decided: November 25, 1980.
DANIEL S. KAMPEL AND CLARISSE KAMPEL, PETITIONERS-APPELLANTS,
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT-APPELLEE
Appeal from a judgment of the United States Tax Court (C. Moxley Featherston, Chief Judge ), 72 T.C. 827 (1979), upholding the validity and application of Treasury Regulation § 1.1348-3(a)(3)(i), which subjects guaranteed partnership payments under I.R.C. § 707(c) to the 30% limitation rule of I.R.C. § 911(b) for the purpose of applying the 50% maximum tax on earned income of I.R.C. § 1348, for taxable years prior to December 31, 1978. Affirmed.
Before Lumbard, Oakes and Newman, Circuit Judges.
This appeal involves the narrow question whether guaranteed partnership income, viewed as salary by Internal Revenue Code § 707(c), is subject to the limits on taxation of earned income imposed by Code § 1348, for tax years prior to 1978.*fn1 The taxpayer-appellant treated all of his § 707(c) payments as earned income in order to receive the more favorable 50% maximum tax rate of § 1348. However, under Treasury Regulation § 1.1348-3(a)(3)(i), all § 707(c) payments, despite their salary characterization, must be included in a taxpayer's aggregate partnership income, of which no more than 30% is eligible to be treated as earned income and hence subject to the 50% maximum tax rate. Using the regulation's computation method, the Commissioner assessed a deficiency against the taxpayer. The Tax Court adopted the Commissioner's position and upheld the validity of the regulation. Kampel v. Commissioner, 72 T.C. 827 (1979). We affirm the judgment of the Tax Court.
The taxpayer-appellant, Daniel S. Kampel, in the tax year in question, 1973, was a partner in a brokerage firm. He was also manager of the firm's pension fund department. For the three years prior to becoming a partner in 1966, Kampel, as an employee of the partnership, had held the same managerial position. Thus both before and after becoming a partner he performed substantially the same services and received compensation for those services computed in substantially the same manner. Appellant's compensation arrangement for these managerial services did not specify a fixed dollar figure but instead used a formula by which his income depended upon his productivity and that of the department; his compensation under this arrangement in 1973 was $379,000. In 1973 Kampel also received from the partnership a distributive share of the partnership's profits of $45,000 and $32,000 of interest on capital he had contributed to the partnership.
These facts brought into play three provisions of the Code: §§ 707(c), 911(b), and 1348. Section 707(c) provides that if payments from a partnership to a partner for services rendered are "determined without regard to the income of the partnership," such "guaranteed" payments shall be treated as salary and not as partnership share.*fn2 The parties stipulated that the payment of $379,000 Kampel received for managing the pension fund department was "determined without regard to the income of the partnership."*fn3 Section 707(c) also provides that guaranteed payments are to be considered as salary "but only" for purposes of § 61(a), relating to gross income, and § 162(a), relating to business expenses. Section 911(b) defines "earned income" to include salary, but it also provides a special rule applicable to net profits received from a business, like Kampel's brokerage firm, in which both personal services and capital are material income-producing factors: no more than 30% of a taxpayer's share of net profits from such a business may be treated as compensation for personal services and hence considered as "earned income."*fn4 Section 1348 provides a 50% maximum tax rate for "personal service income," which this provision defines to mean any "earned income" within the meaning of § 911(b).*fn5
In computing his income tax liability for 1973, appellant treated as earned income, for the purpose of applying the 50% maximum tax rate of § 1348, the entire $379,000 he received for his managerial services. In considering this entire amount as earned income, Kampel relied upon Code § 707(c) because it characterizes such a guaranteed payment as salary. He also included 30% of his $45,000 distributive share of the firm's profits as earned income, relying on the maximum earned income allocation percentage of § 911(b). Because interest income is not within the definition of earned income, Kampel did not include any portion of the $32,000 of interest he received from the partnership as earned income subject to § 1348's maximum 50% rate.
On audit, the Internal Revenue Service (IRS) determined that appellant's tax liability calculation was erroneous and assessed a deficiency of $39,773.*fn6 The agency contended that the proper treatment under § 1348, as specified by Treasury Regulation § 1.1348-3(a)(3)(i),*fn7 was to add the $379,000 of managerial compensation to Kampel's total partnership receipts, the $45,000 profit share and $32,000 of interest, and then apply the 30% limitation to the aggregate sum of $456,000. Under this approach, the taxpayer's earned income, eligible for the maximum 50% rate limitation, cannot exceed 30% of the sum of any guaranteed payments plus all other partnership income received. The regulation thus has the effect of adopting § 911(b)'s income allocation rule in preference to that expressed in § 707(c).
The Tax Court upheld the validity of the regulation and the Commissioner's view that, for the purposes of § 1348, "earned income" is limited to 30% of the sum of the guaranteed payments and net profits, despite § 707(c)'s characterization of the entire guaranteed payment as salary. The linchpin in the analysis was the language of § 707(c), allowing salary treatment "but only for the purpose of section 61(a) (relating to gross income) and section 162(a) (relating to trade or business expenses)." The Court adopted the Commissioner's position that this proviso expressly prevents § 707(c) from making payments eligible in their entirety for § 1348's maximum 50% rate limitation because § 1348 does not affect the determination of either §§ 61(a) or 162(a), but solely modifies the tax rates imposed by § 1. Consequently, the Court found that the regulation did not conflict with the statutory scheme and embodied a reasonable interpretation of § 1348.
The standard for reviewing a treasury regulation is one of reasonableness: a regulation is to be sustained unless it is unreasonable and plainly inconsistent with the statute. Commissioner v. South Texas Co., 333 U.S. 496, 501, 68 S. Ct. 695, 698, 92 L. Ed. 831 (1948). The Tax Court found that Treasury Regulation § 1.1348-3(a)(3)(i)*fn8 was a reasonable interpretation of § 1348 because it simply followed the definitional requirement of § 911(b), which is incorporated by reference in § 1348. As these statutes are silent about the apparently conflicting characterization in § 707(c) with respect to payments within its coverage as salary and not share, the Court stressed the limiting language of § 707(c) as operating only for the purposes of §§ 61(a) and 162(a). It also found that neither § 911(b) nor § 1348 implied that § 707(c) payments could be exempted from the strict 30% rule for income from a trade or business covered by § 911(b). As he argued to the Tax Court, appellant challenges the regulation's validity, principally on the grounds of its conflict with § 707(c), the legislative history, and cases construing the scope of that section.*fn9
Section 707(c) adopts an entity approach to partnership taxation, as opposed to the traditional theory that views a partnership as an aggregate of individuals. H.R.Rep.No.1337, 83d Cong., 2d Sess., reprinted in (1954) U.S.Code Cong. & Ad.News, pp. 4017, 4093. Recognizing that partners may act in different capacities with respect to their partnership for purposes of tax treatment, it allows partners to treat as ordinary personal service income-salary to an "employee"-guaranteed payments determined without regard to the income of the partnership, rather than requiring their treatment as part of the partner's share of the partnership profits. The partnership, correspondingly, can deduct such payments as business expenses. On its face, the section's view of income coming within its scope conflicts with the approach of Treasury Regulation § 1.1348-3(a)(3)(i). Appellant stresses this role-defining aspect of § 707(c) to compel earned income treatment of his compensation.
The purpose of § 707(c), however, does not support appellant's claim. The section was adopted to eliminate the confusing, complicated tax treatment of partner compensation under the then existing law, caused by the aggregate approach to partnerships, whereby complex accounting problems arose when the partnership's earnings were insufficient to cover the compensation the partner had received. H.R.Rep.No.1337, supra, at 4094. Before the section was adopted in 1954, salary in those instances was treated as a return on capital so that the partner reported no taxable income except when his salary exceeded his capital contribution; in such a case, the taxable amount had to be allocated among the capital of the other partners, who would be entitled to deductions for their share of those payments. See Augustine M. Lloyd, 15 B.T.A. 82 (1929). Congress expressly intended to end this complexity in partnership tax treatment by enacting § 707(c). H.R.Rep.No.1337, supra, at 4094; S.Rep.No.1622, 83d Cong., 2d Sess., reprinted in (1954) U.S.Code Cong. & Ad.News, pp. 4621, 4725. Although the section does serve to recognize and define the different statuses partners may hold in relation to their partnership for tax purposes, its primary objective in creating an income characterization rule was thus only tangentially related to distinguishing among a partner's roles, and was more directly concerned with improving accounting practices.
The critical interpretative issue in this case is not the general purpose of § 707(c)'s entity approach to partnership transactions, but rather the meaning of the section's "but only" proviso. The Commissioner finds within that wording a clear congressional intent that § 707(c)'s salary characterization be narrowly restricted with respect to the rest of the Code. The legislative history, however, suggests a different explanation for this particular clause, and three courts have rejected the Commissioner's interpretation and held that § 707(c)'s salary treatment is applicable to Code sections other than just §§ 61(a) and 162(a), see Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968); Carey v. United States, 427 F.2d 763, 192 Ct.Cl. 536 (1970); Andrew O. Miller, Jr., 52 T.C. 752 (1969), acq. 1972-2 C.B. 2.
Clearly a § 707(c) guaranteed payment, whether characterized as salary or as partnership profits share, would be includable in gross income as defined by § 61(a) by virtue of the latter section's own terms. See I.R.C. § 61(a)(1) (compensation for services); id. § 61(a)(13) (distributive share of partnership gross income). The proviso in § 707(c) is therefore difficult to construe because its explicit connection to § 61(a) adds nothing. The most reasonable explanation for Congress's use of the phrase is, as suggested by the legislative materials, that it was intended to reinforce the point made in § 706 that the tax year of the partner receiving the salary income-covered by § 61(a)-and that of the partnership deducting those payments-covered by § 162(a)-must be the same. See S.Rep.No.1622, supra, at 4726 (referring to § 707(c) "treatment" for purposes of §§ 61(a) and 162(a) only, in immediate context of discussion of accounting treatment according to partnership year).*fn10
Although timing for income reporting may very well be the intention underlying inclusion of the proviso, the broad language chosen for its expression encompasses more than that accounting problem. Accordingly courts rejecting a literal approach to the section's restriction on the availability of § 707(c) treatment have read the proviso either to refer solely to the accounting problem of the timing of income-reporting, Andrew O. Miller, Jr., supra, 52 T.C. at 762, or to refer to and make applicable all other provisions of subtitle A of the Code; this latter reading is based on the fact that § 61(a), one of the two sections to which § 707(c) extends under the proviso, begins with the clause "except as otherwise provided in this subtitle, gross income means ...." Armstrong v. Phinney, supra, 394 F.2d at 664 n.10; Carey v. United States, supra, 427 F.2d at 766-67. Although we would hesitate to adopt the broad reading of the proviso adopted in Phinney and Carey, we need not decide the issue because if § 61(a) absorbs § 1348 for the purposes of § 707(c) treatment, then it equally includes § 911(b).
The essence of this case is reconciliation of two competing allocation rules: § 911(b), which limits earned income from partnerships in which both personal services and capital are material income-producing factors to 30% of all income received; and § 707(c), which, by defining guaranteed payments as salary, functions as an alternative allocation rule for such businesses by directing all partnership income falling within its coverage to be attributed to personal services. The issue, as we see it, is which allocation rule controls for the purposes of applying § 1348. In our view, while the § 707(c) characterization of guaranteed payments may well have wider application beyond just aligning the tax years of diverse taxpayers under §§ 61(a) and 162(a), it does not displace the 30% allocation limitation of § 911(b).*fn11 At the very least, that is a reasonable conclusion the Treasury was entitled to reach in promulgating Regulation § 1.1348-3(a)(3)(i).
The structure and legislative history of § 911(b) show an unambiguous intention to create an income allocation rule for the IRS. The definition of earned income in § 911(b) originated in a provision of the Revenue Act of 1924 enacted to impose a lower tax rate on all earned income and amended on the floor to aid farmers and small businesses by eliminating an initial tax preference to incorporated entities not subject to an earned income limitation. 65 Cong.Rec. 2849 (1924). A specified percentage limitation (then 20%) was adopted to reduce the administrative difficulties inherent in determining a reasonable allowance for personal services in businesses in which both personal services and capital were material income-producing factors; rather than simply have the Service apply a "reasonable allowance" standard, the House expressly enacted an arbitrary percentage limitation as the more administratively workable solution. Id. at 2851; Brewster v. Commissioner, 154 U.S. App. D.C. 30, 473 F.2d 160, 163 & 163 n.4 (D.C.Cir. 1972) (per curiam).
The need for the allocation rule embodied in § 911(b) is obviously lessened in the case of a bona fide § 707(c) payment. A valid § 707(c) classification represents a prior determination by the parties of the extent of partnership income attributable to personal services as opposed to capital. Consequently adherence to the income status conferred by § 707(c) could avoid the difficult income allocation problem that the 30% limitation seeks to avoid. But § 707(c) does not create any distinctions according to the nature of the partnership's business in granting employee-salary status,*fn12 which is the specific focus of § 911(b). We therefore conclude that § 707(c) does not stand as a sufficient allocation mechanism to protect against abuses of tax evasion that could be generated if blanket acceptance were required of taxpayer income arrangements in businesses in which both personal services and capital are material income-producing factors. By holding that the 30% rule of § 911(b) is controlling, an otherwise purely elective aspect regarding earned income is minimized because the determination of the compensation allowance remains in the hands of the Commissioner, who is guided by the 30% figure, and not the taxpayer, who could otherwise contract for a specified level of guaranteed payments.*fn13
Of course, in this case, the taxpayer election problem is less compelling because comparatively objective data exist with which to test the reasonableness of the § 707(c) guaranteed payment characterization. Appellant's salary receipts prior to his becoming a partner could be compared to the $379,000 in question to serve as a benchmark against which to gauge the reasonableness of according § 707(c) treatment to the entire sum for § 1348 purposes. Such an approach would have the additional virtue of being consistent with Congress's subsequent repeal of the 30% limitation of § 911(b) for the purposes of § 1348, § 442 of the Revenue Act of 1978, Pub.L.No.95-600, 92 Stat. 2878, ensuring horizontal equity between employees and partners as to tax rates for the same incomes for services rendered.*fn14 But in so amending the Code, Congress made no reference to § 707(c) or to alleviating any problem posed by it in relation to § 1348. Rather, the drafters of the amendment expressed a desire to remove the existing tax advantage for corporations that were not subject to the limitation over sole proprietorships and partnerships, as well as a need to eliminate definitional problems over a business's net profits engendered by the limitation. S.Rep.No.1263, 95th Cong., 2d Sess. 208, reprinted in (1978) U.S.Code Cong. & Ad.News, pp. 6761, 6971. If § 707(c) payments were thought to constitute earned income in their entirety, then the corporate preference of the old law would not have been so striking and partnerships could have avoided the disadvantage by resorting to § 707(c).
Even if we were persuaded to apply retroactively the spirit of the 1978 amendments, the taxpayer would not succeed in this case. The 1978 change merely permits earned income characterization for more than 30% of a partner's share and does not express anything concerning the intended relation of § 707(c) income characterization to § 1348. Congress did not mandate that a § 707(c) payment must be granted full earned income status, but rather left the IRS to its own devices to determine what would be a reasonable allowance for personal service compensation. See S.Rep.No.1263, supra, at 208, (1978) U.S.Code Cong. & Ad.News at 6971 (stressing individual not permitted by revision to convert passive income on investments into personal service income). Hence the IRS could still validly deny Kampel's attempt to characterize 83% of his partnership income as payment received for personal services, and then adhere to the 30% figure as a far more reasonable allocation.
We affirm the Tax Court's judgment upholding Treasury Regulation § 1.1348-3(a) (3)(i) and its application in this case.*fn15