*1340 The petitioner was not entitled to assessment for 1917 as a business having no invested capital or not more than a nominal capital, as provided in section 209 of the Revenue Act of 1917, and was not a personal service corporation during the years 1918, 1919 and 1920 as defined by section 200 of the Revenue Act of 1918.
*265 The respondent has determined deficiencies in income and excess-profits taxes in the following amounts:
| Docket No. | Year | Deficiency |
| 18963 | 1917 | $20,874.37 |
| 1918 | 20,181.59 | |
| 1919 | 29,833.05 | |
| 22693 | 1920 | 13,600.35 |
| Total | 84,489.36 |
The deficiencies arise from the disallowance by the respondent of petitioner's claims that it is entitled to assessment for the year 1917 under the provisions of section 209 of the Revenue Act of 1917 as a business having no invested capital or not more than a *266 nominal capital, and that for the years 1918, 1919 and 1920 it is entitled to classification as a personal service corporation under section 200*1341 of the Revenue Act of 1918. It is also alleged in Docket No. 18963 that the respondent erred in determining deficiencies for 1917, 1918 and 1919 under section 210 of the Revenue Act of 1917 and under sections 327 and 328 of the Revenue Act of 1918. In Docket No. 22693 it is alleged that the respondent rejected the petitioner's application for special assessment for 1920 and petitioner does not question the correctness of this action, but claims that it should be taxed as a personal service corporation. The cases were consolidated for hearing. Upon motion the hearing was limited in the first instance to the issues defined in subdivisions (a) and (b) of Rule 62 of the Board's rules of practice.
FINDINGS OF FACT.
Petitioner is an Illinois corporation, organized in February, 1909, with its principal place of business at 112 West Adams Street, Chicago. The object for which the corporation was formed is stated in the articles of incorporation to be "the manufacture and sale of metal, wooden, rubber and composition goods, particularly automobile wheels and rims; and to purchase, lease and otherwise acquire property, patents, patent rights, trademarks and names, both real and personal, *1342 which are or may be needful to such business, and to sell, lease, promote, and otherwise dispose thereof."
For several years prior to the incorporation of the company Erle K. Baker, an inventor, and Charles G. Hawley, a patent attorney, had been associated in work on various inventions. Two patents had been obtained and there were pending four applications for patents on a demountable rim, all of which were assigned to the corporation. No cash was paid in at the time the corporation was organized. The entire capital stock of $100,000 was issued in equal amounts to Baker and Hawley in exchange for the following described property:
Said property being the good-will and so much of the business of Hawley & Baker, (a firm composed of Charles G. Hawley and Erle K. Baker) as includes the wheels and rims known by the name Universal, together with the title to, and right to use the trade name Universal for and upon wheels and rims, and together with all of the right, title and interest of said Hawley and said Baker, in and to, their inventions specifically known as Demountable and Quick Detachable Rims, which inventions are the subject matters of applications pending in the United States*1343 Patent Office. * * *
In November, 1909, an agreement was entered into between Charles G. Hawley, Erle K. Baker, Walter S. Harris and T. Stewart Harris, whereby the Harris brothers acquired one-half, or 500 shares, of the capital stock of petitioner. Baker and Hawley furnished the 500 *267 shares of stock and agreed to contribute to the treasury of petitioner the cash proceeds of the sale thereof. The Harris brothers agreed to pay into the treasury of the petitioner amounts aggregating $40,000 as such capital might be required to initiate, promote and expand the business of the petitioner corporation. This agreement contained the following provision:
It is hereby mutually understood and agreed by and between the parties hereto that the business of said Universal Rim Company, at present consisting of the manufacture and sale of the so-called "UNIVERSAL RIMS" invented by the parties of the first part, shall be pushed diligently and vigorously with a view to expanding the business as rapidly as possible, the intent hereof being that the money shall be paid into the Treasury in such manner as to promote the best interests of the Company and all its stockholders, all as determined*1344 by the Board of Directors.
During the period from January 31, 1910, to February 26, 1912, the Harris brothers advanced the total sum of $33,214.36, which amount was used in the development of petitioner's patents and in building up additional patents. In 1916 the stock acquired by the Harris brothers was repurchased by and divided equally between Baker and Hawley.
The original patents and patent applications related to an automobile wheel rim of the clamp-on type known as the B.U.D., or Baker Universal Demountable. Within three years after organization this rim proved to be impractical and another demountable rim of the bolted-on type was developed. Applications for patents on the bolted-on type of rim were made and were assigned to the petitioner corporation. All of the patents owned by the petitioner during the taxable period which were taken out by Baker or by Hawley after the company was incorporated were assigned to the corporation in each instance for the nominal consideration of $1. The petitioner paid the cost of obtaining the patents and also bore the expenses incident to the experimental and engineering work which was done in connection with these patents. None*1345 of such costs were capitalized on petitioner's books.
The petitioner also acquired certain applications for patents made by another inventor named Anglada, which applications had been asserted in an interference proceeding in the Patent Office in opposition to certain applications of Baker and Hawley, and were purchased for $500 to dispose of the proceeding.
During the taxable period Baker and Hawley each owned 45 per cent of the stock of the petitioner and Anglada owned the remaining 10 per cent. Anglada's stock was issued to him in consideration of services to be performed. Patents taken out by Anglada were assigned to the petitioner for $1 each. All the patents owned by the petitioner during the taxable period were the inventions of its stockholders, *268 Baker, Hawley, and Anglada. At the beginning of the taxable period the petitioner owned more than thirty patents relating to demountable rim constructions.
Petitioner did not undertake to manufacture automobile rims or wheels, but entered into license agreements with manufacturing companies. During the taxable period petitioner had license agreements with the General Motors Corporation, Standard Parts Company*1346 (successor to Standard Welding Company), Jaxon Steel Products, Dodge Brothers and W. K. Prudden & Company. It also had a verbal contract with the Cleveland Welding Company. All the agreements provided that the petitioner would furnish to the licensee, free of charge, at all reasonable times, services in a consulting capacity concerning demountable rim constructions, the licensee to pay traveling and other expenses incurred upon the request and specific authority of the licensee. The licensees paid the petitioner five cents for each rim manufactured by them which used any device covered by any of petitioner's patents or patent applications, irrespective of the number of patents used. The term "patents" was expressly stated to include patents granted upon pending applications and patents which might be obtained or acquired by petitioner. The following provision is quoted from a typical license agreement:
The LICENSOR hereby grants unto the LICENSEE and the LICENSEE hereby accepts a non-exclusive license to make, have made, use and sell in the United States, and elsewhere, demountable rim constructions for wheels under and in accordance with each and all said PATENTS; but the LICENSOR*1347 hereby reserves unto itself the royalties fixed in Article 5 hereof, and, as one of the considerations, conditions and limitations of this grant, the right, from time to time, to impose minimum price restrictions with reference to the sale of patented demountable rim constructions hereunder; provided, however, that all such restrictions shall be uniform with reference to the LICENSOR and all its LICENSEES, and shall be in force only during such period as the LICENSOR maintains reasonable control of rim constructions purporting to be covered by its patents thereunder.
The agreement further provided that the licensee should observe and abide by all lawful restrictions which the petitioner might impose upon the manufacture and sale of patented demountable rim constructions by virtue of the reservations appearing in the above quoted article and that the licensee should open its books and records and its demountable rim departments to audit and inspection by the petitioner's authorized representatives during all reasonable business hours.
All the money received under these license agreements not required for the running expenses of the business and for experimentation and development*1348 purposes, was distributed to the stockholders in the form of dividends. The company did not maintain bank balances in any considerable amount.
*269 Petitioner's main office was Hawley's law office. In 1919 it rented a small room adjacent to this office and used it as a drafting room. Petitioner's only employees, besides its three stockholders, were a stenographer and a draftsman. All three stockholders were regularly engaged in the active conduct of the company's business. Baker's work consisted principally of calling on the licensees and assisting them in their manufacturing plants in applying and adapting the company's devices to their needs. He called on each licensee at intervals of not exceeding two weeks. He frequently suggested short cuts and helped them to reduce their costs. On one occasion Baker obtained the renewal of certain valuable license agreements by demonstrating to the licensees that a competitor's device increased the cost of manufacture by 75 cents per set of rims. There were on the market many patents relating to demountable rim constructions other than those owned by petitioner and the competition was exceedingly keen. Baker kept in touch*1349 with the production of the licensees and consulted with Hawley and Anglada concerning the experimental and engineering work which was done to meet the needs of the manufacturers. In addition to the mechanical assistance which he rendered Hawley handled all the patent applications and had charge of all litigation and interference proceedings. He gave up his law practice in order to devote all his time to the affairs of the petitioner. Anglada followed up the experimental and development work and made a number of applications for patents during the taxable period.
From 1910 up to the end of April, 1917, the petitioner operated a service station, which did repair work and kept on hand a stock of wheels and rims. The service station was not in the same building with petitioner's office. This service was established at the instance of the licensees, who believed that service and instruction in the operation of the devices should be furnished to the owners of automobiles equipped with the company's devices. No manufacturing was done by the petitioner and the articles sold at the service station were bought from the licensees of petitioner. In 1917 the stockholders decided that*1350 the devices had been sufficiently introduced and that the service station was no longer essential. It was closed out as of April 30, 1917. After the disposition and sale of the service station the petitioner had no stock in trade and kept no inventories. Thereafter, petitioner's only source of income was from royalties or "commissions," as they were called by certain of the licensees who objected to terming them royalties.
Upon the sale of the service station its assets and liabilities were, in closing entries as of April 30, 1917, removed from the books of petitioner by charging to surplus the sum of $66,666.53 and crediting to surplus the sum of $8,334.44, leaving a net amount of $58,332.09 to represent the net assets of the service station closed out as of *270 that date. The books indicate a net profit of the service station for the four months ending April 30, 1917, of $6,272.93.
Although separate books were not kept for the service station, the assets and liabilities accounts and the income and expense accounts of the service station are identifiable on the books of petitioner.
On the petitioner's balance sheet for the year ended December 31, 1916, the item*1351 of surplus is listed in the sum of $56,506.48. The patents and good will are set up at $100,000, which is the amount of the capital stock of the corporation. Royalties receivable are listed in the amount of $20,758.38.
The petitioner's balance sheets at the close of the years involved herein are as follows:
| Item | December 31, 1917 | December 31, 1918 | December 31, 1919 | December 31, 1920 |
| Automobile | $2,600.00 | |||
| Adding machine | 175.00 | |||
| Furniture and fixtures | $224.50 | 224.50 | ||
| Patents and good will | $100,000.00 | $100,000.00 | 100,000.00 | 100,000.00 |
| Bank | 453.28 | 77.02 | 3,572.57 | 71.96 |
| Baker Wheel and Rim Company | 91.59 | 1,271.36 | ||
| J. A. Anglada | 500.00 | 500.00 | ||
| Royalties accrued | 15,879.87 | 12,279.00 | 8,754.58 | 9,482.27 |
| Total | 116,424.74 | 113,627.38 | 113,051.65 | 113,053.73 |
| Capital stock | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 |
| E. K. Baker | 799.96 | 900.00 | 400.00 | 5,700.00 |
| C. G. Hawley | 238.50 | |||
| Accounts payable | 416.53 | |||
| Surplus | 14,969.75 | 12,727.38 | 12,640.42 | 3,641.17 |
| Accrued expenses | 3,419.56 | |||
| Reserve for depreciation | 11.23 | 293.00 | ||
| Total | 116,424.74 | 113,627.38 | 113,051.65 | 113,053.73 |
The Baker Wheel and*1352 Rim Company was affiliated with the petitioner, being owned by the same interests and having been organized to receive certain patents which pertain more specifically to wheels than to rims. It owned no assets other than these patents and did not operate in its own name. Certain expenses in connection with the patents were entered on the petitioner's books in an account entitled "Baker Wheel and Rim Company." In 1919 and 1920 the respective amounts of $15,059.45 and $14,525.79 passed through the Baker Wheel and Rim Company account and were charged off to experimental expenses on the petitioner's books. The accounts of petitioner and the Baker Wheel and Rim Company were consolidated by the respondent in determining the petitioner's tax liability.
Petitioner did not charge off any depreciation in respect of its patents and did not claim any deduction for depreciation of its patents in its income-tax returns for the taxable years.
In a statement attached to its income-tax return for the year 1917 petitioner stated that it was a corporation having a nominal capital, *271 that it was organized by Baker and Hawley, who exchanged their inventions (automobile rims) for stock*1353 of the company, and that its assets were its inventions, patents, good will, licenses outstanding upon which it received royalties, and profits and damages due from infringers of its patents. Its income was stated to be wholly in the form of royalties paid to it by concerns holding its licenses. Dividends paid were listed in the sum of $26,000. Deductions were made for expenditures for traveling and hotel expenses, cost of developing inventions and patenting same, cost of patent litigations and cost of advertising. The return showed a taxable net income of $453.28. Petitioner filed a corporation income and profits-tax return for 1918, which showed a net income for the taxable year of $104.22. Dividends paid amounted to $45,500. For the years 1919 and 1920 petitioner filed a partnership and personal service corporation return. The respondent denied that the petitioner was entitled to assessment for the year 1917 under section 209 of the Revenue Act of 1917 and held that it was not entitled to personal service classification for the years 1918, 1919 and 1920. Petitioner thereupon filed applications for special assessment for the taxable years under the relief provisions of the*1354 statute. The respondent found that petitioner was entitled to special assessment for the years 1917, 1918 and 1919 and determined deficiencies in accordance with the provisions of section 210 of the Revenue Act of 1917 and sections 327 and 328 of the Revenue Act of 1918. The respondent rejected the petitioner's application for special assessment for 1920.
Subsequently the petitioner protested the respondent's allowance of special assessment for 1917, 1918 and 1919 and renewed its claim that it was entitled to assessment for the year 1917 as a business having no invested capital or not more than a nominal capital, and that it was entitled to classification for the years 1918 to 1920, inclusive, as a personal service corporation. Upon audit the respondent refused to allow personal service classification and denied that the petitioner was entitled to assessment under section 209 of the Revenue Act of 1917.
The petitioner derived no income during the taxable years from Government contracts.
OPINION.
MATTHEWS: Section 209 of the Revenue Act of 1917 provides:
That in the case of a trade or business having no invested capital or not more than a nominal capital there shall*1355 be levied, assessed, collected and paid, in addition to the taxes under existing law and under this Act, in lieu of the tax imposed by section two hundred and one, a tax equivalent to eight per centum of the net income of such trade or business in excess of the following deductions: In the case of a domestic corporation $3,000, and in the case of a *272 domestic partnership or a citizen or resident of the United States $6,000; in the case of all other trades or business, no deduction.
Section 200 of the Revenue Act of 1918 defines a personal service corporation as follows:
SEC. 200. That when used in this title -
* * *
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, *1356 profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive.
The underlying purpose and intent of the provisions in the two acts are the same and it is incumbent upon the petitioner to show that for each of the taxable years the capital employed was incidental rather than substantial.
We have found that no cash was paid in at the time of the incorporation of the petitioner and that the entire capital stock in the amount of $100,000 par value was issued in equal amounts to Baker and Hawley in exchange for certain patents and patent applications and other property more particularly described in our findings of fact. We cannot say that the property turned over to petitioner by Baker and Hawley in exchange for the capital stock of the company was reasonably worth $100,000, but it is not necessary to determine its true value. We are of the opinion that the patents and the trade name "Universal" had some value at the time they were exchanged for the petitioner's capital stock. Although the patents originally assigned to the petitioner proved to be impractical, other patents were developed*1357 and improvements were being continually made, all of which related to demountable rim constructions. At the beginning of the taxable period petitioner owned more than thirty patents. The respondent has never determined the value of the patents for invested capital purposes, but this does not mean that petitioner had no invested capital.
Shortly after the company was organized an agreement was entered into between Baker and Hawley, who owned all the stock, and Walter S. Harris and T. Stewart Harris, whereby the Harris brothers agreed, in consideration of the issuance to them of 500 shares, or one-half of the capital stock of petitioner, to pay into the treasury of petitioner sums not to exceed $40,000, to be used in the development of petitioner's patents and in building up the business. About $33,000 was in fact advanced by the Harris brothers *273 for the purpose specified. This amount represents cash paid in to the corporation and it should be included in petitioner's invested capital. We do not know the amount of petitioner's invested capital, but the position that petitioner had no invested capital can not be sustained under the circumstances set out herein.
*1358 With respect to the question whether petitioner had more than a nominal capital, within the meaning of the statute, it may be remarked that it is not the amount of capital which is important, but rather whether it is capital in name only, that is, not substantial. The real issue is, did the earning power of the petitioner function independently of capital? This question is likewise pertinent in determining petitioner's tax liability for the years 1918, 1919 and 1920. Petitioner earnestly contends that its income for these years was attributable primarily to the activities of its stockholders and that capital was not a material income-producing factor. Failure to prove either of these contentions will be fatal to petitioner's right to be classified as a personal service corporation.
It is not disputed that the three stockholders of petitioner, Baker, Hawley and Anglada, were regularly engaged in the active conduct of the affairs of the corporation. We have stated that petitioner was the owner of a number of patents relating to demountable rim constructions and its essential business was developing and licensing these patents. Petitioner did not manufacture demountable rims*1359 and wheels, but entered into license agreements with manufacturing companies under which the licensees paid the petitioner 5 cents for each rim manufactured by them which used any device covered by any of petitioner's patents or patent applications. These license agreements specifically provided that the patents therein mentioned included any future patents which might be obtained or acquired by the petitioner. Mechanical improvements were made from time to time and new applications for patents were taken out by petitioner's stockholders, all of which applications and patents were assigned to the petitioner for the nominal consideration of $1 each. Petitioner paid the cost of obtaining these patents and bore the expenses incurred in experimentation and development work. Although the inventions differed in details of construction, they all dealt with carrying a spare tire inflated and ready for use upon a rim which could be mounted upon an automobile wheel in accordance with the parctice which is now almost universal. The license agreements provided that the petitioner would furnish to the licensees, free of charge, at all reasonable times, service in a consulting capacity, the*1360 licensees to pay the traveling and other expenses in connection with such services where the expenses were incurred upon the request and specific authority *274 of the licensees. Baker kept in touch with all the licensees, calling on them personally at regular intervals, making suggestions and assisting them in their manufacturing operations. Reference is here made to our findings of fact for a more complete statement of the assistance rendered to the licensees in accordance with this provision.
The petitioner claims that the services of its stockholders were indispensable and that the patents were valueless without such service. It is suggested by petitioner that the licensees might have canceled their agreements and refused to make any payments if these services had been withheld.
There is no question that it was advantageous to petitioner to make improvements and to assist the licensees in their manufacturing operations because petitioner's income from the royalties was thereby increased. It was important also that the petitioner keep informed as to the manner in which the licensees were operating under the license agreements. These agreements expressly provided*1361 that the petitioner might audit the books and records of the licensees and inspect their demountable rim departments at all reasonable business hours and the licensees agreed to abide by all lawful restrictions which the petitioner might impose upon the manufacture and sale of the patented demountable rim constructions. The petitioner had the right to insist that the manufactured products come up to a certain standard. Baker testified that he paid all expenses incurred in connection with his visits to the licensees and that they never compensated him for the services furnished, so that these visits appear to have been made for purposes of inspection as well as to render any services which might be desired by the licensees. It is recognized, however, that, because of rapid changes in the wheel and rim industry, if the petitioner had not been ready and willing at all times to render this assistance, the license agreements would have become much less valuable as a source of income. The value to the petitioner of the license agreements was dependent upon the value of the patents and patent applications which overed the devices used by the licensees in the manufacture of the rims and*1362 wheels. It can not be doubted that the perfection of rim devices by the petitioner in the form of basic patents or patent applications and later improvements thereon were extremely valuable as producers of income. Unquestionably the services which the stockholders rendered to the licensees increased petitioner's good will and resulted in the payment of additional royalties, but we do not agree with the petitioner's contention that the petitioner's income was mainly ascribable to the activities of its stockholders. It follows that classification as a personal service corporation should be denied.
*275 The development work and the engineering service which was furnished to the manufacturing companies necessitated the expenditure by petitioner of considerable amounts. In 1919 and in 1920 there were charged off on petitioner's books to experimental expenses the respective sums of $15,059.45 and $14,525.79.
On cross-examination Baker testified as follows:
Q. Where did you get the money to perfect your new patents and your new devices in 1917, 1918 and 1919; where did that money come from?
A. From our royalties.Q. In other words, you put the royalties back into*1363 the business?
A. We put a great deal of it back into experimental work, and for service expense, and things of that kind. We never intended to put it back in the business, if we could possibly help it, because we wanted the dividends, if we could get them, and Mr. Hawley was more insistent on keeping them out than I was, and he mortgaged all he had to put into this service stock.
Q. Well, now, it cost you money to keep your business up during these years, didn't it? Say in 1918, 1919 and 1920, didn't it cost you money to keep your business up, to keep these devices up to the development of the trade?
A. It would necessarily cost money to do that. We couldn't make experlments, we couldn't go around and find out what was necessary to be done and do all of those things without money.
Q. In other words, you couldn't operate unless you had money coming in all of the time, could you?
A. Money was necessary in the business.He further testified that receipts from royalties, less operating expenses (which apparently included experimental and engineering expenses), were promptly distributed in the form of dividends and that petitioner did not maintain bank balances*1364 in any considerable amount. His testimony indicates that the expenses of carrying on experiments and of perfecting the patents and adapting them to the needs of the licensees, were treated in the same manner as the running expenses of the petitioner's business, such as officer rent, so that many items of a capital nature appear to have been charged to expense.
From time to time the petitioner became involved in various interference proceedings and instituted suits for infringement of its patents. The profit and loss statement of petitioner for 1917 shows an item of $20,361.11 for legal expenses. The profit and loss statements for the years 1918, 1919, and 1920 show legal expenses in the respective sums of $5,021.38, $3,800.97, and $3,567.21. On of petitioner's witnesses testified that petitioner at one time received $75,000 in settlement of an infringement suit, but was not certain as to the date such amount was paid.
The petitioner's balance sheet for the year ended December 31, 1916, showed a surplus of $56,506.48.
Under these circumstances we hold that capital played an integral part in the actual production of petitioner's income and that petitioner *276 is*1365 not entitled to assessment under section 209 of the Revenue Act of 1917.
We have carefully considered the cases relied upon by petitioner, including the case of ; affd., , where the court held that the patents involved id not constitute capital. Without discussing the reasoning employed, we consider the facts to be distinguishable from those of the instant case and that the decision is not controlling herein. The court pointed out in the DeLaski & Thropp Co. case that the taxpayer's entire business was simply to collect and distribute the rental or royalty charged for the use of its patents. Its capital stock was reduced from $100,000 to $10,000 and in 1917 it had a surplus of only $2,000. In the instant case we have found that substantial amounts were expended by petitioner during the taxable years in developing patents and furnishing engineering service to the manufacturing companies. Petitioner's stockholders were constantly bending their energies to develop new ideas to succeed prior inventions as a competitive market rendered the old patents obsolete. We*1366 can not accept the proposition that the capital used was merely incidental to the earning power of the corporation. Cf. ; affd., ; .
In reaching this conclusion we have not considered the operation of the service station, which the petitioner claims was only incidental, having been established to furnish instruction in the operation of the devices covered by petitioner's patents. It is clear that capital was essential in operating the service station, which did repair work and kept on hand a stock of wheels and rims, but the petitioner urges that inasmuch as the service station was closed out as of April 30, 1917, after which time petitioner had no stock in trade and kept no inventories, petitioner should not be deprived of the right to assessment under section 209 of the Revenue Act of 1917. Petitioner has endeavored to separate on its books for 1917 the "service station " business from the "personal service" business. It is admitted that there was no actual separation on the books, but petitioner claims that the items are easily*1367 identifiable. Without passing upon the correctness of this method, we conclude that, irrespective of the operation of the service station, capital was a material factor in producing the income sought to be taxed herein. The determination of the respondent is sustained.
Reviewed by the Board.
Judgment will be entered for the respondent.
TRAMMELL, ARUNDELL, MCMAHON, and GOODRICH dissent.