UNITED STATES v. BASYE
Legal provision: Internal Revenue Code
Argument of Griswold
Chief Justice Warren E. Burger: We’ll hear arguments first this morning in number 71-1022, United States versus Basye.
Solicitor General, you may proceed whenever you’re ready.
Mr. Griswold: May it please the Court.
This is a Federal Income Tax case.
It is here on the Government’s petition to review a decision of the United States Court of Appeals for the Ninth Circuit.
The case here rises out of one of the interesting developments in modern society.
In California, there is a substantial system of both group medical insurance and group medical practice.
In this particular case, the medical insurance is provided by Kaiser Foundation Health Plan Incorporated and the medical services are provided by a partnership known as Permanente Medical Group.
The individual taxpayers before the court are members of this partnership or their spouses in cases where joint returns were filed.
The years involved are 1960 and 1961 except in one case where 1962 and 1963 are also involved.
The case was heard in a District Court on a stipulation of facts.
The basic stipulation appears at pages at 79 to 88 of the appendix.
And the texts to the stipulation are the full text of three substantial documents attached to in a part of the stipulation.
And the case turns largely on the effect of those documents and payments made pursuant to them under the Federal Tax laws.
The first of these documents is the partnership agreement of the Permanente Medical Group usually referred to in this case simply as Medical Group.
This partnership agreement appears on pages 102 through 113 of the appendix.
The next document appearing at pages 116 through 150 of the appendix is the medical service agreement being a contract entered into as of July 1, 1959 by the Kaiser Foundation Health Plan which is obligated to produce services under its contracts with its members and the Medical Group which thereby undertook the obligation to provide the services.
Under this contract, Medical Group agreed to supply health services to the members of the Health Plan and the Health Plan agreed to make payments to Medical Group.
The question and issue in this case relates to a portion of the payments and I will spell this out in detail in just a moment.
Finally, there is in the appendix at pages 159 through 199, a trust agreement establishing a retirement plan for the Permanente Medical Group.
That is the way it is entitled at the beginning, trust agreement, retirement plan for the Permanente Medical Group on page 159.
This is a typical non-vested retirement plan providing for benefits for physicians only and only to the physicians who persists in their connection with Medical Group or related groups for period stated in the trust.
Justice Potter Stewart: There are no non-medical employees than other beneficiaries?
Mr. Griswold: There are no non-medical employees in this retirement plan.
Non-medical employees were taking care off in some way, otherwise how is not -- does not appear in the appendix.
Justice Potter Stewart: Did the plan cover physicians who are not members of the partnership, but who were staff employees?
Mr. Griswold: Did that plan?
Justice Potter Stewart: Cover physicians, doctors who are not in the partnership, but who were employed by it?
Mr. Griswold: Yes.
The plan covers physicians who are employees of Permanente Medical Group as well as physician to our partners in Permanente Medical Group.
The payments involved in this case were made by Health Plan to the trust pursuant to the agreement between Health Plan and the partnership at Medical Group and let us now turn more specifically to the agreement.
I would like to call the Court’s attention to page 122 of the appendix which is in the agreement between Health Plan and Medical Group.
Section (B) (3) of the agreement, recites this.
This is near the top of page 122.
Health Plan desires to arrange by contract for all medical services in the service area required to satisfy or convenient or incidental in connection with satisfying the medical service obligations provided in membership contracts.
Medical Group agrees to provide such medical services for the consideration and subject to the terms and conditions set forth in this agreement.
Thus all of the payments provided by the agreement are expressly stated to be in consideration of the services rendered by Medical Group.
Similarly at the bottom of page 124 of the appendix, it is agreed that and I quote the last two lines on 124, “With the end of service area, Medical Group shall provide to all members, all medical services required by or incident to membership contracts.”
And then at the top of page 126, appears Section (C) (3) of the contract under the heading, Compensation for Medical Services.
And the first sentence of (C) (3) reads “as full consideration for rendering medical services as required by Section (C) (1) and (C) (2), Medical Group shall receive the compensation provided in part three here up.”
And this leads us to Part 3 of the contract, Article H beginning on page 137 of the appendix and continuing for the next several pages.
It is there provided in the introduction to Article H, “As base compensation to Medical Group for Medical Services to be provided by Medical Group hereunder.
Health Plan shall pay to Medical Group the amounts specified in this Article H.”
And then each one then provides for the per member price and provides for a payment based on the number of members.
The initial per member price for July 1959 and each exceeding month, it appeared near the bottom of page 137 was $2.61329 per member per month.
But continuing with Article H, it appears that this base compensation consists of several items.
Incidentally, I may say that if the time the contract was entered into, there were 350,000 members that meant coverage of sum of 900,000 persons because members were families.
I understand that something close to three million persons are now covered by the General Plan.
But there are further provisions for adjustment to the per member price in Section H-2 and H-3 on pages 138 in the top of page 139 and then we come to the paragraph which give rise to this case.
This is paragraph H-4 on page 139 of the appendix and it is headed, Provision for Savings and Retirement Program for Physicians.
And since this is the key to the case, I would like to read the paragraph.
In the event that Medical Group establishes a savings and retirement plan or other deferred compensation plan approved by Health Plan.
Health Plan will pay in addition to all other sums payable by Health Plan under this agreement.
The contributions required under such plan to the extent that such contributions exceed amounts if any contributed by a physicians as the plan was established, the physicians made no direct contribution.
Provided, however, that Health Plan shall commence contribution on July 1, 1959 and provided further that Health Plan’s obligation to make such contributions shall continue, only so long as this agreement or any continuation or extension generally similar to this agreement that shall remain into -- remain in effect.
And it appears later in the appendix at 162 that the rate of health plans contribution to this trust shall be 12 cents per member per month.
And with 350,000 members, that worth out to about $500,000 per year and the record shows that over a period of four years something over $2 million was paid by Health Plan into the retirement trust.
Following the execution of the medical service agreement, that is the agreement between Health Plan and Medical Group, the trust agreement was entered into.
It was actually signed about December 30, 1959, but it was effective as of July 1, 1959, the date when the agreement between Health Services and Medical Group became effective and nothing turns on the fact that there was some delay and working out and finally signing the trust agreement.
As I’ve already indicated the trust agreement is entitled retirement plan for the Permanente Medical Group.
And it is a typical non-vested retirement trust.
It provides for benefits only to physicians, but it includes not only the partners in Medical Group, but also physicians who are employees of the group.
It provides for tentative credits for each physician based upon his age, experience, and length of service.
It provides that these credits may be forfeited if the physician leaves the partnership or its employee except under certain circumstances.
In that event, the forfeited amounts are creditable to the other physicians who are beneficiaries of the trust.
As the respondents here agree and expressly stated page 4 of their brief, in no event is any amount refundable to Health Plan.
Justice Potter Stewart: Mr. Solicitor General, if a physician’s interest a partner physician’s interest is forfeited then I think take it the Internal Revenue Service in some way would recognize the extent of his, shall I call it loss at that time in the year of forfeiture?
Mr. Griswold: No, Mr. Justice.
I think we get to that question only if we assume that the payments are income to the trust, but if it is decided as we contend that the payments are always income to Medical Group then it simply becomes a question of what is the distributable share of each partners’ income in the trust each year.
And the payment to the trust we contend is income to the Medical Group partnership and it’s a part of the income which must be shown on the information return of the partnership and allocated to the partners and proportion to their interest in the partnership income.
In that so, what happens to any particular physicians interest and a trust is an irrelevant as far as this case is concern.
Justice Potter Stewart: That I understand, but I wondered whether he doesn’t have a loss of some kind at the time of forfeiture that might be assertable?
Mr. Griswold: I do not believe so Mr. Justice.
He simply has a -- perhaps a reduced income from the trust which will affect him.
But this is from point of view of the tax law as we contend the same as if the payment was made to Medical Group and Medical Group then made a payment to the retirement trust.
That would not be income to the partnership when it was paid to the retirement -- to the partner when it was paid to the retirement trust and it would not be a loss to the partner when it --if he had a forfeiture.
I think this all turns on the somewhat subtle but nevertheless controlling issue in this case, are these payments income to the Medical Group which we contend they are or are they income to the partnership -- to the retirement trust which is the basis which the court below decided?
Chief Justice Warren E. Burger: Mr. Solicitor General, I supposed the plan -- the retirement plan for general employees other than physicians involve a substantial number of people and the substantial amount of money.
And are those employees tax on the deferred income on the year in which it’s contributed to the pension fund or when they received it at the end of the line?
Mr. Griswold: Mr. Chief Justice, that depends on – in the first place, there is nothing in this record about this or whatever.
Chief Justice Warren E. Burger: Oh, I see.
Well, taking a typical one that we’re familiar with --
Mr. Griswold: Taking -- taking a typical one if the retirement plan is for employees and if it is nondiscriminatory so that it meets the standards of Section 401 and following of the Internal Revenue Code then amounts paid into it would be deductible by medical plan and would not be taxable to the employees until they were paid out to the employees.
This plan is quite clearly, not within Section 401. In the first place, it is discriminatory because it applies only to the top-salaried people, the physicians, but even more clearly, it is not exclusively for employees and their beneficiaries which are the only things to which the Retirement Trust Provisions in Section 401 apply.
In the years involved here, at least 1960, 1961, there was no provision whatever in the law for a retirement, deduction of retirement benefits for self-employed persons and partners are of course self-employed persons as partners in law offices have known with respect to the tax law for a long time.
Unknown Speaker: Mr. Solicitor General, I take it that -- that Government’s theory is that the money is paid to the trust and it’s for the use and benefit of the partnership and his income to it.
Mr. Griswold: Yes Mr. Justice.
That’s exactly it.
Unknown Speaker: Now -- and it is -- and it would -- the individual partner would only actually benefit by it if he doesn’t leave the partnership and retires pursuant to the plan.
At the time, he -- he takes -- at the time he does something that is also in the profit shared.
He already had paid taxes on a certain amount of money that was income to the partnership and that is now in the trust.
Doesn’t he, when he leaves the partnership, resigns or something, he has no any kind of a capital loss?
Mr. Griswold: He may -- he may Mr. Justice have a perhaps even an ordinary loss.
He may have a deduction for a loss.
There is no basis in the -- this record for determining that and there is no issue in this case as to that loss except as it bears on the remaining problem.
Unknown Speaker: Yes, but it would be a very odd situation in the tax law wouldn’t it, if you pay taxes on some income and it does not even outdo your basis on some property?
Mr. Griswold: Yes, it would surely -- it would certainly increase his basis in the partnership.
Unknown Speaker: Right.
Mr. Griswold: It would certainly increases basis in the partnership.
Indeed, there has been confusion in this case about this and it is a complicated case.
Let me point out --
Unknown Speaker: -- this was my question and perhaps I didn’t phrase it very well, but it seem to me that on a Government theory, if there is taxability to the partnership enhanced to the underlying partners that there had to be some kind of a deduction eventually in the event of departure from the partnership and forfeiture?
Mr. Griswold: Mr. Justice, I think my answer was quite and adequate and perhaps illustrates the difficulty of the case to one who has been working on it for months.
It is quite plain that the increase in income, not offset by a corresponding withdrawal of funds from the partnership would increase each partner’s basis in the partnership and would be taken into account in one way or another.
Unknown Speaker: Does this qualify the buildings that he can’t take away with it --?
Mr. Griswold: Probably, it matters due from the partnership.
Incidentally, in the foldout, just before page 203 is the computation of the amounts allocated to each partner in this case by the revenue agent.
And I think this illustrates the same thing because I believe that there was an error by the revenue agent in calculating the deficiencies because he apparently allocated the payments -- payment to the trust on the basis of the retirement formula in the trust.
But the payment should have been allocated only to partners and to partners on a pro-rata basis since that it is the way that all earnings and excess of withdrawing accounts were distributable under the partnership agreement.
Now this question is covered by paragraph 24 of the stipulation at page 87 down at the bottom.
The partners agree -- the parties agree that any recomputations of the various sums involved in these actions which may be required by Court’s adjudication herein will be made, verified, and settled by counsel.
And I’m -- I feel fairly confident that after this Court’s decision that can be done.
But in the event, that counsel cannot agree upon such recomputations.
The sums may be settled by the Court upon application in 10 days notice.
And I mentioned this because it may be what through the court below of the track, same way that I think I was throwing off the track and I would like to avoid suggesting the same error here.
This case can be made to appear and very likely is, very complicated.
There is even a considerable discussion in the respondent’s brief to the effect that the Government is preceding on the entity theory of partnerships while they said that the conduit theory is applicable.
It seems odd that we should still be discussing such things in 1972.
I think it is by now accepted that partnerships are both entities and aggregates and are so treated in the tax law.
They are treated as entities were the purpose of filing information returns, but partnerships are not taxed under our law and never have been.
The tax is imposed on the partners.
They are not taxed on their income actually received from the partnership, what they are taxed on is their distributive share of the partnership income whether they received or not.
I don’t want to oversimplify this case, but I would like to suggest that the question at issue here was resolved many years ago, and that the case on careful examination involves no question which has not been long established in our tax law.
The first of two cases is the venerable classic, Lucas against Earl decided in 1930.
In an opinion by Justice Holmes, that case involved an agreement between a husband and wife under which the income of the husband became a joint property of both spouses.
It was contended and the Ninth Circuit held that income was taxable half to the husband and half to the wife.
But this Court reversed Justice Holmes and his one own opinion said that, “This case is not to be decided by attenuated subtleties.
There is doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts, however, skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.”
That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree on that from which they grew.”
In the other case in Heiner and Mellon in 304 U.S. that involved a partnership and involved income which under the applicable state law could not be paid and the court held that it was nevertheless income to the partnership and came within the distributive share.
Let me turn to a hypothetical example.
Let’s assume a large law firm with a hundred or more partners and his many associates.
For convenience, I’ll call it Ropes and Cromwell. Let us assume that it has a large and important client which we’ll call International Conglomerates, Inc.
The client has worldwide operations and it’s constantly confronted with legal problems.
It has its own legal staff whether it relays heavenly on the services provided by Ropes and Cromwell.
International Conglomerates is much interested in the continuity of the services of the individual members of Ropes and Cromwell.
In the past, Ropes and Cromwell has billed at appropriate intervals and these have been paid.
Now, let us suppose that Ropes and Cromwell suggested the corporation that hereafter 10% of the bill be paid to the law firm’s retirement fund.
Obviously enough, this would make no difference under Lucas and Earl, and the Culbertson case, the entire amount would be taxable to the partnership.
I don’t think it would make any difference that the law firm’s retirement fund was a non-vested one under which no partner had any immediate right.
The payment to the retirement plan would still be income to the partnership of Ropes and Cromwell because it is a payment made on account of services rendered by the partnership and taxable to the partnership under Lucas and Earl.
Well now, let us suppose that instead of a payment to the firm’s retirement fund, the payments made to a trust for such of the wives of the partners at Ropes and Cromwell as survived the partners.
Here, no partner would have any right to receive any specific amount.
I suggest though that the payment would still be clearly income to the partnership.
And finally, let us assume that International Conglomerates came to Ropes and Cromwell and said, “We are very much interested in the continuity of your firm and then encouraging people to stay here in order that they may have background and experience in our work.
With the result that when we have a problem, we may go to someone who already knows a great deal about our business and the way we operate.
Accordingly, we want to join with you in the establishing a non-vested pension plan under which we will make regular annual payments and the plan will eventually provide retirement payments, but only to those members, employees of the firm who satisfied length of service requirements.”
But it seems to me is what we have here putting the respondent’s case in its strongest terms, but such a payment would still be a payment by International Conglomerates, Inc. on account of services rendered by Ropes and Cromwell and would thus, under Lucas and Earl, and Culbertson be income to Ropes and Cromwell.
Since it is income to Ropes and Cromwell, each partner of Ropes and Cromwell would be taxable on his distributive share of that income, whether distributed or not and even though it could not be distributed as this Court held in Heiner and Mellon.
In this case, the payments made to the retirement fund by Health Plan were made on account of the services rendered by Medical Group and pursuant to the compensation contract between Health Plan and Medical Group, which specifically provided for the payment of this retirement amounts as part of the compensation, that’s in quotation mark “Payable to Medical Group, for medical services to be provided my Medical Group hereunder.”
The whole point here is that payments are income to the partnership which performed the services.
We do not get to the question of the right to receive payments from the retirement trust until the payments made by the Health Plan for the services of Medical Group are treated as income to the retirement trust, but the payments are not income to the retirement trust, they are income to Medical Group under the clear teaching of Lucas against Earl.
And since the payments are income to Medical Group, it does not matter that the partnership Medical Group by its contract cost these amounts to be payable to the retirement fund in such a way that no one had an immediate vested right to get cash and no partner could currently receive his share.
In this respect, the situation is like that in other good old case, Griffiths against the Commissioner, where the Court held that the taxability of the income currently could not be defeated despite the technically elegant arrangement which had been set up to divert the taxability.
For the reasons which I have indicated since the diversion of earned income that is the amounts paid pursuant to a contract for personal services rendered runs directly follow that one of the fundamental principles of income taxation that earned income is taxable to him who earns it, no matter what diversionary arrangements is made for its payment.
The decision below is erroneous and should be reversed.
Chief Justice Warren E. Burger: Thank you, Mr. Solicitor General.
Argument of Valentine Brookes
Mr. Valentine Brookes: Thank you Mr. Chief Justice, may it please the Court.
To a substantial extent the Solicitor General who has argued another case than the one before you.
Let me first refer to his example about the mythical law firm of Ropes and Cromwell.
He suggested that the facts there were that the law firm suggested the 10% of what had been its normal retainer should be paid to a trust which was to establish a retirement plan.
Let me read you what the party stipulated in this case.
The primary purpose of the -- I beg your pardon, it is on page 83 of the record, Your Honor and it is in the stipulation of facts.
It will also be -- it will also appear virtually in haec verba in the opinion of the Court of Appeals which is on page 32 of the appendix to the petition for certiorari.
The stipulation is that the primary purpose of the retirement plan was to create an incentive for physicians to remain with Medical Group or other groups of physicians contracting to serve Health Plan members and thus to ensure Health Plan, that it would have a stable and reliable group of physicians providing medical services to its members and so on.
Then it states that the retirement plan was patterned after one which was in effect already in Southern California between another Medical Group and the same Health Plan.
And finally, that the payments which Health Plan agreed to and did make to the plan were paid solely to fund the retirement plan and were not otherwise available to Medical Group or to the individual members or employees thereof.
Justice William H. Rehnquist: Mr. Brookes, I presume that the stability which that paragraph refers to would benefit Medical Group as well as Health Plan, wouldn’t it?
Mr. Valentine Brookes: Yes, Your Honor.
The point that I seek to make use of the initiative was taken by Health Plan in which for its benefit according to the stipulation and it was so understood by both courts below.
The opinion of the Court of Appeals is the more of a voluminous and it speaks of the facts more freely than the District Court does.
There were no findings of fact in the District Court other than the opinion.
The Court of Appeals at page -- which in the opinion will appear at page 32 of the petition for certiorari and again, I might make quotations from page 39 of the petition.
This is the appendix to the petition and in that case I would call your attention to the shift of pages.
The Court of Appeals says the primary purpose of the retirement plan as to ensure Kaiser a stable and reliable pool of physicians providing medical service to its members.
The plan accomplishes this purpose by creating an incentive for physicians to devote their careers to Kaiser Members and so on. Now, this is virtually from the stipulation in haec verba.
But then at page 39 of the appendix to the petition, the court interprets that language again.
In distinguishing a circuit court case, Hulbert which had been cited by the Government below, the court said that Hulbert was not in point because there the partnership had it chosen not to enter the sales agreement or had it entered a different one on different terms would have received the whole of the payments as current income.
In this case, and I am quoting the Court of Appeals, “The party stipulated that the payments which Kaiser agreed to and did make to the trust were paid solely to fund the retirement plan and were not otherwise available to Permanente, that’s the partnership, or to the individual members or employees thereof.
Then turning to the next page.
Chief Justice Warren E. Burger: (Inaudible)
Mr. Valentine Brookes: Yes, Mr. Chief Justice?
Chief Justice Warren E. Burger: Go to that.
I am having a little difficulty seeing how your material in Section 16 pages 83 and 84 differs from the hypothetical that the Solicitor General had suggested.
Could you pinpoint what you think is the distinguishing factor?
Mr. Valentine Brookes: Yes, Your Honor.
In the hypothetical which the Solicitor General suggested, he suggested that the law firm made the suggestion to its client that a portion of what had thereto for been paid as the retainer, 10% should be paid into a retirement fund and become deferred income.
The stipulation as construed by the Court of Appeals and also by me, says that this is not what happened there, that this money that was paid into the trust would not otherwise have been available.
It would not otherwise have been paid for the benefit of the partners and their employees and --
Chief Justice Warren E. Burger: Was that -- is that a recycle which can control the economic reality, do you think?
Mr. Valentine Brookes: I think the answer is that probably the result is the same in either case, Your Honor.
But I do wish the facts to be before the Court.
And if they do, if these two different thrusts of initiative do make a difference then I think the Court should be aware that the Court of Appeals below decided the case on an understanding of the facts which it drew from the stipulation of facts which was to the effect that the initiative here came from Health Plan rather than from the partnership.
And the partnership did not ask Health Plan to take some of the current earnings it would otherwise have received and defer them.
Now, Mr. Chief Justice and may it please the Court.
There are cases which we discussed at some length in our brief which hold that this initiative, the question of who suggested the deferment is irrelevant.
The cases that I refer to involved what we call a non-funded plans.
This is where the employer merely refrains from paying sums to the employee, holds them in its treasury and pays them later at some time agreed upon by the party.
This is a type of retirement fund.
Justice William H. Rehnquist: Mr. Brookes, let’s get back to just a moment for the line of question of the Chief Justice was pursuing on.
In paragraph 16 of the stipulation on page 84 of the record which you had earlier read to us, the last sentence there, that the payments which Health Plan agreed to and did make to the trust were made solely to fund the retirement plan.
We are not, otherwise, available to Medical Group or to the individual members or employees there.
It seems to me a natural reading of that last sentence would mean that the funds after paid to the retirement plan were not otherwise available.
Are you suggesting that that means that Health Plan would not have made these payments in any other form than as a payment to the retirement plan?
Mr. Valentine Brookes: Yes, I am your honor.
Not solely from that language however.
And incidentally, the Court of Appeals adopted the interpretation which I am urging which is drawn in part from the language earlier in paragraph 16 which starts out by saying, “The primary purpose of the retirement plan was to create an incentive for physicians to remain with the Medical Group, and then in omitting some words, to ensure Health Plan that it would have a stable and reliable group of physicians providing medical service.”
Unknown Speaker: Mr. Brookes, if the medical partnership was to receive the $100,000 a year.
Health Plan said, “We’ll give you, we’ll pay you the $100,000 but we will also pay $25,000 because there’s some particular benefit we want, Health Plan wants to the retirement fund.
Is that what the argument is?”
Mr. Valentine Brookes: This is what I have just stated.
Yes, Your Honor.
This is not my only argument.
However, I am seeking to get the facts before the Court.
Unknown Speaker: No, no.
I gather the argument is a $100,000 would be income --
Mr. Valentine Brookes: Yes, it would.
Unknown Speaker: -- but the $25,000, the parties agreed should not be income because it was not to be paid for medical service?
Mr. Valentine Brookes: No, Your Honor.
My point is, it would not be that the parties would so agree, but rather I would turn to the substance of their agreement.
And this gets too far as the most critical point in this case in my opinion which is that as to the taxpayers, the amounts paid into the trust were wholly contingent and forfeitable.
They had no enforceable right to them until the lapse of conditions which had not occurred at this time.
They must either serve 15 years or serve 10 years and become 65 before any of their accounts seems to be tentative.
But even after the attainment of these conditions, they must continue to make themselves available even after retirement.
For consultation purposes and refrain from competition.
If they fail to live up to those conditions then too, they forfeit even though their payments had began up to the time of the second type of conditions of forfeiture.
Unknown Speaker: On your theory, when is, if ever, anything taxable to the partners?
Mr. Valentine Brookes: When they get it, Your Honor.
Unknown Speaker: Does your approach in your analysis of these facts tie in with the history of the Permanente Group and Health Plan.
Weren’t they born out of the same ball of wax originally?
Mr. Valentine Brookes: Oh, I think not except in the most general way, Your Honor.
There had been a predecessor partnership.
Health Plan had been in existence for years prior to the execution of any of the contracts that are on the record here.
Indeed, it entered into the employment agreement if I may so term it with the partnership, six months before the establishment of the funded plan.
So there was a period of six months in which it was contemplated.
There might be such a plan but it was not in being and yet the physicians were working under the partnership agreement and the other agreement with Health Plan.
These were not, however simultaneously born.
Unknown Speaker: Are you suggesting that the two organizations, Health Plan and the Medical Group are just came together by accident?
Mr. Valentine Brookes: No, I am not Your Honor.
The Health Plan was established by a funding of a large sum from prominent California family for the purpose of providing prepaid low cost medical care on a nonprofit basis.
It had --hospitals acquired more, they found that it couldn’t operate them without physicians.
It also found that it could not balance the budget if outside physicians selected by the patients were employed at normal fee rates, so it became necessary to establish a relationship with the group of physicians who would provide it exclusively with their services.
It is the outgrowth of the years of experience which has produced the documents and the record here.
There was a prior partnership agreement.
The one before you was entered into a 1959 and the record does not state how long back in the history the prior relationship of Health Plan with other partnerships had been created.
And I do not know.
Unknown Speaker: It’s a very -- it’s a very celebrated development in medical practice of course in California.
Mr. Valentine Brookes: And so it is Mr. Justice.
And the essential key to its success is the availability of the group of physicians under the exclusivity conditions which exists here.
The court below used the language exclusivity.
It was not original with me.
I am borrowing their language and it is exclusive in both directions.
That is to save Health Plan contracts to have the medical services performed exclusively by the physicians who are either partners of or employees of the partnership.
And in turn, the partnership contracts that its partners and its employees will perform services -- no services for any other Health Plan but this one.
There’s a limited provision for their having private practice in which case there earnings go into the partnership as well but their private practice is not permitted to interfere with their employment or their services for Health Plan because they must provide their full time or the equivalent thereof for Health Plan.
The Court of Appeals in further response to your question, Mr. Justice Rehnquist, as to whether I correctly interpret that one sentence in the stipulation isolated from the balance of the stipulation.
So that the agreement provides that Kaiser’s contributions to the plan are to be in addition to all other sums payable by Kaiser.
Thus, had Permanente elected not to establish the retirement plan, it could not have received additional current income.
It then states, there -- nor is there any evidence in the record, this is at page 40 of the opinion, rather of the appendix to the petition for certiorari.
Nor is there any evidence in the record to suggest that Permanente agreed to accept less direct compensation from Kaiser in exchange for the retirement plan payments.
That Kaiser would not have been willing to make the payments except into the trusts under the conditions imposed is consistent with the primary purpose of the retirement plan to ensure Kaiser a stable and reliable group of physicians.
We therefore conclude that Permanente, there is a deletion at this point Mr. Chief Justice.
We therefore conclude that Permanente never having had the right to receive the income could not have diverted it to others.
This, I believe distinguishes this case from the hypothetical of the law firm that was assumed for argument purposes by the Solicitor General.
Justice William J. Brennan: Thus, you are not conceding as I understand it Mr. Brookes at all that in the Solicitor General’s hypothetical case, that the result would be other than the result that you can turn for in this case.
Mr. Valentine Brookes: Mr. Justice I am glad you gave me the chance, the opportunity of making that clear.
I do not concede that that different, that the case depends upon that difference.
My case is --
Unknown Speaker: You’re suggesting the Court might find it does, but you’re not getting any --
Mr. Valentine Brookes: The Court might still find it and I think also.
This -- the difference make create a climate for the approach to the case.
And I would like that climate which I considered to be somewhat adverse to be removed.
The law probably makes no difference, no distinction.
The rules are quite clear in the case of the status of employees or independent contractors that the result that we argue for would follow because their interests in the retirement payments are entirely profitable and contingent.
Even in the event of a nonqualified plan where there are employees, Congress has stated its policy and its policy is with a funded but nonqualified plan.
This is a funded plan and a nonqualified plan.
The payments by the employer to the trust or into the fund are not current income to the employee if their rights are non-forfeitable at the time that the payments were made, Section 402 (b) of the Code so states.
We can not claim that we come under the umbrella of that Section because we are independent contractors.
We are not the employees.
It is true that some of the physicians are employees but they are employees of the partnership and paradoxically, the Government does not seek to tax them.
On the contrary, it seeks to tax the amounts paid to the retirement fund for their possible future benefit to the partners and would allow the partners no deduction for the amounts that are actually potentially receivable by the employees.
And the paradox becomes complete.
Because of the fact that the so works out this plan that it is quite possible that ultimately the only beneficiaries will be the employees.
If the partners all peel off one by one and leave no one but those persons who are presently employees as participants in the plan, all forfeitures go to the benefit of those remaining in the plan and I have indicated the hypothesis that they are employees.
They may later become partners but at this time they are employees and may be the sole beneficiaries.
Chief Justice Warren E. Burger: But isn’t just that what the statute provides for, one status for partners, and another status for employees.
Your quarrel airs with the statute, is it not?
Mr. Valentine Brookes: No, Your Honor.
We seek to rely up on the statute.
We do not believe that the Government’s position based upon Lucas against Earl is some because it is not derived from the statute.
Lucas against Earl is certainly a distinguished and important case but to illustrate, Your Honor, how statutes may change what has been the law in the past.
If Mr. Earl is still alive, he can derive the benefits from the statute which he could not derive under the method he attempted in Lucas against Earl because all he needs to do now is file a joint return with his wife and he would get the split income benefits that he sought by the devise that was denied to him.
So statutes do change things and we rely upon the statutes, and we have discussed this as a considerable length in our brief and I would like -- it’s difficult to discuss a statute in all oral argument without the statute before you.
But I -- this is not such a conflict statute as that.
First, the Section 701 which appears in the appendix to respondent’s brief which is to white one, it appears at page 3 of the appendix.
The appendix is separated from the rest by a blue insert sheet.
It says that a partnership as such shall not be subject to the income tax.
Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.
The point that we see in that Section is that Congress is thinking of a partnership not as an entity conducting business but rather as an aggregate of individuals, of persons carrying on business as partners.
It is consistent with that trust that emphasis that Section 703 which appears on page 5 of our appendix says that the taxable income of a partnership shall be computed in the same manner as in the case of an individual except that and none of the exceptions is applicable here and the Government has never contended that any of them was applicable here.
So it says that the taxable income of a partnership shall be computed in the same manner as in the case of an individual.
There history behind these projections.
They are derived -- the ones which -- the language which I have read is derived without significant change from the prior Code.
This Court construed the prior code in Neuberger to adopt the context then before it, the aggregate theory rather than the entity theory.
There are lots of words used for these theories and there the Court used both the entity language and the unit language.
And it also referred to the partnership as an association of individuals.
And it allowed a partner to offset his individual non-capital losses against his share of the partnership’s non-capital losses even though the statutes could more readily who have been construed in the other way under the doctrine of ejusdem generis which the Court refused to apply because it thought and I “that Congress has recognize the partnership both as a business unit and as an association of individuals.”
But they said this weakens rather than strengthens the Government’s argument that the privileges are distinct and that the unit characteristics of the partnership must be emphasized.
And interestingly, at that point they cited among the cases a case from the Court of Claims that Craik case.
And the Craik case involved a nonresident who was a member of the resident partnership.
The question was whether he was taxable upon the entire distributive share of his income of the partnership or merely a portion of it.
Some of the partnership income was also from foreign sources as he resided abroad.
And the Court of Claims used the language undoubtedly referred to by this Court in referring to the Craik case that at common law, each partner was the agent for the other partners in carrying up their common purpose.
The income earned by the partnership was regarded as having been earned by the individual partners either by himself individually or through his agents, the other partners.
The court below used the term that the partnership was acting only as the agent of its members and it used that in this context, in this sense, in the petition and in the brief, both the Government has sought to make capital of the use of the term agent.
But this is the classical concept of the relationship of one partner to the other.
And in the Craik case which this Court spoke of approvingly in Neuberger.
The court did say that each partner was regarded as having earned the income.
The statute says that in Section 701 that the businesses done by individuals or by persons doing business in the form of a partnership and it shows that the income of the partnership shall be computed in the same manner as in the case of an individual.
If those instructions are applied then we see that the fact that the payments into the trust by Health Plan create only forfeitable and contingent rights and the taxpayers is controlling.
Under volumes of doctrine including many decisions from this Court whether on the cash or the accrual basis, a taxpayer does not have income so long as his claims to whatever the property is remained contingent and forfeitable.
That rule has been applied consistently in deferred compensation cases.
Lucas against Earl has never been applied in deferred compensation cases.
It has been cited by the Government time after time in deferred compensation cases as it was in both courts here and it has been rejected in all of those cases including the two courts below here.
And the reason is, Mrs. Earl received money in 1921 and it was at that time that Mr. Earl was held taxable upon it.
He was not held taxable upon any income in an earlier year before somebody received it.
And so it should be here, these individuals should be taxable when they receive their income and not before.
Unknown Speaker: Of course in Lucas against Earl, you didn’t have the added ingredient of a partnership.
Mr. Valentine Brookes: This is true, Your Honor.
The Code has a further answer to the Government’s position and that is, it says, that this is Section 704 it appears in the appendix to our brief and that the relevant part is on page 5.
It’s the first words of Section 704.
A partners’ distributive share of income gain, loss, deduction or credit shall and so on be determined by the partnership agreement then it goes on.
And I was mistaken, this is the critical language.
The partner’s distributive share of any item of income shall be determined in accordance with this distributive share unless the agreement of the parties provides to the contrary.
The point is that a partner is not taxable on -- inflexibly on “X” percentage of the net income of the partnership.
It used to be under the old Code.
There’s a difference now.
His distributive share is of an item of gross income as well as of net income.
The purpose of this was to permit persons who attribute or contribute appreciated property to a partnership.
And by a partnership, interest based on the appreciated value to be the sole taxpayers on that appreciated value if the property is sold for a profit.
So that the property or the gain which the partners have bought by admitting, the new partner will not be taxable to all of them proportionately.
Justice Potter Stewart: What happens to -- and I am just asking for information because I -- what happens if part of the income of a partnership in a particular year is invested in a capital asset which of course would be presumably depreciable?
Is any of the property that was so invested figured in the distributive share of a partner?
Mr. Valentine Brookes: Well, if it was sold.
Justice Potter Stewart: No, not sold just -- let us say a partnership bought a building.
Mr. Valentine Brookes: The point of appreciation in value above basis would be related to the depreciation to be taken by the partnership [Voice Overlap] not to remember years.
Justice Potter Stewart: That on subsequent years, I understand it.
Mr. Valentine Brookes: In subsequent years.
Now the statute and the regulations recognizes permit the parties to vary the depreciation amongst themselves so that the depreciation may go to the party who contributes the appreciated asset rather than being enjoyed by the partners who have not contributed the appreciated asset and conversely, in the example I gave a moment ago, if that property, that building should be sold the statute permits that partner to be the one exclusively taxable upon that appreciation which has now become gain.
So the distributive share may be only of one item of gross income and my point is that a distributive share is a proportionate share.
A case the Government relies on Heiner against Mellon in so long.
Unknown Speaker: Have you answered the Justice’s questions?
Mr. Valentine Brookes: I answered what I thought was his question.
Unknown Speaker: Well, assume a partnership gets $200 on income, a $100 of it they distributed to the partners, a $100.00 of it they put into physical, they buy a chair with it.
Mr. Valentine Brookes: Oh! [Voice Overlap]
Unknown Speaker: It’s all distributed.
That’s all taxable to the individual partner.
Mr. Valentine Brookes: If I hear -- I did not so understand the question.
Yes, Your Honor, so it would be.
But there is nothing forfeitable or contingent.
Unknown Speaker: I understand but nevertheless the amount the partnership puts into the chair is taxable to the partner?
Mr. Valentine Brookes: Oh, yes, of course it is.
Unknown Speaker: They do 50-50 partners.
Mr. Valentine Brookes: Yes.
Unknown Speaker: And they buy a $100 chair and they have to -- although they had $200 of otherwise net income, they each have a distributive share that year of a $100, wouldn’t they?
Mr. Valentine Brookes: Yes, they do, Your Honor.
Unknown Speaker: And each would, and the partnership would own a $100 chair, that would be depreciable over its expected life.
Mr. Valentine Brookes: No, they’re just treated like an individual or corporate taxpayer.
There taxable income is determined as if they were individuals and if an individual has income and he buys a depreciable asset, his income is not reduced thereby.
He gets depreciation in the future, so it would be here.
But the point that I am seeking to make goes off from that, Your Honor and it is to allot the word distributive.
The statute now permits distributive shares to relate to items of gross income, not merely to the sum of net income.
And the word distributive was construed by this court as meaning proportionate.
And here, no partner knows what his proportion of the chair of this item of income is, if it is income.
Now, of course, we deny that it is income.
But if it were deemed to be income of the partnership, his proportionate share is unknown.
It’s dependent upon future events.
Justice Byron R. White: Well, you don’t know what’s going to happen to the chair either, do you?
Mr. Valentine Brookes: It’s purchased from taxable income which has come in and should be taxed.
This -- but there was no deferment of receipt there Mr. Justice White.
Here there is non-receipt, and not only a deferment of receipt but the contingency of possible non-receipt.
My time has expired.
Unknown Speaker: Mr. Brookes, I shouldn’t ask a question when the red light is on but suppose everything were exactly the same as it is here except that Health Plan paid this amount to Medical Group.
The Medical Group in turn promised to pay it over to the trust and did in fact pay it over to the trust, and he questions about his taxability to the partnership under those circumstances?
Mr. Valentine Brookes: Your Honor, only if the documents could be so construed that medical plan have no alternative but to do this.
But the fact, that that is not the case is very important here.
Unknown Speaker: How does it differ?
Mr. Valentine Brookes: Medical plan has never received this income in the case which you have spoken of.
Medical plan had to receive it but it is obligated to do something with it.
The doctrine of receipt and non-receipt is obviously important in the income tax law.
The plan here came into bidding under the thrust of the initiative of, let me call it the employer, and Medical plan has no control over it.
Now, I grant, Your Honor that you have given me a hypothetical in which they can only do one thing with it.
They can only pay it over to a trust and I assume the other provisions are the same as they are here but they cannot get it back except under conditions of that possible forfeiture.
Yet, the fact that they have received it could be regarded as all important.
Here they have not received anything.
Unknown Speaker: Because they have agreed not to.
Mr. Valentine Brookes: Well, yes, Your Honor.
They have agreed not to.
Unknown Speaker: That is the earning entity has agreed not to.
To me, this is --
Mr. Valentine Brookes: The stipulation of facts may answer your question, Your Honor, page 84 of the record, it says, “No payments were made to the trust during the years in question by Medical Group or by an individual or by individual participants in the retirement plan.”
That is the last sentence of a paragraph on page 84 of the record, Your Honor.
Chief Justice Warren E. Burger: Thank you Mr. Brookes.
Thank you Mr. Solicitor General.