*3213 1. Petitioner made a payment of $40,000 to its four principal stockholders as compensation for services in addition to the compensation regularly provided for each of the fiscal years ended June 30, 1920, and June 30, 1921. Thirty-seven thousand five hundred dollars of this amount was distributed in accordance with an agreement by the principal officers and stockholders prior to payment. Held, that $2,560 of such amount constituted a legal deduction from gross income in income-tax returns for the years in question as reasonable compensation for personal services actually rendered.
2. Petitioner made certain payments during the fiscal year ended June 30, 1920, for altering and repairing a building, installing air ventilation beneath the floor and bricking up the windows in one wall. The proportionate part of the payments made for repairs is a legal deduction from gross income.
3. Reclassification of petitioner's assets for depreciation purposes determined.
4. Depreciation determined by the respondent approved subject to correction due to reclassification of assets.
*657 In these proceedings, consolidated for the purpose of hearing and decision, petitioner seeks a redetermination of income and profitstax liability for the fiscal years ended June 30, 1920, June 30, 1921, June 30, 1923, and June 30, 1924, for which the Commissioner has determined deficiencies of $68,495.16, $6,218.82, $342.07, and $1,121.84, respectively.
The petitioner alleges error on the part of the Commissioner (1) in failing to allow as a deduction from gross income in each of the fiscal years ended June 30, 1920, and June 30, 1921, $40,000 paid to stockholders of the petitioner as additional compensation; (2) in failing to compute depreciation upon the proper classification of fixed assets; (3) in failing to allow adequate rates of depreciation on kiln equipment and machinery; (4) in failing to allow as a *658 deduction from gross income in the fiscal year ended June 30, 1920, certain expenditures made in altering and repairing a building.
A fifth assignment of error relating to the statute of limitations as it might apply to the returns for the fiscal years 1920 and 1921, was waived by the petitioner. A*3215 sixth assignment of error relating to the basis used by the Commissioner in computing depreciation was also waived by the petitioner.
FINDINGS OF FACT.
1. The petitioner is an Ohio corporation with its principal office and place of business near Cleveland. It was incorporated in 1886.
2. During the tax years involved it was a manufacturer of a complete line of office chairs and other chairs on orders from hotels, banks, public buildings, and dining establishments.
3. During the fiscal years ended in 1920 and 1921, the petitioner's president was Fred D. Hills. As president, Hills received no salary and took no active part in the conduct of the business, but did consult with his fellow members of the board of directors on matters of finance and policy, and entertain trade as it came to the plant.
4. Arthur B. Hunn, vice president, who had been a salesman with the corporation since January 1, 1895, was in charge of the New York sales office, his territory covering Boston, New York, Philadelphia, Baltimore and Washington. For many years prior to 1917, he received a commission of 7 per cent on his gross sales, out of which he was required to pay and did pay his office*3216 expenses, rent, office help, etc., and his traveling expenses. In 1917 his compensation was increased so that thereafter he received, in addition to his commission, 25 cents on each chair sold. For the fiscal year ended June 30, 1920, A. B. Hunn's sales amounted to $356,282.79, on which he was paid a commission of $24,939.30; for the succeeding fiscal year his sales for the first six months, with some sales in January, 1921, amounted to $119,756.19, on which he was paid commissions of $8,382.92. For the balance of that fiscal year he was at the plant of the petitioner assisting in its management.
5. T. W. Foote was treasurer and general manager, having occupied those positions from November, 1913, when he first became connected with the corporation. He is a graduate of Chicago Manual Training, and of the Massachusetts Institute of Technology with the degree of Civil Engineer. After receiving his degree in 1902, he was employed as a civil engineer with the Illinois Steel Co. and the Bethlehem Steel Corporation in the operation of open hearth furnaces and other general engineering duties. Subsequently, he was secretary and sales manager of the Franklin Co. of Chicago, designers, *3217 engravers and printers. In 1913, he purchased an interest *659 in the petitioner corporation and became its treasurer and general manager at a salary of $6,000 per annum, which salary was increased to $12,000 per annum just prior to the tax years involved.
6. In the territory covered by the home office at Cleveland, Foote had made sales for the year 1920 approximating $200,000. He had entire charge of the management of the factory and at that time considerable factory extensions were being made. Questions of credit and purchase of material were passed upon by him. He also designed machinery for use in the plant and obtained patents thereon which he assigned to the corporation.
7. H. G. Hunn was a stockholder in the corporation during the tax years involved and represented the corporation in and from the Chicago sales office. He had been with the company since 1907 as a salesman and, like A. B. Hunn, received a commission of 7 per cent on his sales. Out of his commission he paid his office expenses and his traveling expenses. He spent close to 70 per cent of his time on the road. His sales for the fiscal year 1920 were $230,240.08 and for the year, 1921, $131,581.56. *3218 Commissions paid to him amounted to $15,880.26 for 1920, and to $8,861.63 for 1921.
8. Fred D. Hills, the president of the corporation, was the uncle of A. B. Hunn and H. G. Hunn, and T. W. Foote was the brother-in-law of A. B. Hunn and H. G. Hunn. The petitioner was a family corporation and managed somewhat informally.
9. At the beginning of the calendar year 1920, petitioner corporation had a paid-up capital stock of $50,000, divided into 500 shares of $100 each. On February 2, 1920, T. W. Foote purchased for cash a block of 160 shares of stock of the company, retaining 80 shares for himself and transferring 55 shares to A. B. Hunn and 25 shares to H. G. Hunn. Immediately thereafter and at informal meetings of the four individuals named the question of compensation was discussed and the claims of the various individuals for additional compensation were presented. Hills, who at the time was receiving no salary, claimed that he should receive approximately $2,500 per annum to reimburse him for moneys expended by him in entertaining trade. The two Hunns showed that with the gradual increase in expenses they were required to meet they should receive a commission rate of*3219 10 per cent, the rate paid by other concerns to salesmen maintaining branch offices at their own expense and paying their traveling expenses. Foote showed that a commission of 7 per cent upon his sales of $200,000 would give him more than the salary he was receiving as manager of the plant.
10. Article 5 of the by-laws of the corporation provided as follows:
Compensation of Officers: The compensation of the directors shall be such as the stockholders may from time to time determine. the compensation of *660 other officers shall be fixed by the board of directors, and said officers shall, if the board of directors so determined, furnish bonds for the faithful performance of their duties in such amounts as the board of directors may require, and with sureties to the satisfaction of said board.
At a directors' meeting held August 10, 1920, T. W. Foote suggested that the salary of the secretary be increased to $3,300 per annum, retroactive to July 1, 1920; same was put as a motion by A. B. Hunn and unanimously carried. Compensation to the other officers was to remain the same as during the past year. The records of meetings of the board of directors during the fiscal*3220 years ended in 1920 and in 1921, are otherwise silent as to salaries.
11. As a result of the discussions and conferences referred to in paragraph nine above it was determined that there should be paid additional compensation approximately as follows:
| Hills | $2,500 |
| Foote | 20,000 |
| A. B. Hunn | 10,000 |
| H. G. Hunn | 5,000 |
The proper allocation of the amounts to be paid was left to Foote. He determined that additional compensation for the fiscal year ended June 30, 1920, should be paid as follows:
| Stockholders | Common stock | Preferred stock |
| Shares | Shares | |
| F. D. Hills | 480 | 750 |
| A. B. Hunn | 2,160 | |
| H. G. Hunn | 900 | |
| T. W. Foote | 3,942 | |
| Charles Hanson | 18 |
The additional compensation was distributed strictly in accordance with the common stock shareholdings, except that Foote received the share that would have been paid to Hanson if he had participated in the distribution.
12. It was the understanding of the stockholders that a similar distribution should be made for the fiscal year ended June 30, 1921, and such distribution was made.
13. The additional compensation of 25 cents per chair to A. B. Hunn and to H. G. Hunn was made during*3221 the fiscal year ended June 30, 1920, but thereafter discontinued.
14. The surplus of the company at July 1, 1919, was $405,269.24. The net income for the fiscal years ended June 30, 1920, and June 30, 1921, before the deduction of any amounts as additional compensation, as determined by the Commissioner, was $241,738.75 and $56,047.41, respectively. No dividends as such were declared and paid to the stockholders during the fiscal year ended June 30, 1920.
*661 15. In the determination of the deficiencies for 1920 and 1921, the Commissioner disallowed the deduction of $40,000 distributed to stockholders at June 30, 1920, and at June 30, 1921.
16. In the fiscal years 1920 and 1921, payments in the total amount of $25,583.39 were made to the National Dry Kiln Co. of Indianapolis, and this amount was charged to building account upon the petitioner's books. In 1921, $6,424 of this amount was transferred to the machinery account as follows:
| Kiln trucks | $1,700 |
| Elevator | 1,180 |
| Material for elevators | 476 |
| Other kiln trucks | 2,368 |
The balance of $19,159.39 was still left standing in the building account.
17. To other contractors payments were made*3222 in 1921 as follows:
| Elevator | $2,919.00 |
| Elevator | 625.50 |
| Elevator | 195.00 |
| Electrical equipment | 500.00 |
| 4,239.50 |
These amounts were also charged to the building account, making a total in the building account at June 30, 1921, for kiln equipment, $23,398.89. This total should properly be classified as machinery and equipment.
18. During the fiscal year ended June 30, 1920, it was found that the floor boards and beams of one of the petitioner's buildings were being attacked by dry rot due to lack of proper ventilation. It was also found that the floors were settling to some extent, cracks were appearing in the wall, and that the bricks were falling out. A civil engineer was consulted and his opinion received as to the best method of protecting and restoring the building. He was paid a fee of $300. In accordance with his recommendation, certain windows in one of the walls were bricked up, holes were cut in the foundation and a ventilating pipe was run through the building to the roof. The workmen installing the ventilating pipe damaged the roof in that section so that a portion thereof had to be repaired and replaced. The cost of repairing the roof was*3223 $1,201.75. The cost of bricking up windows and cutting holes in the foundation and of putting in the ventilating flue was $3,831.31, making a total cost of the alterations and repairs including the engineer's fee of $5,333.06.
19. In the determination of the deficiency proposed for the fiscal year ended June 30, 1920, the respondent disallowed these items as ordinary and necessary business expenses and held that these should be charged to the capital accounts.
*662 OPINION.
SMITH: The principal question presented by these proceedings is whether the petitioner is entitled to deduct from gross income in its income-tax returns for the fiscal years ended June 30, 1920, and June 30, 1921, $40,000 distributed at the close of each of those years to its stockholders. The distribution was equal to $5.33 1/3 cents per share of common stock; F. D. Hills, A. B. Hunn, and H. G. Hunn, owning 3,544 shares of stock, received their pro rata shares of the distribution, but T. W. Foote, owning 3,942 shares, received slightly more than his pro rata share - he receiving the pro rata share which would have been paid to Hanson, owning 18 shares, if the distribution had been strictly in*3224 accordance with the stockholdings. The petitioner claims the deduction of $40,000 distributed at the close of each of the taxable years referred to as compensation paid for personal services actually rendered under section 234(a)(1) of the Revenue Acts of 1918 and 1921, which provides that a corporation may deduct from gross income in its income-tax returns all ordinary and necessary expenses, including "a reasonable allowance for salaries or other compensation for personal services actually rendered." The Commissioner has disallowed the deductions upon the ground that the amounts were in effect distributions of profits to the stockholders.
The evidence of record with respect to this distribution shows that T. W. Foote testified as follows:
Q. Did you reach any determination as to approximately the salaries that should be paid?
A. Mr. Hills, who was president, stated that he was under some expense in taking our trade out when they visited our factory, as he was drawing nothing in the way of compensation as president, and felt entitled to a reasonable return. Mr. A. B. Hunn spoke about the increase in his traveling expenses and maintenance of his office in New York, and*3225 spoke of other firms in the same industry paying more in the shape of commission, when the salesmen had to pay their own expenses and maintenance of their office. I, on the other hand pointed out to them that I had sold over $200,000 worth of goods, and if I were paid the prevailing commission of seven per cent, that my sales alone would have netted over $14,000. Mr. H. G. Hunn was in agreement with Mr. A. B. Hunn relative to the commission that should be paid, and showed where other houses that were making a high grade line, such as we professed to make, were paying their salesmen ten per cent. So after discussing all these points, we tried to set approximately what each one would get operating on some where near a correct basis of compensation. The thing was left for me to formulate after we had arrived at the approximate amount, or benefits, each one would receive. In round figures, to my best recollection, Mr. Hills was allowed $2,500 a year; and, based on my sales, which was added remuneration to me in excess of the salary I was allowed, I was to be given about $20,000 a year, which would be based on our sales, and not on our - you can call it a commission or salary bonus, *3226 or however you describe it - dependent upon what I sold. And, as I recollect, the rate of sales being made by Mr. A. B. Hunn were in the neighborhood of $340,000 or $350,000 a year, which would entitle him to in *663 the neighborhood of $34,000 or $35,000 in the shape of commissions. Mr. H. G. Hunn's sales were considerably less than Mr. Arthur Hunn or myself; I don't remember just what his sales figured but that is a matter of record. * * *
On cross examination he testified as follows:
Q. Whatever money that you got out of the Marble & Shattuck Company came in the way of dividends declared by the Company at the close of their fiscal year or whatever time they made dividend declarations?
A. Yes, sir.Q. It is true, is it not, if there had been a declaration of dividends whereby your company would have distributed $40,000 in dividends, you would have received dividends to the same amount, of that $40,000, that you received in the way of additional compensation? That is true, isn't it?
A. I would have received slightly more on a strictly commission basis than I received through the salary bonus.
Q. You would have received slightly more?A. If I had*3227 been paid on a commission basis and had been paid for the work I did.
Q. In the year 1920, it was not by any vote of the directors that you should receive a commission in addition to salaries?
A. That was the point I raised, in discussing what I felt I was entitled to.
Q. Was there any discussion toward the close of the year how you were going to split up this very big profit that you had, before it was decided that you could pay more pay to the people who had been doing your work?
A. Based upon what they were accomplishing.Q. Based upon what you found they had done in the way of sales?
A. Yes.Q. Your Company declared dividends on other amounts this year, did they?
A. Which year?Q. In 1920. You received dividends as well as additional salary?
A. No dividends.Q. You used the money you would have used in paying dividends in paying salaries, didn't you?
A. That is the way that we used it.Q. That which you distributed, if you had not taken up this proposition of adding to your compensation, you would have received in dividends if a dividend declaration had been made?
A. Yes, sir.Q. As a matter of fact, I believe that you*3228 reported this as a dividend?
A. No; I reported it as a salary bonus. Q. Some of your men reported it as a dividend. A. I reported it as salary. Q. So far as you are concerned, you reported it as salary? A. Yes.This evidence indicates that at the close of the fiscal year ended June 30, 1920, the petitioner knew that its profits for the fiscal year would be unusually large. The stockholders considered that the compensation which was being paid to them was less than they were entitled to receive for personal services actually rendered to the corporation. It was believed that fair commissions were 10 per cent of the gross sales. The stockholders agreed among themselves *664 that in lieu of paying a dividend of approximately $40,000, the same should be distributed to them as additional compensation. This amount in addition to the amounts theretofore received would make the commissions on sales of the principal stockholders for the fiscal year ended in 1920 approximately 10 per cent. It appears to have been the expectation of the stockholders that $37,500 would thus be distributed. But the determination of the distribution was left to Foote, who was the*3229 principal stockholder, the treasurer, and the general manager. He determined that the distribution should be made according to stockholdings, except that Hanson, who owned only 18 shares, was to receive no part thereof. Foote being the principal stockholder, received the pro rata share that would have gone to Hanson if the amount were paid as a dividend on stockholdings.
Although a payment of additional amounts to employees of a corporation as compensation for personal services actually rendered is not to be disallowed as a deduction from gross income simply because paid in direct proportion to the stockholdings of such employees, it must be made plain that the amounts distributed are paid as compensation for personal services rendered and not merely as a distribution of profits. In , we said:
* * * The fact that salaries paid to its officers by a corporation are in direct proportion to the stockholdings of the respective officers is strong evidence of an intent to distribute profits as salaries and must be overcome by clear evidence showing that the salaries are reasonable in amount and actually represent compensation for*3230 personal services rendered. * * *
The amount of compensation which a corporation shall pay its officers for their personal service is, in the first instance, a matter within the judgment and discretion of its board of directors, and the only limitation upon the deduction of such amount for income tax purposes is that the amount must be reasonable. * * *
We can not determine from the evidence before us what would constitute reasonable compensation of the stockholders for services actually rendered during the fiscal years ended June 30, 1920, and June 30, 1921. Foote was paid a salary of $12,000, which was double the amount that he had received prior to some time in 1919 or early 1920. He claims that in addition to that amount paid him for managing the business he should receive 10 per cent upon sales made at the factory for which presumably he was responsible. This, however, is not clearly proven. The evidence does not show that Foote maintained any separate office for the making of sales or that he incurred any expenses in connection with the making of such sales. Neither does it appear that he was responsible for any sales made during the fiscal year 1921. It also appears*3231 that A. B. Hunn and *665 H. G. Hunn received during the fiscal year ended June 30, 1920, in addition to compensation of 7 per cent upon sales, 25 cents for each chair sold. The amount of this additional compensation is not before us. Fred D. Hills, the president, received no salary up to the beginning of the fiscal year ended June 30, 1920. He was under some expense for entertaining customers who came to the office. The $2,560 paid to him during each of the years 1920 and 1921 was for the purpose of reimbursing him for expenses made. We think that this amount is clearly an ordinary and necessary expense of the petitioner. It is immaterial that it was paid directly in proportion to his shareholdings. We believe, however, that the evidence warrants the determination that the balance of the $40,000 paid during each of the years 1920 and 1921 was a distribution of profits as determined by the Commissioner. The disallowance of the deduction of $37,440 of the $40,000 distributed during each of these years is therefore sustained.
It has been set forth in the findings of fact and agreed to by the parties that the expenditures for kiln equipment made in 1920 and 1921, and*3232 included in the building account, should properly be transferred to the machinery and equipment account.
The petitioner alleges that it is entitled to a depreciation rate of 10 per cent on machinery and equipment, whereas the Commissioner has allowed depreciation at the rate of only 7 1/2 per cent per annum. In support of its contention petitioner introduced the testimony of T. W. Foote, the superintendent and manager of the company, who stated that in his opinion machinery and equipment had a life of only 10 years. However, it appears from his testimony that he left out from his consideration the normal replacement of parts of operating mechanism and pipe due to use, accidents, and rusting since he stated, "I am not saying that the main structure of the machines won't be as good as the day it was manufactured. I am speaking of the operating mechanism." It has not been shown that the replacement of rusted pipes and operating mechanism has been charged to capital. After a review of the testimony on this point we are of the opinion that the petitioner has failed to show that the depreciation allowed by the Commissioner was inadequate except that an adjustment should be made on*3233 account of a transfer of $23,398.89 from the building account to the machinery and equipment account which would institute a recomputation of depreciation.
Petitioner claims that the $5,333.06 spent by it during the fiscal year ended June 30, 1920, in the remodeling of a building, was for repairs. The respondent contends, on the other hand, that it was for an improvement or betterment to the building and that the amount does not constitute an ordinary and necessary expense of operation.
*666 The evidence indicates that the repairs made upon the roof constituting $1,201.75 was a repair expense. The roof was damaged by workmen walking across it in putting the flue pipe through the roof and it was necessary to replace about one-fourth of the roof. We are of the opinion, however, that the cost of bricking up the windows in a wall for the purpose of strengthening the wall was in no proper sense a repair of the wall. The evidence indicates that the wall was close to the main line of the New York Central Railroad tracks and that the vibration of the trains passing caused cracks to come in the wall and it was the engineer's opinion that the wall should be strengthened by bricking*3234 up the windows. We are also of the opinion that the cost of putting in the ventilating pipe was a betterment or improvement and that the respondent has correctly classified the payment as a capital payment. Of the $5,333.06 disallowed as a deduction, we think that only $1,201.75 paid for the replacement of a portion of the roof can properly be claimed as such.
Judgment will be entered under Rule 50.