*2566 1. PERSONAL SERVICE CORPORATION. - Where the business and income of the petitioner was obtained mainly by nonstockholder employees and the evidence does not indicate what part thereof was attributable to the activities of the principal stockholder, personal service classification will be denied.
2. CLASSIFICATION FORMER YEAR. - The granting of personal service classification by the Internal Revenue Bureau for one or more years does not of itself warrant the granting of that classification for a succeeding year.
3. RESERVE - CONTINGENT LIABILITY. - Where a collection agency set aside a portion of its receipts in a reserve fund to protect a contingent liability, such reserve is not an allowable deduction from gross income.
*560 The respondent determined a deficiency against the petitioner of $1,602.14 for the year 1921. Petitioner asks redetermination for 1920 and 1921 and alleges that the respondent erred in not classifying it as a personal service corporation, in disallowing as an expense certain sums set aside in a reserve fund to meet contingent*2567 liabilities, and in disallowing as an expense a life insurance premium on the life of its president and chief stockholder.
At the hearing, counsel for petitioner withdrew the assignments of error as concerns the year 1920 and the disallowance of the life insurance premium, leaving for consideration only the questions of personal service classification, and the deduction of the reserve fund for the year 1921. The respondent did not determine a deficiency for the year 1920 and the appeal for that year is dismissed, irrespective of the withdrawal of the errors assigned for that year by counsel for petitioner.
FINDINGS OF FACT.
The petitioner is a Missouri corporation with its principal office at 3107 Olive Street, St. Louis. It is engaged in the business of a collection agency specializing in delinquent accounts. It had a capital stock of $50,000 divided into 5,000 shares of $10 each, which during 1921 was held as follows: Walter S. Schelp, president and general manager, 4,998 shares; E. C. Wickham, vice president and secretary, 1 share; and C. H. Mehnert, bookkeeper, 1 share.
Schelp was an attorney at law and gave all of his time to the general management of the business. *2568 Wickham was an accountant having supervision of the accounts and reports, but nothing to do with the operation or management of the business, and C. H. Mehnert was the bookkeeper who gave her entire time to the business.
The business of the petitioner was obtained by solicitors who traveled throughout the country selling service contracts, of which the following is a typical specimen contract:
1. THIS CERTIFIES THAT of hereinafter designated as the Client, has retained the service of the Commercial Liquidation Company, *561 Incorporated, of St. Louis, Missouri, hereinafter designated as the Company, for a period of TWO YEARS from date of acknowledgment by the Company of the coupon attached hereto at the time of execution and made part hereof and in accordance with the terms and conditions and the classification of delinquent claims, as herein set out.
2. The Company agrees, upon receipt of coupon portion of contract to forward to the Client, Fidelity Bond of Indemnity in the sum of Twenty-five Thousand Dollars ($25,000.00) executed by the Southern Surety Company, Des Moines, Iowa, which Bond is to indemnify Clients from and against any and all loss by reason of the*2569 defalcation of the Company during the term of this contract in connection with any claims collected by the Company for the Client during said term.
3. The Company agrees that on all claims of the Client it will use due diligence and will employ such lawful means, methods and procedure, look up transfers of property, deeds of assignments, investigate the circumstances and surroundings of debtors, telegraphic and individual service, as in its judgment, discretion and experience believe will effect collections and settlements, and the fee and commissions are the only charges to be made hereunder by the Company, and the Client will not be required to pay Court Costs or Attorney's Fees in such actions or proceedings as shall be instituted other than exceptional cases, covering which mutually satisfactory arrangements shall have been agreed upon in advance.
4. The Client has paid the Company One Hundred Dollars ($100.00), Service Fee, which sum has this date been received and is hereby acknowledged. The Client assures the Company payment of commissions according to the rates herein on all collections or settlements effected, either direct to the Client, or to the Company, which*2570 are to be promptly reported by both parties hereto and to participate in the benefits and privileges of the service on at least fifty present and subsequent delinquent claims, with address of the debtors, legally due, and within the statutes of limitations amounting to at least Eighteen Hundred ($1,800.00) Dollars.
BONDED AGREEMENT
1. The Company agrees, through the use of its service from the claims of the Client under the conditions and provisions of the Agreement for Service, to recover in cash or effect settlements of at least Two Hundred Fifty Dollars, ($250.00), net, over and above Service Fee paid, within the specified period of this contract, a partial list of the present delinquent claims to be received by the Company within thirty days from date the coupon is acknowledged by the Company, the other and subsequent delinquent claims at reasonable intervals thereafter, provided, in the event the sum realized be less than Two Hundred Fifty Dollars ($250.00) net, the Company will, at the option of the Client, either (1) repay and remit to the Client that part of the fee paid by the Client in the same proportion as the amount Two Hundred Fifty Dollars ($250.00) net has not*2571 been realized with six per cent (6%) interest from date hereof, as guaranteed by Bond executed by the Southern Surety Company, Des Moines, Iowa, to cover said option and made part hereof; or, (2) the Company will accept for service during another year from the original period such additional claims which the Client may forward at the same commission rates on collections or settlements, and the performance of either of the options, respectively; (1) or (2) by the Company for the Client shall be in full satisfaction of its obligations hereunder.
*562 2. The Company agrees, within ten days from date, to have issued in favor of the Client the Surety Bond in the sum of One Hundred ($100.00) Dollars, executed by the Southern Surety Company, Des Moines, Iowa, as designated in clause one of the Bonded Agreement.
(a) The Client agrees during the upon the termination of this contract the Company is to retain any claim or claims in the process of development or being paid in installments until settled or otherwise disposed of, and all offers of compromise from debtors will be mutually submitted for acceptance or rejection, and that the Company's obligations herein do not apply to*2572 claims against debtors who have received their discharge in bankruptcy, or who have made composition or other settlements, and to cooperate and on request give the Company such evidence, information and advice as will tend to aid and assist the Company to successfully carry on the service.
(b) All the obligations of the Client to the Company, and all the obligations of the Company to the Client, are fully set out in this contract and coupon, and no representative or representatives of the Company has any power or authority to make any other or different contract for the Company, either written or oral, or to modify or waive any of the terms and conditions or classification of delinquent claims in this contract.
IN WITNESS WHEREOF, We hereunto set our hands and cause to be affixed the official seal of the Company as of the date coupon signed by Client is received by the Company, in the City of Saint Louis, State of Missouri.
COMMERCIAL LIQUIDATION COMPANY.
Trade Mark
By (Sgnd.) W. S. SCHELP, President.
ATTEST Secretary
(Seal)
CLASSIFICATION OF DELINQUENT CLAIMS, AND COMMISSION RATES ON COLLECTIONS AND SETTLEMENTS
| Delinquent claims not over ninety days past due | 3% |
| Delinquent claims over ninety days past due and up to six months past | |
| due | 5% |
| Delinquent claims over six months past due, $150 or more | 10% |
| Delinquent claims over six months past due, $50, and up to $150 | 15% |
| Delinquent claims over six months past due, less than $50, and all | |
| claims litigated, individual service through local correspondent, or | |
| paid in small installments | 25% |
| Minimum commission | 50c |
*2573 COPY OF DATE WRITTEN IN COUPON 19
COUPON
COMMERCIAL LIQUIDATION COMPANY
(Incorporated)
Title Guaranty Building
St. Louis
E-9
No. 9203
GENTLEMEN:
I or We this date have retained your service for Two Years for One Hundred Dollars, Service Fee and Commissions, according to the terms and conditions *563 and the classification of delinquent claims, as set out in the Contract attached hereto at time of execution, to which we have agreed, as if fully recited herein, and hold as a part hereof.
Debt Entry Sheets Pink Statement Stamps.
Street Address Town State
Date 19 Business
By Representative. Signature of Client
By
To secure the client the contract provided for a fidelity bond of $25,000 to be issued by the Southern Surety Co., Des Moines, Iowa, indemnifying the client against defalcation by the petitioner, and in addition provided for another bond in the sum of $100 by the same surety company, providing for the return to the client of the service fee, or proportionate part thereof in the event the petitioner failed to collect the amount of delinquent debts agreed upon.
In order to obtain the bonds to secure the clients in the return of the service*2574 fees, the petitioner entered into a contract with the surety company by which the latter agreed to furnish the bonds for an agreed compensation to be paid by petitioner to the surety company, and in order to secure the surety company against loss it was provided that the petitioner should set aside and deposit in bank under joint control a certain percentage of all service fees collected. This fund was to be used in making the refunds to the clients, or to reimburse the surety company for any payments it might make on account of said bonds. It was further provided that, "The reserve or guaranty fund aforesaid shall revert to the Commercial Liquidation Co., as and when the liability of the Surety Company under the outstanding bonds has terminated, and all liability of the Surety Company thereunder is cancelled."
This contract was in force during the taxable year and for a number of years prior and subsequent thereto.
During the year 1921 petitioner by reason of business done in the year 1921 added to its reserve for the purposes aforesaid the sum of $7,282.35. The reserve fund was maintained in a separate bank account and separate from the general funds of the petitioner. The*2575 evidence does not show that during the taxable year any part of the reserve fund was paid out, and it was not shown that any liability became fixed, was accrued against it, or was admitted to be due.
There were between 15 and 20 solicitors or salesmen engaged in the sale of the service contracts during the year 1921, who sold contracts sufficient to net the petitioner the sum of $97,803.90, and were paid $61,642.65 commissions on account thereof. One salesman received $9,105.60 and another $5,367.50.
About 25 girls and 4 or 5 men were employed in the office of petitioner, whose duty it was to look after the collections and carry *564 on the business. The girls were mainly stenographers and file clerks and the men's duties were supervisory. The plan of the business was to write letters and send circulars by the follow-up method to the delinquent debtors until a settlement was reached or the account was turned over to some attorney to bring suit. This correspondence was carried on by the clerks, stenographers and other employees. The pay of these nonstockholder office employees was $32,419. The compensation of the officers and stockholders was:
| Officer | Shares held | Salary |
| Walter F. Schelp, president | 4,998 | $8,400.00 |
| E. C. Wickham, vice president and secretary | 1 | 2,000.00 |
| V. Ottman, assistant secretary | 1 | 1 562.50 |
| Total | 5,000 | 10,962.50 |
During the taxable year there was no capital invested in any way except in furniture and fixtures, and at no time were any dividends declared or paid to any stockholder other than stock dividends. Petitioner was not engaged in trading, merchandizing or manufacturing.
The balance sheet for December 31, 1920, and December 31, 1921, is as follows:
| Dec. 31, 1920 | Dec. 31, 1921 | |
| ASSETS | ||
| Cash | $1,237.93 | $2,906.28 |
| Investment surplus fund | 157.87 | |
| Accounts receivable | 14,146.33 | 16,469.80 |
| Furniture and equipment | 7,328.84 | 8,176.69 |
| Contracts and agreements | 60,293.28 | 60,293.28 |
| Patents and trade-marks | 298.00 | 298.00 |
| Reserve funds for contract liability | 10,386.49 | 17,628.46 |
| 93,690.87 | 105,930.38 | |
| LIABILITIES | ||
| Capital stock | 50,000.00 | 50,000.00 |
| Accounts payable | 7,341.80 | 7,748.92 |
| Notes payable | 1,000.00 | |
| Reserve for depreciation | 4,716.29 | 6,219.02 |
| Unearned income guarantee reserve | 10,386.49 | 17,628.46 |
| Reserve for general purposes | 157.87 | |
| Surplus | 21,246.29 | 23,176.11 |
| 93,690.87 | 105,930.38 |
The gross income for 1921 is as follows:
| GROSS INCOME FROM SERVICES | |
| Retainer fees from contract holders | $97,803.90 |
| Commissions on collections made for clients | 39,077.73 |
| Contract earnings delinquent list service | 600.00 |
| 137,481.63 |
*2577 *565 The ordinary and necessary expenses were:
| Commissions paid to agents | $61,642.65 |
| General office pay roll (excluding officers) | 32,419.00 |
| Rent | 3,493.03 |
| Bond premiums | 3,801.60 |
| Collection expense | 4,012.97 |
| Postage | 3,979.68 |
| General expense | 2,811.00 |
| Stationery and supplies | $1,587.22 |
| Traveling expense | 949.75 |
| Dues and subscriptions | 443.34 |
| Telephone and telegraph | 720.77 |
| Printing department expense | 1,539.63 |
| Bank exchange | 258.41 |
| Miscellaneous items | 2,232.06 |
| 119,891.11 |
During the year about 5 per cent of the accounts were turned over to outside attorneys for collection or suit. Suit was filed on about half of them at an expense of $4,012.97 to petitioner. Except in special cases, attorneys' fees and court costs were to be paid by petitioner.
On November 5, 1925, the Commissioner of Internal Revenue sent the petitioner the following letter:
IT:CA-2552-7
NOVEMBER 5, 1925.
COMMERCIAL LIQUIDATION COMPANY,
1010 Title Guarantee Building,
St. Louis, Missouri.
SIRS:
You are advised that after a consideration of your 1918 corporation return based upon all the evidence submitted in writing and in conference held in the*2578 Unit September 23, 1925, that your claim for personal service classification for 1918, under the provisions of Section 200 of the Revenue Act of 1918, has been allowed, since the Department, under the law, deems that your business was one in which the use of capital was not essential and that the profits may be ascribed primarily to the personal services of the principal owners.
Your 1918 return will, therefore, be closed upon that basis showing no tax liability.
In accordance with the above decision, you are requested to disregard Bureau letter dated February 17, 1925, in which you were notified of a deficiency in tax.
Respectfully,
(signed) C. R. NASH,
Assistant to the Commissioner.
By F. R. CLUTE,
Head of Division.
OPINION.
MILLIKEN: Petitioner contends that its status as a personal service corporation was fixed by the letter of the respondent, copied in the findings of fact, granting that classification for the year 1918.
In the recent case of , the same question was raised and the Board there said:
The petitioner contends that, having been granted personal service classification*2579 for the preceding taxable years 1918, 1919, and 1920, when it operated substantially the same kind of a business under similar conditions, including the employment of substantially the same professors, it should be granted *566 personal service classification in this proceeding. We do not agree with such contention. The granting of a special classification for one year does not of itself warrant the granting of that classification for a succeeding year. ; .
The letter of the respondent granting personal service classification for 1918 is not controlling and this question is decided adversely to the petitioner.
In order to entitle it to be classified as a personal service corporation, petitioner must show (1) That it is engaged in rendering personal service as distinguished from trading, merchandising or manufacturing; (2) that the principal stockholders are regularly engaged in the active conduct of the business; (3) that capital, whether invested or borrowed, is not a material income-producing factor; and (4) that the income may be ascribed primarily to the activities*2580 of the principal stockholders.
The petitioner manifestly was a one-man corporation. Walter F. Schelp, the president and manager, owned 4,998 shares of its stock and the other two shares were held by employees to qualify them as directors. The former devoted his entire time to business of petitioner. The evidence does not show what the duties of Mr. Schelp were, nor does it indicate in any way what he did to obtain business or to earn income in the performance or carrying on of the business. So far as the record shows, the business may have been just as large and just as profitable without him as with his assistance. The business of the company was obtained primarily by the efforts of the solicitors or salesmen, who during the year brought $97,803.90 into the gross income of the company.
We think the facts of this case bring it within our decision in the case of , and the cases therein cited. It was there said:
It remains for us to determine whether petitioner's income may be ascribed primarily to the activities of the principal stockholders. During the years herein involved petitioner had from 89 to 140 employees. *2581 Of this number from 7 to 9 were office managers who received compensation ranging from $1,100 to $10,952.74, and from 27 to 39 were salesmen whose compensation ranged from $1,000 to $6,000. The remaining number of employees were general clerks, file clerks, stenographers, etc. The employees outnumbered the stockholders from 6 to 10 times. The salesmen and office managers outnumbered the stockholders from 2 to 3 times. Total salaries paid to employees far exceeded total salaries paid to stockholders. In 1920 salaries were paid to employees in an amount 3 times that paid to stockholders. In Appeal of , we stated:
"* * * We do not mean to hold that personal service classification must be denied in all cases were there are employees under the supervision of stockholders, but where, as here, employees so greatly outnumbered the stockholders and there is no evidence of the character of the service performed by *567 most of them and they receive substantially one-half of the earnings over the expenses other than salary, we can not find that the income is to be ascribed primarily to the activities of the stockholders. In*2582 our opinion this clause means more than that the stockholders shall obtain the clients and supervise the work, or that clients shall look to their experience; it means, among other things, that the corporation may not rely upon non-stockholders to do a substantial amount of the work which produces the income whether such work be detailed or supervisory. Just as another clause excludes from personal service classification those corporations where capital contributes materially to the income, so does this clause exclude corporations where the services of employees so contribute."
See also .
The discussion of the Circuit Court of Appeals in Metropolitan Business Collegev. Blair, U.S.C.C.A., 7th Cir., February 16, 1928, is particularly applicable in the instant case:
"If this were a prosperous manufacturing corporation, employing many skilled workmen and capable foremen, salesmen, and the like, it could not be said that the corporate income was primarily attributable to the activities of the few others who, in managerial capacity, successfully planned and dominated the corporate affairs. The*2583 absolute indispensability of a competent working force would be too apparent to ascribe to management primacy of influence in producing corporate income.
"The teaching body is here a skilled working force, without which the income would have been restricted to such as would arise from a student body which these three men alone might handle. Stenographers, messengers, and others serving them in personal capacity, might well be said to be incidental to the management, and such service would not prevent the conclusion that the personal activities of the managing stockholders were a primary factor in producing the income. * * *
"Probably petitioner's very success is ascribable largely to wisdom in the choice of competent teachers; at least it may be safely said that the petitioner would be the first to resent the imputation that its teachers were mere rubber stamps or talking machines."
Petitioner contends that its income results primarily from the activities of the stockholders in securing offerings of merchandise and distributing same for sale, and that selling was less difficult and of secondary importance. We are not inclined to agree with this contention. A very attractive*2584 factor of petitioner's business was its capable selling organization, which was no doubt influential in causing principals to market their products through petitioner's agency.
The stockholders of petitioner exercised supervision over the office managers and salesmen. When offerings of merchandise were received and allocated to the various territories, one of the executive stockholders would telephone its territorial office manager and inform him that he should sell a certain quantity of merchandise at a certain price. Market information and sales aeguments were also thus dispensed and transmitted to the salesmen. It remained necessary, however, for the salesmen to call on the trade and sell the offerings, and undoubtedly petitioner's volume of sales depended largely upon the ability and industry of its salesmen.
We are of the opinion that petitioner's income can not be ascribed primarily to the activities of the principal stockholders, and that classification as a personal service corporation should, therefore, be denied. *2585 .
*568 In the instant case there were in all about 45 or 50 employees who received $94,061.65 as compensation, and there were three officers and shareholders whose compensation was $10,962.50. Under these circumstances we hold that the income of the petitioner can not be ascribed primarily to the activities of the principal stockholders and personal service classification must be denied. See also , , .
The remaining question relates to the right of petitioner to deduct from gross income the amount added to the reserve fund during the taxable year. At the hearing counsel for petitioner stated his theory as follows:
My theory is that it never became the company's money until after the period of the guarantee had expired, to see whether or not it was consumed.
We can not agree to this theory. Obviously, the money belonged to someone. The client had paid it over to petitioner and parted title with it. Under the contract with the surety*2586 company the petitioner had pledged the money to secure a contingent liability and the surety company merely had a lien upon it. The transaction was just the same in legal effect as if the petitioner had purchased liberty bonds or other securities and pledged them as collateral security. In such case the securities would be the property of the petitioner and in this case clearly the petitioner is the owner of the reserve fund and it formed part of its gross income when collected from its clients.
It is not shown that there were any disbursements from this fund during the taxable year, or that petitioner became liable for any refunds to its clients, or any payments by the surety company on that account, and the question arises, May petitioner deduct this reserve against contingent liability as an ordinary and necessary business expense?
The case of , was that of an advertising agency that set up a reserve for short-rates. The agency contracted with publications for a large amount of space for a specified period of time at a reduced rate. In the event it did not use all the allotted space it was to be charged a higher rate. *2587 To meet this contingent liability it set up this reserve, for which it asked deduction, which was denied by the Board as follows:
With respect to the item oil reserve for short rates, the taxpayer contends that this is not income but an increase in its liabilities. This contention, on its face, is unsound. The funds for which this reserve was created were collected by the taxpayer from its clients as a regular part of its business. There does not seem to have been any distinction made, at the time of collection, in billing clients or otherwise, between the amounts which were admittedly income and the amounts placed in the reserve. As far as the record shows, this segregation *569 of receipts was a voluntary act on the part of the taxpayer, for the purpose of providing funds from which payment could be made upon completion of the contract either to the publisher, if the lower rate had not been earned or to the advertiser, if all the space contracted for by the taxpayer had been used. The question of the deduction of reserves has been before the Board in a number of cases. In the *2588 , we said:
"The revenue laws prior to the 1921 Act have never recognized reserves as being deductible from gross income in determining net income except in the case of insurance companies. * * * The statute specifies what deductions are allowable and, except in the case of insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such. Items of expense must actually have been paid or liability therefor incurred in order to be deductible under that Act."
The same conclusion was reached in , reserve against freight and advertising refunds; , freight rebates; , possible increase in electric service charges; ; and , where contractors had agreed to maintain and keep in repair street improvements for a number of years and set aside a reserve to meet such contingent liability.
It is not shown whether taxpayer kept its books on the cash receipts*2589 and disbursements basis or the accrual basis. If they were kept on the cash basis, the petitioner is not entitled to any deduction for the reserve fund, because it has not shown that any part thereof was paid out during the taxable year. On the other hand, if the accrual method was used it would be necessary for petitioner to show that it had actually become liable for refunds during the taxable year, which has not been done.
Judgment will be entered for the respondent.
Footnotes
1. 3 months. ↩