*2035 1. Two partnerships engaged in business as insurance brokers organized a corporation the stock of which was paid in and held by the individual partners. The partnerships and individual partners agreed to turn over to the corporation all orders for insurance, together with all premium payments or other payments from which a commission was due, and the partnerships guaranteed all collections to the corporation. The corporation agreed to pay to each partnership monthly the proportion of a fixed sum which the net earnings of each partnership for the preceding calendar year bore to the net earnings of the corporation for such year, and any surplus ordered by the corporation to be distributed was to be distributed annually, on a specified date, in the same proportion. The corporate income was derived entirely from the two partnerships and its expenditures consisted of rent and clerical and office expense. No dividends were declared and no distributions were made except those provided for in the agreement. In its return the corporation deducted the total fixed monthly payments made during the taxable year, as officers' salaries, although no salaries were authorized or drawn. Held,*2036 the fixed monthly payments were clearly not deductible as salaries of officers, but that, since they were in fact expended by the corporation in discharge of the legal obligation fixed by the contract, constituted an annual outlay payable as consideration for the gross income of the corporation, and bore no semblance to a dividend, they constituted ordinary and necessary expenses paid in the maintenance and operation of the corporation's business.
2. Quaere: Whether any surplus distributed at the end of the year would have been deductible?
*800 These proceedings involve petitioners' liability as transferees for the unpaid income and profits taxes for 1917 assessed against the Chicago Insurance Agencies, Inc., in the sum of $5,971.44.
FINDINGS OF FACT.
Petitioners are individuals, with address at 175 West Jackson Boulevard, Chicago, Ill. Since before 1913 they have been members of two partnerships engaged in the insurance brokerage business. Of these partnerships one, known as Wiley, Magill & Johnson, was composed of petitioners Wiley*2037 and Magill and previously of one Johnson, who died in 1916. The other, known as Rogers & Rollo, was composed of petitioners Rogers and Rollo and of C. M. Rogers, Sr. Before 1913 each firm had its individual office, staff of clerks, and clientele. They saw an advantage in combining their two organizations so as to have but one office, but they would thus be allowed by the board of underwriters to have but one membership instead of two. Therefore, retaining the two operating copartnerships, *801 they in 1913 organized a corporation called Chicago Insurance Agencies. Its paid-in capital stock was $5,000, of which the individual partners were the holders.
With this corporation the partnerships immediately made an oral agreement, the terms of which were incorporated in a written agreement dated January 8, 1920. After reciting that it was the desire of the parties thereto "that all insurance business of the said copartnerships, their individual partners, and brokers controlled by them, shall be conducted through" the corporation, the instrument provided in its first section for the maintenance of a suitably equipped office with the necessary personnel for the conduct of an*2038 insurance agency and brokerage business. Other sections provided:
Second: The said copartnerships and each of their individual members shall turn over to the said corporation or its agent all orders for insurance as soon as received. Immediately upon the receipt of any cash, check, draft, money order, note or other evidence of indebtedness by either of said copartnerships or any member thereof, the same shall be immediately paid over to the said corporation or its designated cashier or agent, and any such check, draft, money order, note or other evidence of indebtedness so received by said copartnerships or any member thereof shall be properly endorsed so that the same may be collected by said corporation. All payments, whether by cash or otherwise, received on account of premium payments or other payments from which a commission is due, shall be paid over to the said corporation without deduction on account of said commission or otherwise excepting on payments received from other members of the Chicago Board of Underwriters, and then for only its regular rates of commission.
Third: Each of the said copartnerships guarantees to the corporation the collection within*2039 six months of all sums due on business turned over to the corporation by the respective copartnerships, their respective members, employes, agents or brokers. When any account is six months overdue it shall be paid to the corporation on demand by the copartnership controlling the business, or said copartnership shall submit satisfactory evidence of the cancellation of the risk and shall pay the earned premiums to the corporation.
Fourth:The said corporation from June 1, 1919, to June 1, 1920, shall pay to Wiley, Magill & Johnson, copartnership, the sum of Fifteen Hundred One Dollars and Fifty-nine cents ($1,501.59), and to Rogers & Rollo, copartnership, the sum of Thirteen Hundred Thirty One Dollars and Fifty-one cents ($1,331.51), provided, that if the balance sheet of said corporation at the end of any month shows a deficit, then upon demand, Wiley, Magill & Johnson shall return fifty-three per cent (53%) of said deficit to said corporation, and Rogers & Rollo shall likewise return forty-seven per cent (47%) of said deficit to said corporation. Surplus of net earnings which remain after paying said sums to said copartnerships shall be kept in separate account. On May 31, 1920, which*2040 completes the first year of this contract, there shall be computed the net earnings which each copartnership contributed to the total net earnings of said corporation as respectively determined by the method prescribed in paragraph five herein. If Wiley, Magill & Johnson during this period shall have earned less than fifty-three per cent (53%) of the total earnings, they shall pay to Rogers & Rollo the percentage of Thirty-Three Thousand Nine Hundred and Thirty Six Dollars ($33,936.00) equal to the *802 difference between the percentage earned by them and fifty-three per cent (53%), but not exceeding in any case three per cent (3%) of the total of said Thirty-Three Thousand Nine Hundred and Thirty-Six Dollars ($33,936.00). The undivided surplus on hand on May 31, 1920, shall be divided between the said copartnerships in the proportion which the net earnings of each copartnership respectively bear to the total net earnings, provided, said Rogers & Rollo shall receive not less than forty-seven per cent (47%) nor more than fifty per cent (50%) of said total net earnings.
On May 31, of each year after 1920, there shall be computed the net earnings of each copartnership contributed*2041 to the total net earnings of said corporation during the preceding calendar year as determined by the method prescribed in paragraph five herein. Commencing June 1, 1920, there shall be paid monthly to each of the said copartnerships the proportion of Two Thousand Eight Hundred and Thirty Three Dollars ($2,833.00) that the net earnings of each copartnership respectively for the previous calendar year bear to the total net earnings of the corporation for said year, and any surplus ordered by the corporation to be distributed shall be distributed on May 31 of each year after the year 1920 to each of the said copartnerships in the same proportion. It is the intent of this agreement that after May 31, 1920, each copartnership shall receive for each ensuing calendar year the percentage of the drawing account and of any surplus ordered by the corporation to be distributed which shall have been earned by each of said copartnerships respectively and contributed to the total earnings of the said corporation during the preceding year.
The fifth section provided a method to "establish the respective earnings of each copartnership which is party to this agreement," by allowing to each a monthly*2042 credit for "the full commission on all business conducted through the said Chicago Insurance Agencies, by it, its respective members, agents, or brokers," and certain other specified credits.
In operating under this arrangement the partnerships did business in their respective names; the existence of the corporation was not generally made known to the public. Checks which were received by the partnerships were turned over to the corporation, and the corporation kept the books. The corporate income was derived entirely from the two copartnerships and consisted of the premiums and commissions on insurance written by the partners, and its expenditures consisted of clerks' salaries, rent, and incidental office expenses. Under the agreement the corporation was never to sustain a loss. Drawings were made every month on the corporation by the partnerships, and whatever profits remained undrawn at the end of the year were distributed according to the agreement. The sums drawn were received by the partnerships and deposited to their accounts. Each partnership then distributed its part in accordance with the terms of its particular partnership agreement. The corporation declared no*2043 dividends and made no distributions except those provided for.
*803 During 1917 the partnership of Wiley, Magill & Johnson received monthly $1,501.59 and Rogers & Rollo $1,331.51, a total of approximately $33,996 being so drawn by them. Each petitioner received as his share annually $6,000 or more from 1917 up to and through 1921, the year of dissolution. These sums were paid under the provisions of the contract in accordance with the practice followed in prior and subsequent years. From 1917 to 1921 the average amount so distributed was between $25,000 and $30,000.
There was never any meeting of the corporation's board of directors except some informally announced and held, and no minutes were kept. Article 5 of the corporate by-laws provided that: "Salaries of the officers of this corporation shall be such as may be fixed from time to time by the Board of Directors." But no salaries to officers were ever authorized, and none were drawn.
The corporation was dissolved in 1921. When it wound up its affairs the only things on the books were accounts amounting in all to about $6,000. Each partnership took the ones attributable to it. Office furnishings of the value*2044 of about $500 were likewise returned to the firms which had supplied them.
The corporation filed an income-tax return for 1917 on March 18, 1918, showing a gross income of $55,491.15 and total deductions of $58,701.23. Among these deductions was $33,996, described as salaries of officers. In their personal income-tax returns for 1917 petitioners Wiley and Magill included in gross income their proportionate parts of the $33,996, representing the sums drawn monthly from the corporation. On March 7, 1923, the corporation and the Commissioner signed a consent in writing for the determination, assessment, and collection of the amount of income, excess-profits, or war-profits taxes due for 1917, irrespective of any period of limitations, and on January 25, 1924, signed a second, such consent to be in effect for one year from the date of taxpayer's signature. On the Commissioner's list for January, 1925, an assessment for 1917 of $46,428.18 appears against the corporation. On October 10, 1925, a distraint warrant for $5,971.44 and accrued interest of $513 was issued, and on January 4, 1926, was returned uncollected because an offer in compromise had been submitted on the tax. The*2045 offer was rejected.
OPINION.
STERNHAGEN: These petitioners voluntarily set up for themselves a complex organization for the conduct of their business, and however artificial it may appear to be, since they have adopted it and have thus acquired legal rights, it must be recognized as the situation upon which their tax liability is determined. We must, so far as the evidence permits, consider each petitioner in 1917 in his several *804 capacities as an individual, as a member of one of two copartnerships, and as a stockholder, director and officer of the corporation; we must recognize each corpartnership; we may not ignore the legal existence of the corporation and its later discontinuance; and we must duly regard the contractual relations which all of these established among themselves as the method of carrying on their business and handling its profits. It is of no avail to talk of the "substance" or "equity" of the case, if this means to ignore any of the actual facts or to submerge their legal significance beneath a confusion of organization.
The petitioners were all in the insurance business. Each was at liberty to conduct his own business in his individual capacity, *2046 receive his full earnings and have this used as the measure of his tax upon his individual return. Instead, the individuals elected to form partnerships, and thereby the method of taxing their income was modified, additional returns were required from the partnerships (Revenue Act of 1916, sec. 8(e), Revenue Act of 1917, sec. 1204(1)) and the partnerships were subjected to excess-profits taxes as if they were legal entities (Revenue Act of 1917, sec. 201 et seq. ). Then, for the purpose of reducing costs and promoting efficiency, these individuals, without changing their partnership relations, superimposed upon this structure a new and separate corporation, which in its turn was required by the revenue act to file returns for both income and excess-profits-tax purposes, to pay its separate taxes, and whose stockholders were taxable as well upon the dividends which they received from it. Having set up these organizations, each for its separate purpose and with its separate function, the petitioners recognized them as vital before the law by expressing their interrelations in a contract. Thus we have the individuals, the partnerships, and the corporation all taxable upon their*2047 income under the provisions of the statute peculiarly applicable to each in its own legal circumstances, each with its own items of gross income and deductions to arrive at its net; and it does not simplify the determination of the tax of any one of these to treat it as an incidental instrumentality having less than full independent stature.
The petitioners present numerous and various points, some of which defy the logic of the organization which they adopted. To discuss them all in the order presented would not be justified, for we think the correct disposition of the ultimate issue will be clear enough. But some of the underlying assumptions upon which petitioners' varying arguments rest should be disposed of.
Whether the corporation was a personal service corporation is a question of no significance in the present case, which concerns 1917, as it might be in a later year under the acts of 1918 and 1921; for the Act of 1917, which controls the present controversy, contains *805 no recognition of "personal service corporations" as that term appears in section 200 of the later statutes. The method of taxation which by section 209 of the 1917 Act is applied to corporations*2048 of only nominal capital is wholly unlike the exemption applied in later acts to "personal service corporations." In 1917 corporations of nominal capital were not exempt, but were subject to a flat 8 per cent tax; in later years, personal service corporations were themselves exempt from all tax, their earnings being taxed to the stockholders in the manner of partners. Thus one of petitioners' syllogisms falls entirely with the fall of its major premise. Whatever may be the transferee liability of a stockholder in respect of a distribution received from a personal service corporation upon whose income he has already been taxed because theoretically received, the theory of it is manifestly inapplicable to the transferee liability of a stockholder of a corporation of nominal capital which has been taxed under section 209 and its income then distributed to its stockholders. Irrespective of any other arguments that such a stockholder may have against transferee liability for the corporation's tax, it is clear that he can not say that he has already paid his distributive share of the corporation's tax upon its income because, unlike the personal service stockholder, he has had nothing*2049 whatever to do with the tax of his corporation. Even if it be true, therefore, that respondent has at one time treated the corporation under section 209 or that the subordinate revenue agent has suggested that it was a personal service corporation under the later act, petitioners take no advantage thereby in respect of their transferee liability under section 280, Revenue Act of 1926, in accordance with which the respondent is now calling upon them to satisfy the corporation's deficiency.
The question principally presented and argued is the corporation's right to the deduction taken on its 1917 income-tax return for "Salaries of officers, $33,996," which the respondent has disallowed. The evidence is beyond dispute that salaries to officers were neither accrued nor paid and that the amount in question was that provided by the contract to be paid in monthly amounts by the corporation to the two copartnerships. It is vain therefore to discuss the corporation's right to deduct officers' salaries, or whether the amount thereof was reasonable, or whether salaries might be recognized when informally but not formally authorized by the directors. If the amount of $33,996 is deductible*2050 by the corporation, it is not because the amount was paid as salaries, as clearly it was not, but because the payment was of a character which brings it within the statutory deduction of section 12(a) first, Revenue Act of 1916, for ordinary *806 and necessary expenses of the maintenance and operation of the corporation's business.
The question therefore really is whether the evidence is sufficient to prove the payment to have been such an expense as under the statute may be deducted. That the amount was in fact expended by the corporation in discharge of the legal obligation fixed by the contract is clearly shown by the evidence. There is nothing about the measure of the obligation which gives it the semblance of a dividend, for it was fixed not with reference to the amount of stock held by any of the individual stockholders, but entirely at the beginning of the period with reference to the proportionate amount of receipts of the past period for which each copartnership was responsible. Nor did the monthly amount fluctuate with the amount of the earnings; it was a definite condition without which the corporation could have no receipts. Since the gross income of the corporation*2051 is to be recognized as that of a separate entity, there must also be recognition of the annual outlay required to be paid as a consideration therefor under the very contract which provides the income. The corporation deducted only the fixed monthly payments thus actually made under the contract, and we need not consider whether any surplus distributed at the end of the year would have been deductible. We are of opinion that the amount of $33,996 mistakenly claimed as officers' salaries is deductible as an ordinary and necessary expense paid in the taxable year 1917 in the maintenance and operation of the corporation's business. Since the deficiency was predicated upon the disallowance of such deduction, it was invalid, and there is no liability of the petitioners as stockholders at the time of dissolution.
Judgment will be entered for the petitioners.