelter advantages and growth potential, the recruitment of younger professionals will be easier and corporate practice will grow. The march toward professional incorporation continues. (Vol. 6