*2931 1. The tax liability of this petitioner for the year 1918, on the income derived from its business as a broker, should be recomputed under the provisions of section 303 of the Revenue Act of 1918.
2. Evidence fails to overcome the presumption that the Commissioner correctly included the amount of two certain notes in the gross income of the petitioner for the year 1920.
*39 The respondent asserts deficiencies for the years 1918, 1919, and 1920, in the respective amounts of $31,279.81, $14,093.02, and $14,199.68. The only issues submitted to the Board are, (1) whether the petitioner's tax liability for the year 1918 should be computed under the provisions of section 303 of the Revenue Act of 1918, and (2) whether the value of certain notes received by the petitioner in 1920 should be included in its gross income for that year. All other errors alleged in the petitions have been settled by a stipulation of the parties filed with and accepted by the Board. Counsel for*2932 the parties agree that the two proceedings should be consolidated for hearing and decision.
FINDINGS OF FACT.
The petitioner is an Ohio corporation, with its principal office at Cincinnati. It was incorporated on May 31, 1917, to take over and operate the business of Isaac Winkler & Bro., which from some time in 1910 had been operated as a partnership with Isaac Winkler and his son Eli Winkler, as the only partners, with interests in proportions not disclosed by the record. Upon the death of Isaac Winkler in May, 1916, Eli Winkler became the sole proprietor of the business and so remained until the date of incorporation. The petitioner's authorized capital was $1,000,000, divided into 5,000 shares of common and 5,000 shares of preferred stock of the par value of $100 each. Dividends on the preferred stock are cumulative at the rate of 6 per cent per annum and no more, and such stock has full voting rights. All the preferred stock was issued to creditors of the business at date of incorporation.
In 1918 Eli Winkler, in his own name, owned 4,996 shares of the common and 1,197 shares of the preferred stock of the petitioner, and as co-trustee with his mother, Bertha Winkler, *2933 he held an additional 3,240 shares of preferred stock, which had been issued on account of amounts due by the business to Isaac Winkler at the date of his death. S. T. Shoneman, secretary of the petitioner and brother-in-law of Eli Winkler, owned 190 shares of the preferred stock and the remaining 373 shares were owned by other members of the Winkler family who were not actively engaged in the business of the petitioner.
Bertha Winkler, the widow of Isaac Winkler, was entitled to receive all dividends paid on the preferred stock held by herself and Eli Winkler as trustees. Upon her death such stock was to be divided equally among six children, the issue of Isaac and Bertha Winkler. In such distribution Eli Winkler was to receive one-sixth of such rusteed stock as his own and an additional one-sixth as trustee for his brother, Walter Winkler.
*40 The Columbia Chemical Co. was organized July 11, 1899. In 1918 it had outstanding 50,000 shares of capital stock of the par value of $100 per share. The petitioner received 635 shares of such stock from the estate of Isaac Winkler, which, for estate-tax purposes, had been valued by the Commissioner at May 31, 1916, at $200*2934 per share. Subsequent to its incorporation and prior to January 1, 1918, the petitioner acquired 195 additional shares of such stock at a cost not disclosed by the record and in the year 1918 it purchased 75 additional shares and paid therefor the amount of $9,375, and at the close of the year 1918 it owned 905 shares of the stock of the Columbia Chemical Co.
In the year 1918 the petitioner's business operations were conducted in two ways. As a general trader on its own account its sales of merchandise amounted to $851,015.06, from which it realized a gross profit of $160,446.45, which included dividends on Columbia Chemical stock in the amount of $9,478.90 and interest or dividends on other investments. It was also sales agent for the products of the Columbia Chemical Co. and in that year its sales of such products amounted to $4,782,263.28, from which it realized a gross profit of $118,086.68, which was 2 1/2 per cent of the total sales prices charged to purchasers for such products.
The predecessor of the petitioner began to sell the products of the Columbia Chemical Co. in 1899 in conformity with the terms set forth in the following letter:
CARNEGIE BUILDING,
Pittsburgh,*2935 Pa., Dec. 20th, 1899.
MESSRS. ISAAC WINKLER & BROTHER,Cincinnati, Ohio.
GENTLEMEN: Confirming conversation which we have this day had with your Mr. S. M. Winkler, we hereby give you the sale of our product of Soda Ash from our works now being erected at Barberton, O., for one year after operations shall have been commenced, excepting such portion of the product as shall be required by the Pittsburgh Plate Glass Co. for its own use. You to make such sales at the best prices that can be secured, subject, of course, to the same general control, supervision and conditions as are exercised by other companies of like character over their selling agents, and to receive therefor a commission of four per cent (4%) off the net amount of such sales, after freight has been deducted. Said 4% to cover your commission and guarantee of accounts. It being further understood that you are to discount all bills in 10 days, if we so elect, at a further discount of one per cent (1%). It being understood that no commission is to be paid to you on sales to the Pittsburgh Plate Glass Co.
Yours truly,
W. L. CLAUSE, President.
Accepted:
ISAAC WINKLER & BRO.
*41 After the*2936 first year of the business relationship established as and when above set forth, no other written contracts relating thereto were entered into. Thereafter the predecessors of the petitioner continued to sell the products of the Columbia Chemical Co. and received therefor compensation in the amount of 2 1/2 per cent of such sales, bt after the close of the first year did not guarantee payment of the accounts of purchasers. This business relationship, among other assets of its predecessors, was taken over by the petitioner at the date of incorporation and continued through the year 1918, resulting in sales and profits in such year in the amounts set forth above.
Upon the receipt of an order for the products of the Columbia Chemical Co. a contract was entered into, which in terms was identical with the following:
ENTERPRISE MILL SOAP WORKS, INC.,
Philadelphia, Pa.
GENTLEMEN: We have this day sold to you for the account of the Columbia Chemical Division, Pittsburgh Plate Glass Company:
QUANTITY: Five (5) cars,
QUALITY: 58% Light Soda Ash "Columbia" brand in bags
SHIPMENT: In about equal intervals during the period of August 29th, 1923 to March 1st, 1924.
PRICE: *2937 One dollar and twenty cents ($1.20) per 100# basis 48%, f.o.b. Barberton, Ohio, freight equalized with Syracuse, N.Y., less 2 1/2%.
TERMS: Cash less 1% in 10 days from date of invoice.
This sale covers a similar contract made by you with the Crystal Soap & Chemical Company, Philadelphia, Pa.
GENERAL CONDITIONS OF SALE: Payments to be made in United States currency. Each delivery to stand as a separate sale. Invoice weights, tares and tests to govern. Buyers to give sellers reasonable notice of shipping instructions. If buyers default in any payment, sellers may at their option cancel further deliveries. Sellers not responsible for strikes, lockouts, transportation disabilities, and all other contingencies beyond their control.
COLUMBIA CHEMICAL DIVISION
PITTSBURGH PLATE GLASS COMPANY
THE ISAAC WINKLER & BRO. CO.,
Agents
S. T. SHONEMAN, Secretary.
Accepted:
ENTERPRISE MILL SOAP WORKS, INC.
JOS. W. LEBERMAN, Treas.
Contracts in the terms set forth above were subject to the acceptance of the Columbia Chemical Co. and in each instance the originals thereof were sent to that company for its approval and if accepted the merchandise was shipped*2938 directly to the purchasers. The products *42 so sold by the petitioner in the year 1918 were billed to it on memorandum form and by it were billed to the purchasers. Bills against the petitioner were less commission and cash discount; bills against the purchasers were at prices shown on the contracts.
On the bills against it the petitioner was allowed a cash discount of 1 per cent for payment within 10 days. In almost all instances the petitioner paid within the 10 days and took the cash discount, which it passed on to the buyers as consideration for payments by them within 10 days. A very great majority of the buyers paid within 3, 4, or 5 days and within the time necessary for the petitioner to receive the funds necessary to pay its bills to the Columbia Chemical Co. not later than 10 days from the dates thereof.
Throughout the year 1918 Eli Winkler was regularly active in connection with sales of the products of the Columbia Chemical Co. by the petitioner and had complete charge and direction of that branch of the business.
Sales of each of the departments of the petitioner were separately recorded in the underlying books of account in 1918; posted to the ledger*2939 individually, but in one account in that book, so that identity was not lost and sales of the brokerage business were readily distinguishable from those of the trading branch. The books of account show the amounts of expense directly chargeable to each branch of business and afford a basis for the allocation of the expenses jointly chargeable.
The gross income of the trading branch of the petitioner's business in 1918, including interest in the amount of $9,478.90, was $160,446.45, which was 57.604 per cent of the total gross income. The expense directly chargeable to such branch was $47,447.23 and the ratable part of the joint expense allocable thereto was $33,947.44. The net income of the trading branch was $79,051.78. The gross income of the brokerage business for such year was $118,086.68, the expense thereof, which was 42.396 per cent of the joint expenses, was $24,984.99, and the net income $93,101.69.
Not more than 5 per cent of the gross income of the petitioner in 1918 was derived from gains, profits, commissions or otherwise from Government contracts. The entire income of the petitioner, other than the profits realized from the trading business, was measured by*2940 2 1/2 per cent of its sales of the products of the Columbia Chemical Co. in the manner set forth above.
The balance sheets of the petitioner at the beginning and end of the taxable year were as follows:
| BALANCE SHEET | ||
| Schedule "C" | ||
| Jan. 1, 1918 | Dec. 31, 1918 | |
| ASSETS | ||
| Cash on hand and in bank | $29,739.22 | $23,049.18 |
| Accounts receivable | 835,633.77 | 942,865.57 |
| Notes receivable | 4,192.51 | 7,592.51 |
| Inventories | 7,347.52 | 5,785.08 |
| Liberty bonds | 107,500.00 | 293,000.00 |
| Investment account | 340,565.00 | 407,939.99 |
| Brand, investment, contracts and patents | 250,000.00 | 125,000.00 |
| Office furniture and fixtures | 1,800.00 | 1,640.00 |
| Total assets | 1,576,778.02 | 1,806,872.33 |
| LIABILITIES | ||
| Accounts payable | 34,941.24 | 118,974.25 |
| Notes payable | 411,664.56 | 530,926.00 |
| Total liabilities | 446,605.80 | 649,900.25 |
| Capital stock | 1,000,000.00 | 950,000.00 |
| Surplus | 130,172.22 | 206,972.08 |
| Total liabilities, capital stock and surplus | 1,576,778.02 | 1,806,872.33 |
*43 After having received an extension of time the petitioner filed its corporation income and profits-tax return for the year 1918 in the office of the collector of internal revenue on April 21, 1919. *2941 This return showed net income in the amount of $150,967.47 and total tax due in the amount of $33,121.74. Thereafter the Commissioner audited such return, made certain adjustments in invested capital, increased the income to the amount of $172,153.47 and asserted the deficiency here involved. In correspondence, subsequent to the audit, he denied the petitioner's request for the computation of its tax liability under the provisions of section 303 of the Revenue Act of 1918 on the ground that not all the principal stockholders were regularly engaged in activities incident to the production of the income realized from the alleged personal service branch of the business, but conceded that such income was made up of commissions and that capital was not material in its production.
The money borrowed by the petitioner in the year 1918 and represented by the items of bills payable in its balance sheets was used for the most part in the purchase of Liberty bonds and no part thereof was necessary or was used for the purpose of paying its obligations to the Columbia Chemical Co.
In 1920 the president of E. F. Drew & Co., a New York corporation, asked Eli Winkler to serve that concern*2942 in an advisory capacity, and on July 9 of such year had him elected "nominally as treasurer," thereof. It was agreed that Winkler should receive salary at the rate of $50,000 per annum. The minute book of E. F. Drew & Co., covering the period from January, 1920, to December 23, 1921, and recording the election of Winkler as treasurer, contains no resolution *44 or other provision fixing any salary for Winkler. The by-laws of such company provide that "the salaries of all officers of the corporation shall be fixed by the Board of Directors."
Representing payments of salary to him, Eli Winkler received two notes from E. F. Drew & Co., dated August 31, 1920, each in the amount of $13,518.79, the first due four months and the second six months from date. These notes were signed for the Drew Company by its president and secretary, both of whom were directors of such company. The notes so received were turned over to the petitioner by Winkler, but were not included by it in its income and profits-tax return for 1920. The respondent has added the amount of such notes, $27,037.58, to the petitioner's gross income for the year 1920. The notes have never been paid. Subsequent*2943 to December 31, 1920, at some date not disclosed by the record, Ernest F. Drew and Benjamin Cohen became receivers in equity for E. F. Drew & Co., Inc. Some time after the close of the year 1920, but at a date not proved at the hearing, the petitioner made a demand on the receivers for the payment of the notes, and such demand was refused for reasons set forth in the following letter:
NEW YORK, Sept. 10th, 1923.
THE ISAAC WINKLER & BRO. CO.,
50 Broad St., New York, N.Y.
Attention - Mr. Eli Winkler.
DEAR SIRS: In accordance with your request that the receivers write you, explaining why they have been unable to allow your claim in so far as it relates to two notes held by you, - one dated August 31st, 1920, in the sum of $13,518.79 maturing in four months, and the other dated August 31, 1920, in the sum of $13,518.79 maturing in six months, - and why they have been unable to allow you any credit in respect of these notes in arriving at a proposed settlement of the disputed items in your claim, the receivers beg to say that these notes cannot be recognized as a valid obligation against the estate in any respect because the receivers have satisfied themselves that the*2944 real consideration for the notes was the service to be rendered for the Drew Company by Eli Winkler in connection with his office as Treasurer of said company. The By-Laws of the Drew Company provided that "the salaries of all officers of the corporation shall be fixed by the Board of Directors." Whatever agreement, if any, may have been reached between Mr. Drew and Mr. Winkler in respect of the compensation or bonus Mr. Winkler was to receive for his duties as Treasurer of the company, such agreement would not be legally binding upon the estate in the hands of receivers unless such agreement was ratified or confirmed by the Board of Directors of the company, and no such ratification or confirmation of any agreement with Mr. Winkler was made by the Board of Directors.
It might further be pointed out that Mr. Winkler did not become Treasurer of the company until August, 1920, so that even if there had been a ratification of any agreement, the receivers could contend that there had been a failure of consideration for the notes. But, as has been pointed out, this question does not arise in view of the fact that there was no ratification or *45 confirmation of any agreement, *2945 and consequently, the notes could not be binding upon the company in the hands of receivers.
Yours very truly,
ERNEST F. DREW AND BENJAMIN V. COHEN,
Receivers in Equity for E. F. Drew & Co. Inc., (a Delaware Corp.)
BY BENJAMIN V. COHEN.
The deficiency here in controversy is based, in part, on the action of the Commissioner in adding the Drew notes, in the amount of $27,037.58, to the petitioner's gross income for the year 1920.
OPINION.
LANSDON: All but two of the issues raised in the pleadings have been settled by stipulation. The deficiencies for 1918 and 1920 remain in controversy. As its defense against the additional tax liability asserted against it, for the year 1918, the petitioner contends that for such year it is entitled to have its tax computed under the provisions of section 303 of the Revenue Act of 1918, which is as follows:
That if part of the net income of a corporation is derived (1) from a trade or business (or a branch of a trade or business) in which the employment of capital is necessary, and (2) a part (constituting not less than 30 per centum of its total net income) is derived from a separate trade or business (or a distinctly separate*2946 branch of the trade or business) which if constituting the sole trade or business would bring it within the class of "personal service corporations," then (under regulations prescribed by the Commissioner with the approval of the Secretary) the tax upon the first part of such net income shall be separately computed (allowing in such computation only the same proportionate part of the credits authorized in sections 311 and 312), and the tax upon the second part shall be the same percentage thereof as the tax so computed upon the first part is of such first part; Provided, That the tax upon such second part shall in no case be less than 20 per centum thereof, unless the tax upon the entire net income, if computed without benefit of this section, would constitute less than 20 per centum of such entire net income, in which event the tax shall be determined upon the entire net income, without reference to this section, as other taxes are determined under this title. The total tax computed under this section shall be subject to the limitations provided in section 302.
A personal service corporation, as referred to in the section above cited, is defined in section 200 of the same*2947 Act as follows:
The term "personal service corporation" means a corporation whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits or income derived from trading as a principal, or (2) of gains, profits, commissions or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive.
*46 In the settlement of the controversy we must determine (1) whether there were as many as two distinct branches of the petitioner's business, and (2) whether one such branch which produced not less than 30 per cent of the total net income was so constituted and conducted that, standing alone, it would be entitled to personal service classification. As a trader, the petitioner bought and sold merchandise and realized substantial profits from such*2948 transactions. In addition to its general trading it acted as sales agent for the Columbia Chemical Co. The Commissioner has conceded that the income of this branch of the business was from commissions and the evidence shows that such commissions were 2 1/2 per cent of the total sales of the products of the Columbia Chemical Co. made by the petitioner in the year 1918. The petitioner's books show the amounts of income received from the two branches of its business and that more than 30 per cent of the total income is attributable to the brokerage or commission branch. We are convinced that petitioner's business in the year 1918 consisted of two distinct branches, viz., trading in merchandise as a principal and selling the products of the Columbia Chemical Co. as an agent. Cf. .
Having determined that the petitioner transacted its business through two distinct branches or departments thereof, we must next decide whether, if standing alone, the commission business, which earned net income in the amount of $93,101.69, as set forth in our findings of fact, would be entitled to personal service classification*2949 under the provisions of section 200 of the Revenue Act of 1918. The activities of the petitioner, through Winkler, in the sale of the products of the Chemical Company were personal service. To come within the provisions of such section the petitioner must show (1) that its principal stockholders or owners were regularly engaged in the active conduct of the brokerage branch, (2) that capital was not a material income-producing factor therein, and (3) that the income of such branch was primarily ascribable to the activities of the principal stockholders or owners.
The evidence amply sustains the petitioner's contention that capital was not a material income-producing factor in the commission branch of its business. In the correspondence resulting from this controversy the Commissioner concedes that this is true but at the hearings and in his brief suggests that the investment of a substantial amount of the petitioner's capital in the stock of the Columbia Chemical Co. may have contributed in some way to earning the commissions which the petitioner received from the sale of the products of that company. Winkler testified that the petitioner had bought the stock of the chemical*2950 company because it was regarded as good investment and that events had confirmed that judgment and also that the sales *47 agreement was in nowise contingent on any stock ownership in the chemical company by the petitioner.
The holdings in question were less than 1 per cent of the outstanding stock of the chemical company, and the dividends therefrom were regarded as earnings of the trading branch of the business. No representative of the petitioner was at any time a director of that company. We are satisfied that such stock ownership had no bearing on the income of the commission branch of the petitioner's business which, we are convinced, was produced without the use of capital.
The facts as to ownership or holdings of the petitioner's capital stock are fully set forth above. In 1918 Eli Winkler owned 4,996 out of a total of 5,000 outstanding shares of the petitioner's common stock. He also owned, in his own name 1,197 shares of the preferred stock then outstanding in the number of 5,000 shares. In addition to this, as cotrustee with his mother, he held 3,240 shares of such preferred stock which he controlled and voted. Of the remaining preferred stock, 190 shares*2951 were owned by S. T. Shoneman, who was secretary of the petitioner and 373 shares by members of the Winkler family who were not active in the business. It appears, therefore, that Eli Winkler was the only stockholder who was regularly engaged in the active conduct of the brokerage branch of the petitioner's business. Except his mother, whose power of attorney he held, no other person owned or held as much as 3 per cent of the stock. In these circumstances we are of the opinion that in 1918 he was a principal owner or stockholder, and was regularly engaged in the active conduct of its business. ; .
That the income of the commission branch of the petitioner's business resulted practically in its entirety from the activities of Winkler is conclusively established by the evidence and is not seriously question by the respondent. Selling the proucts of the Columbia Chemical Co. was Winkler's work. He knew the business, the dealers, and all the conditions of the trade. By correspondence, telegraph and telephone, he personally took most of the orders. In this*2952 branch of the business he had no helpers and employed no solicitors.
If the conclusions above are sound, the petitioner should prevail on this issue, unless Bertha Winkler's interest in the preferred stock is a bar to the application of section 303 of the Revenue Act of 1918, to the situation here. Prior to incorporation, Eli Winkler was the sole owner of the business, which was encumbered with certain obligations to his mother and other members of his father's family. It is plain that he intended to carry over intact to the corporation all his rights and interests in the sole proprietorship. With that purpose in view he had the common and preferred stock of the petitioner issued *48 in such manner that he had full control of the corporation, and, in the taxable year 1918, received or was entitled to receive 87 per cent of the income thereof. By incorporation he neither evaded nor sought to evade any of his obligations as the predecessor sole proprietor, and merely shifted responsibility for the payment thereof from himself as an individual to the corporation, which he completely controlled and whose earnings resulted practically in their entirety from the use of his*2953 capital, brains and experience. The petitioner, no less than its predecessor was a one-man business.
If our decision on this point sustains the contention of the petitioner, the relief accorded will result from a change in the method of computing the tax liability of the corporation. Section 303, unlike section 200, does not provide for a distribution of earnings to shareholders prior to the determination of tax liability. The tax here, no matter how computed, will be asserted against and paid by the corporation. None of the income of the brokerage branch of the business results from the activities of nonstockholders. The relief sought by the petitioner can not inure to the benefit of Bertha Winkler, an inactive stockholder, since her income from the corporation is a fixed amount measured by 6 per cent of the par value of her preferred stock, and can not be affected by tax adjustments favorable to Eli Winkler or the petitioner. In these circumstances we are of the opinion that the tax liability of the petitioner for the year 1918 should be computed in conformity with the provisions of section 303 of the Revenue Act of 1918.
The petitioner contends that the two notes, in*2954 the amount of $27,037.58, which it received from Winkler in 1920, were void or voidable when received and, therefor, had no value at December 31 of that year. The evidence on this point is not convincing. At December 31, 1920, one of the notes was due, and the other did not mature for two months thereafter, and it seems clear that at that date there had been no default in payment, denial of liability, or indication of insolvency or inability to pay. Apparently counsel for the petitioner would have us hold that on account of the cited provision in the by-laws of E. F. Drew & Co. the notes were void and uncollectible when made. We can not agree with the conclusion. Winkler was employed by the president of Drew & Co. The directors acquiesced in such employment when they elected him treasurer. One or more or all of them must have known that the salary of Winkler was to be at the rate of $50,000 per annum. One or more or all must have been aware that notes of the company were given in discharge of salary obligation. The *49 fact that the minutes of the directors of Drew & Co. contain no resolution fixing the salary of Winkler is not conclusive that such action was never*2955 taken in such a way as to bind that corporation. There could have been proper action by the directors that was not recorded in the minutes.
The letter from the receivers of Drew & Co. upon which the petitioner, in part, bases its contention that the notes were invalid or void when made was written in 1923. The statements therein in relation to the notes are mere conclusions of law and have no evidentiary weight as proof of absence of value in the notes at December 31, 1920. We are of the opinion that the evidence fails to overcome the presumption that the Commissioner's inclusion of the anount of such notes in the petitioner's income for the year 1920 was correct.
Reviewed by the Board.
Decision will be entered under Rule 50, in conformity with the stipulation of the parties and the findings of fact and opinion herein.
STERNHAGEN and MURDOCK dissent.
TRAMMELL, dissenting: I am unable to agree with the Board's decision for the following reasons:
(1) There was 32 per cent of the stock of the corporation owned by persons who were not regularly engaged in the active conduct of the business and in this connection, in my opinion, the statute provides*2956 for stock ownership by those who are regularly engaged in the business and not stock control.
(2) It appears that the petitioner was responsible for the payment of goods which it claims to have sold on a commission basis. The goods were billed to it and it was equired to pay therefor, thus requiring capital, notwithstanding the fact that it customarily received the purchase price of the goods befoe it was required to pay the bills. The obligations to pay were the petitioner's obligations. In this connection it seems to me that the credit of the company, which was established by its financial standing based upon its assets, was a material income-producing factor in the petitioner's brokerage business.
(3) It seems to me that this case is governed by the case of .
MARQUETTE agrees with this dissent.