Internal Revenue Service
Revenue Ruling

TaxLinks.com   sm

 Rev. Rul. 72-75

1972-1 C.B. 401

Sec. 7701

IRS Headnote

A professional service organization operated in the form of a business trust in California is taxable as a corporation since by the terms of the trust instrument the organization possesses a preponderance of corporate characteristics.

Full Text

Rev. Rul. 72-75

Advice has been requested whether the unincorporated professional service organization described below will be classified as an association taxable as a corporation for Federal income tax purposes pursuant to section 301.7701-2 of the Procedure and Administration Regulations, exclusive of the 1965 amendments.

The association is organized and operated in the form of a trust in California, and is engaged in the practice of medicine with the objective of dividing the gains and profits therefrom, pursuant to a trust instrument dated April 1, 1967. The State of California has no specific statute dealing with business trusts.

Under the trust instrument, the beneficial interests in the trust are divided into a number of shares, held equally by its two beneficiaries. The shares are freely transferable although no person is eligible to hold any shares, either directly or indirectly, unless such person is a duly licensed physician in the State of California. The trust is to continue for 20 years following the death of one of the original beneficiaries unless sooner terminated by the unanimous vote of the trustees, or by the written vote or consent of beneficiaries holding a majority of the total then outstanding shares of beneficial interest.

The instrument further provides that there shall be one trustee, the original being one of the two beneficiaries. At the time there are more than five beneficiaries, the number of trustees will automatically increase to three, each to be elected to a three year term.

Title to all the trust assets, as well as the income derived from the medical practice, is vested in the trustee, who has the power to carry on the conduct of the medical practice; control, sell, exchange, improve, repair, and generally manage the trust estate; employ physicians and others to perform services in connection with the medical practice; collect the income and pay all expenses of the medical practice; and make distributions to the shareholder-beneficiaries.

For purposes of taxation, organizations fall into certain classes, including associations taxable as corporations, partnerships, and trusts. The classification in which an organization belongs is determined under the tests and standards provided in sections 301.7701-2, 301.7701-3, and 301.7701-4 of the regulations.

Although an organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of persons designated as beneficiaries, the organization will not necessarily be classified as a trust. It will be classified as an association or partnership if, applying the principles in sections 301.7701-2 and 301.7701-3 of the regulations, it more nearly resembles an association or a partnership than a trust.  Revenue Ruling 70-101, C.B. 1970-1, 278, as amplified by Revenue Ruling 70-455, C.B. 1970-2, 297, states that a professional service organization that meets the requirements for corporate classification under section 301.7701-2 of the regulations, exclusive of the 1965 amendments, in its organization and operation will be classified as a corporation.

Section 301.7701-2(a) of the regulations provides, in part, that in order for an organization that has associates and an objective to carry on business and divide the gains therefrom to be classified as an association taxable as a corporation, it must have a preponderance of the corporate characteristics of centralization of management, continuity of life, free transferability of interests, and limited liability.

Although the Internal Revenue Code rather than local law establishes the tests or standards which are to be applied in determining the classification in which an organization belongs for Federal income tax purposes, local law governs in determining whether the legal relationships which have been established in the formation of the organization are such that the standards are met. Section 301.7701-1(c) of the regulations.

California does not have a specific statute dealing with business trusts, but under State law, it appears that a trust instrument will be given effect according to its tenor. Compare Goldwater v. Oltman, 292 P. 624 (1930), Bernesen v. Fish, 28 P. 2d 67 (1933), and Engineering Service Corp. v. Longridge Investment Co., 314 P. 2d 563 (1957). Therefore, classification of the association will be based on the terms of its trust instrument.

Pursuant to section 301.7701-2(b) of the regulations, an organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will not cause a dissolution of the organization. If the organizational agreement provides that the organization is to continue for a stated period, the organization has continuity of life provided no member has the power to dissolve it in contravention of the agreement.

Since the association's trust instrument provides for a term of 20 years following the death of one of the original beneficiaries unless sooner terminated by the unanimous vote of the trustees, or by the written vote or consent of beneficiaries holding a majority of the total then outstanding shares of beneficial interests, the association has continuity of life.

Section 301.7701-2(c) of the regulations provides that an organization has centralized management if any person (or group of persons that does not include all the members) has continuing exclusive authority to make the management decisions necessary to the conduct of the business for which the organization was formed without ratification by the members of such organization.

Since the trust instrument gives the trustee the authority specified in the regulations, the association has centralized management.

An organization has free transferability of interests if each member, or those members owning substantially all the interests in the organization, has the power, without the consent of the other members, to confer upon his substitute all the attributes of his interest in the organization.

Since the trust instrument provides that shares issued by the trustee shall be freely transferable among licensed physicians in the State of California, the organization has free transferability of interests.

Accordingly, since the association has the corporate characteristics of continuity of life, centralized management, and free transferability of interests, it has more corporate than noncorporate characteristics and it is classified as an association taxable as a corporation for Federal income tax purposes.