*3908 The petitioner was a personal service corporation during the year 1920.
*1311 The petitioner has instituted this proceeding for the redetermination of a deficiency in income and profits tax for 1920, in the amount of $7,237.75. The only question in issue is whether the petitioner was a personal service corporation during the year 1920.
FINDINGS OF FACT.
The petitioner is a Minnesota corporation with its principal office in Minneapolis. In 1903, J. H. Mitchell, formerly employed by various concerns for the purpose of preparing copy for advertisements, *1312 engaged in the advertising agency business in St. Paul. In 1908 the petitioner was organized and Mitchell turned over to it for $45,000 par value capital stock his individual business and the property connected therewith. This property consisted of about $3,000 tangible property, including cash and accounts receivable and the balance good will. Three or four other individuals joined with him in forming the corporation but they dropped out from the corporation prior to 1920. During*3909 1920 the capital stock of the petitioner was held as follows:
| Shares | |
| J. H. Mitchell | 260 |
| E. W. Sann | 78 |
| F. W. Skinner | 76 |
| R. W. Foulke | 41 |
| G. A. Murdock | 41 |
| Wm. H. Oppenheimer | 32 |
| 499 |
There were 65 shares of preferred stock outstanding on January 1, 1920, which were exchanged for common stock shortly after the first of the year. All of the stockholders, excepting Oppenheimer, devoted all their time to the business during the entire year 1920 and were actively engaged in the business of the corporation. Sann had had some experience before he came with the taxpayer. He and the other stockholders were trained by Mitchell. Mitchell, Sann, Skinner, and Foulke procured the clients. They were the only ones who came in contact with the clients and served them. Murdock was in charge of the copy department. The practice in outlining campaigns was to have a conference participated in by Mitchell and Sann, or Skinner, or Foulke, whichever of them was servicing a particular client, and sometimes the client. Murdock also participated in these conferences. After these stockholders had worked out the plan and decided what to do and a written requisition in detail*3910 had been made by them, Murdock would write the copy himself or give detailed instructions to one of the copywriters as to what was wanted.
The petitioner did for clients the following: Planned campaigns; selected media; prepared copy; saw to it that it was run properly and the requisite number of times; checked the bills for the advertisements; looked after the advertiser's interests in respect to adjustments of disputes with the publisher, and gave advice concerning advertising and selling.
At the time that a client was secured for the petitioner the client entered into a contract with the petitioner by which the petitioner *1313 agreed to give the client its best counsel and advice regarding its sales plans and advertising policy; its cooperation in directing the sales work, and in all matters pertaining to the marketing of its products as required; its services in the preparation of such booklets, catalogues, circulars, posters, letters and such other media as might be agreed upon as necessary to the success of the campaign. In consideration of this the client agreed to pay the actual cost of all material necessary for such work, plus a commission of 15 per cent; The*3911 client agreed to pay the publishers gross card rates for all space used, less any cash discounts given the agency by the publishers, payments to be made on the same dates that the petitioner might have to pay the publishers to secure cash discounts from them.
The balance sheet as at January 1, 1920, was as follows:
| Assets | |
| Accounts receivable | $61,387.33 |
| Bills receivable | 37.00 |
| Cash | 12,083.31 |
| Surrender value life insurance | 1,796.21 |
| Investments - stocks | 4,450.00 |
| Furniture and fixtures | 5,151.63 |
| Good will | 42,218.69 |
| 127,124.17 | |
| Liabilities | |
| Accounts payable | $46,905.03 |
| Expense payable | 2,761.63 |
| Bad debt reserve | 15,937.25 |
| Depreciation reserve | 1,218.28 |
| Capital stock | 35,300.00 |
| Surplus | 25,001.98 |
| 127,124.17 |
The balance sheet at December 31, 1920, was as follows:
| Assets | ||
| Cash | $13,907.43 | |
| Bills receivable (clients) | 8,745.00 | |
| Accounts receivable (clients) | $48,900.59 | |
| Less: Reserve for losses | 16,150.48 | |
| 32.750.11 | ||
| Bills receivable (stockholders) | 2,950.00 | |
| Accounts receivable (stockholders) | 6,644.71 | |
| Insurance (cash loan value) | 1,538.75 | |
| Investments | 3,990.00 | |
| Equipment | $5,608.66 | |
| Less: Reserve for depreciation | 1,121.93 | |
| 4,486.73 | ||
| Good will | 42,218.69 | |
| Total assets | 117,231.42 | |
| Liabilities | ||
| Accounts payable (publishers, etc.) | $27,429.11 | |
| Bills payable (publishers, etc.) | 4,537.61 | |
| Expense payable | 1,786.42 | |
| Employees' bonus fund | 1,573.55 | |
| Reserve for accrued taxes | 108.45 | |
| Capital stock | 39,363.00 | |
| Surplus | 42,433.28 | |
| Total liabilities | 117,231.42 |
*3912 The petitioner performed services for 108 clients during the year 1920. From fifteen of these it accepted interest-bearing notes for payment of bills due in the aggregate amount of $97,657.80. These notes were endorsed by the petitioner and deposited in its bank the same as a check. The petitioner borrowed during the year $3,000 on one occasion for 90 days and $2,500 on another for 60 days. On several occasions also it gave its notes for small amounts to engraving companies or to publishers. It occasionally happened that an engraving company desired immediate payment for work performed for an advertiser of the client; when the work was delivered to the petitioner the petitioner gave its note to the engraving company for such period of time as it estimated would elapse before the job was paid for by the advertiser.
*1314 The petitioner's tax return for 1920 shows in part as follows:
| Net charge to our clients | $685,452.56 |
| Less: Amount charged us by publishers and agents for services, etc | 580,570.45 |
| Gross income from services | 104,882.11 |
| Interest received from clients on past due accounts, etc | 222.57 |
| Cash dividends received during the year | 157.00 |
| Gross income from all other sources | 214.89 |
| Total | 105,476.57 |
| Total deductions | 80,856.84 |
| Net income | 24,619.73 |
*3913 The correct net income as shown by the exhibits submitted in evidence was $22,243.35.
Losses sustained by the petitioner resulting from bad debts claimed on its return for 1920 amounted to $330.23. To employees who were not stockholders the petitioner paid compensation of $31,603.49. The compensation paid to officers and stockholders during the year 1920 was as follows:
| J. H. Mitchell | $11,330.00 |
| F. W. Skinner | 4,952.56 |
| E. W. Sann | 6,223.51 |
| G. A. Murdock | 3,600.00 |
| R. W. Foulke | 4,451.90 |
| Total | 30,500.97 |
During the year 1920 the petitioner received from clients $675,546.25. Of this amount $506,057.28 was received during the month that the client was billed or by the 14th of the following month. An additional $64,456.05 was received between the 14th and 19th of the month next after the month billed. Most of the balance was received within 30 days to 60 days after billing; $10,548.69 was received between 60 and 90 days after billing.
OPINION.
SMITH: The question presented is whether the petitioner is a personal service corporation within the meaning of section 200 of the Revenue Act of 1918, for the year 1920. *3914 In order to qualify as a personal service corporation a corporation must meet three tests: (1) The income of the corporation must be ascribed primarily to the activities of the principal owners or stockholders; (2) such principal owners or stockholders must themselves be regularly engaged in the active conduct of the affairs of the corporation; and (3) capital, whether invested or borrowed, must not be a material income-producing *1315 factor. A failure to comply with any one of these requirements is fatal to a claim for personal service corporation classification. Home Insurance Agency,5 B.T.A. 1020">5 B.T.A. 1020; Matteson Co. v. Willcuts, 12 Fed.(2d) 447. No question is raised by the respondent but that the petitioner meets the other requirements of a personal service corporation contained in the definition thereof.
In considering the question of the classification of corporations as personal service corporations or corporations subject to tax under the other provisions of the taxing statute, it becomes pertinent to inquire into the connotation of the term "personal service corporation" as used in the statute. In this connection it is important*3915 to note that the personal service corporation came into being under the provisions of the Revenue Act of 1918, which imposed a high excessprofits tax, and that it dropped out of the purview of the taxing act with the year 1921, which was the last year in which an excessprofits tax was imposed. The idea of Congress was apparently that the excess-profits tax should apply primarily to corporations which had a considerable amount of capital; in such case the exemption allowed such corporation of a reasonable return upon the amount of capital invested would not make the tax burdensome, for the tax was only a portion of the earnings in excess of a reasonable return upon the capital invested. Where, however, a corporation had little or no capital, as was generally the case where the income was to be ascribed largely to the activities of the principal stockholders, the high rates of the excess-profits tax would make the tax peculiarly burdensome to the corporation. That this was the idea in the mind of Congress is evident from a consideration of the reports of the committees of Congress which had the Revenue Act of 1918 in charge. Senator Simmons, in reporting that the Conference Committee*3916 had put into the 1918 Act section 200 of that Act, addressed the Senate as follows:
Mr. President, the Senate made a very striking amendment to the House bill in its amendment permitting a corporation whose principal income is derived from the personal activities of the principal stockholders to be taxed as a partnership instead of as a corporation. The fundamental reason for that change is found in the fact that the excess profits taxes and the war profits taxes for 1918 would be extremely oppressive - I might use a harsher term than that - would be almost destructive if they were imposed without allowing a reasonable exemption or deduction.
This exemption or deduction is based very largely upon the invested capital. With a deduction which for excess profits tax cannot be less than 8% of the invested capital, and for war profits tax cannot be less than 10% of the invested capital - with this allowance entirely exempt from taxation - a capitalistic corporation is by the very letter of law guaranteed a reasonable profit, however high the tax may be upon that part of their profits in excess of this allowance, so that no concern whose business is based upon capital, whose profits*3917 *1316 are the returns of capital, can be bankrupted or can be deprived of what in the business would is regarded as a fair return upon the capital invested in the business. But where the income is not derived from capital, but is derived from the personal exertions of the principal owners of the corporation, there can be no exemption based upon invested capital. If these excess profits and war profits taxes were imposed, therefore, upon a corporation that had no capital or very little capital, they would constitute a flat tax upon the entire earnings, without any deductions except for the actual expenses incurred in the conduct of the business. That would be a great hardship. (57 Cong. Rec., Pt. 3, p. 3135.)
The application of section 200 of the Revenue Acts of 1918 and 1921 to an advertising agency has been considered at length in S.A. Conover Co.,6 B.T.A. 679">6 B.T.A. 679; Fuller & Smith v. Routzahn, 23 Fed.(2d) 959; Sweeney & James Co.,10 B.T.A. 966">10 B.T.A. 966; and Botsford-Constantine & Tyler,10 B.T.A. 565">10 B.T.A. 565.
A careful consideration of the evidence in this case, together with that involving the same taxpayer for the*3918 years 1918 and 1919, 3 B.T.A. 1095">3 B.T.A. 1095, leads to the conclusion that the income of the corporation for 1920, must be ascribed primarily to the activities of the principal owners or stockholders and that such principal owners or stockholders were regularly engaged in the active conduct of the affairs of the corporation. The petitioner had nothing to sell to its clients except its services. These services were principally rendered by the stockholders. It was for these services that the commissions were allowed the petitioner. See S. A. Conover Co., supra.
As to whether capital was a material income-producing factor, the witnesses for the petitioner were unanimous in the expression of an opinion that capital was not an essential of the ordinary advertising agency or of the petitioner in particular. Advertising agencies do not make a practice of financing advertisers. Reputable publishers do not favor such practice. In the instant case the petitioner did accept from a number of its clients interest-bearing notes payable within from 60 to 90 days which it deposited in the bank the same as a check and was charged no discount thereon. These notes were paid when due, *3919 with the exception of four small notes during the year 1920, the total of which was less than $1,100. One of these clients testified that the notes were given in ordinary course of business; that the client would undoubtedly have continued with the petitioner if it had insisted upon receiving a check, for the client in such case could have had its own note discounted at its own bank. In S. A. Conover Co., supra, we stated:
* * * It is not sufficient to defeat personal service classification that capital be used in the business or that capital be incidental to the production of the income. The capital must be a material factor in producing income. Capital must be of such use that the production of income would be materially lessened without it.
*1317 To the same effect is the language of the court in Fuller & Smith v. Routzahn, supra. There the court stated:
* * * It is further said that plaintiff's capital gave it a financial standing and entitled it to a commercial rating. This is probably true. Yet the evidence is convincing that plaintiff's business success was not due to the presence of capital, or to its financial rating, but that its*3920 standing in the advertising world, on which its business success was based, was due to the prestige of Smith and other principal stockholders. Clients sought plaintiff's services because of that professional standing and reputation, and not because of the financial rating of plaintiff.
It can not be denied that a small amount of the income of the petitioner was ascribable to capital. But this income was only about $600 in the aggregate. In the circumstances, we are of the opinion that capital was not a material income-producing factor. We are, therefore, of the opinion that petitioner was a personal service corporation during the year 1920.
Judgment will be entered for the petitioner.