*236 Decision will be entered for the respondent.
Use of substantial inventory and, intermittently, other capital, by petitioner engaged in part in hosiery manufacturing business, held, to demonstrate that capital is a material income-producing factor so as to defeat petitioner's exemption as personal service corporation, under section 725, Internal Revenue Code, notwithstanding that most of its gross income was derived from personal service business of selling on commission.
*500 Petitioner challenges respondent's determination of deficiencies in excess profits tax for the calendar years 1942 and 1943 in the respective amounts of $ 39,197.05 and $ 47,300.76.
The sole issue is whether petitioner is exempt from excess profits tax as a personal service corporation, as defined in section 725 (a) of the Internal Revenue Code. The issue is further narrowed by the parties to a consideration of whether capital was a "material income-producing factor" in petitioner's activities.
Some of the facts have been stipulated.
*237 FINDINGS OF FACT.
The stipulated facts are hereby found.
Petitioner, a New York corporation, filed its returns for the years involved, prepared on a calendar year-accrual basis, with the collector for the third district of New York. Attached to its income tax return for each year was Treasury Department Form 1121 P. S. (personal service corporation return of income), on which petitioner claimed it was a personal service company.
It was incorporated in 1930. In 1942 and 1943 its stockholders were Gus Grissmann, Margaret O'Donnell, and Walter Tarpey, who were respectively president, secretary-treasurer, and vice president. All were actively engaged in the conduct of petitioner's business. Grissmann and Margaret O'Donnell owned 77 of petitioner's outstanding 87 shares of no par common stock. Petitioner had only three other full time employees, who performed clerical duties.
During the years involved petitioner acted as mill agent for six large manufacturers of women's full-fashioned hosiery. Its function was sole selling agent for these manufacturers on a commission basis. It procured orders from jobbers, department stores, and the like, which were then forwarded to the mill; *238 upon receipt of the order at the mill, the ordered hosiery was shipped to the customer, who was billed by the mill.
On or about the tenth of the calendar month next succeeding shipment, the manufacturer remitted to petitioner a commission of approximately *501 5 per cent. During the tax year ended December 31, 1942, such sales effected by petitioner aggregated $ 1,549,211.20 and commissions thereon, representing gross income from this business, were $ 106,492.64. During the tax year ended December 31, 1943, such sales effected by petitioner aggregated $ 1,988,635.41 and commissions thereon, representing gross income from this business, were $ 100,529.65.
This phase of petitioner's business was started with capital of $ 600.
Commencing in 1939 and continuing through 1942 and 1943, petitioner, at the request and for the accommodation of its customers, undertook a new activity -- the supplying of lace stockings, generally known as "cut and sewn" stockings. There was at all times material here a demand for such stockings.
The mills with which petitioner had dealings as mill agent were unwilling to undertake the manufacture of lace stockings, as the technique of making them was *239 quite different from the manufacture of full-fashioned hosiery.
Petitioner was able, however, to find two contractors who undertook their fabrication. Petitioner secured the lace from lace suppliers, who billed petitioner for it, sending the lace to the fabricators. Petitioner then would bill the fabricators for the lace at cost. The fabricators would secure the welts and feet, without petitioner's assistance, and proceed to cut the lace, sew the welts and feet to the cut lace, and then ship the hose in the greige to a dyer, selected by petitioner, who would dye, examine, and box the stockings and ship them to petitioner's customers, pursuant to orders on hand. There was always a backlog of unfilled orders from petitioner's customers with the dyer and no stockings were made except in fulfillment of orders.
Upon shipment the dyer notified petitioner, who then billed the customers.
It was necessary for petitioner to pay cash for the manufacture of the lace stockings. In order to secure cash, since petitioner did not otherwise have funds to finance this phase of its business, petitioner sold the accounts due from its lace stocking customers to a factor, Meinhard Greeff & Co. (hereinafter*240 sometimes referred to as Meinhard), at a discount. The accounts were sold immediately upon shipment of the goods, at a discount of 6 per cent per annum, plus an additional commission of 1 1/2 per cent of the net amount of all sales. The bills from the fabricators and the dyer were forwarded to Meinhard for payment out of funds credited to petitioner on the factor's books.
During the tax years in question the sales made and bills paid by *502 the factor for materials purchased and fabricating costs were as follows:
| 1942 | 1943 | |||
| 1942 | ||||
| Sales | Bills | Sales | Bills | |
| Jan | $ 14,524.84 | $ 14,575.21 | $ 41,735.54 | $ 27,749.26 |
| Feb | 19,346.64 | 15,743.75 | 40,172.39 | 31,027.16 |
| Mar | 24,360.93 | 27,156.47 | 59,287.51 | 36,911.99 |
| Apr | 26,882.21 | 32,272.96 | 32,669.36 | 22,064.52 |
| May | 33,647.26 | 35,589.49 | 29,606.37 | 31,157.07 |
| June | 31,927.90 | 23,722.97 | 30,876.92 | 25,114.67 |
| July | 29,031.36 | 34,522.98 | 33,829.22 | 30,198.90 |
| Aug | 29,284.97 | 21,581.11 | 35,718.97 | 28,806.44 |
| Sept | 23,952.33 | 29,539.94 | 18,154.75 | 30,061.14 |
| Oct | 38,689.41 | 31,077.51 | 37,929.84 | 38,908.14 |
| Nov | 39,880.51 | 47,560.47 | 37,034.10 | 42,705.28 |
| Dec | 44,410.66 | 36,760.67 | 31,961.25 | 36,021.13 |
| Total | 1 355,939.04 | 350,103.53 | 1 428,976.22 | 380,725.70 |
As of January 1942 petitioner had a credit balance of approximately $ 17,000 in its account with Meinhard. By June 1942 the balance had been depleted to about $ 8,000.
During the tax year 1942, the total sales of lace stockings aggregated $ 355,955.20; 1 cost of goods sold was $ 331,713.14; gross income was $ 24,242.06. During the tax year 1943 the total sales of lace stockings aggregated $ 429,271.87; 1 cost of goods sold was $ 391,754.13; gross income was $ 37,517.74.
In 1942 the dyer shipped 35,584 dozen pairs to customers, of which 549 dozen were returned; in 1943 the dyer shipped 43,126 dozen pairs to customers, of which 1,116 dozen were returned.
The quantity of hosiery on hand at the end of a year was somewhat greater than at other times, as at that time the dyer gave preference to other work. A flow of 1,200 dozen pairs was required for the business.
In December 1942 petitioner had an inventory on hand of 5,748 dozen pairs of stockings. This consisted of an assortment*242 of irregulars, menders, seconds, returns, and about 250 dozen rejects. There were also 4,000 dozen pairs in the greige.
In December 1943 petitioner had 3,891 dozen pairs in the greige and 1,772 dozen pairs of irregulars, seconds, and the like, including 391 dozen pairs of rejects.
As of the beginning of May 1942 petitioner had on hand 2,861 dozen pairs; as of the end of the month, 2,733 dozen pairs.
*503 Petitioner's balance sheets as of December 31, 1941, 1942, and 1943, were are follows:
| Dec. 31, 1941 | Dec. 31, 1942 | Dec. 31, 1943 | |
| ASSETS | |||
| Cash -- bank | $ 17,279.85 | $ 9,833.38 | $ 6,642.21 |
| Meinhard Greeff & Co | 19,362.87 | 20,017.83 | 40,149.12 |
| Mill comm. and accounts receivable | 14,355.45 | 17,286.53 | 3,648.82 |
| Inventory | 1,450.83 | 20,923.14 | 19,206.84 |
| U. S. defense bonds | 1,000.00 | 1,000.00 | 11,000.00 |
| Furniture and fixtures | 21.72 | 213.07 | |
| Prepaid expense | 290.51 | 425.00 | 2,046.03 |
| Loans to officers | 6,808.19 | 6,932.10 | |
| Total | 53,739.51 | 76,315.79 | 89,838.19 |
| LIABILITIES | |||
| Accounts payable: | |||
| Direct billing (lace stockings) | 5,025.87 | 9,878.46 | 13,028.23 |
| General | 991.57 | 498.33 | 697.54 |
| Loans payable | 741.10 | ||
| Three months note to officers for | |||
| bonus | 15,000.00 | ||
| Accrued expenses and "S.S. Tax" | 1,759.16 | 292.20 | 3,243.54 |
| Federal income tax | 14,695.06 | 20,177.38 | 23,369.65 |
| CAPITAL | |||
| Capital stock | 5,041.81 | 5,041.81 | 5,041 81 |
| Tax paid surplus from personal | |||
| service dividends | 30,266.06 | 35,320.54 | |
| Total | 53,739.51 | 76,315.79 | 89,838.19 |
*243 As shown by its tax returns: For 1942 petitioner's net income was $ 50,443.44; for 1943, its net income was $ 58,424.13.
Respondent determined:
It is held that your corporation does not qualify as a personal service corporation as defined in Section 725(a) of the Internal Revenue Code and Section 35.725-2 of Regulations 112 and is therefore subject to the excess profits tax imposed by Section 710 of the Internal Revenue Code.
During the years 1942 and 1943 capital was a material income-producing factor in petitioner's activities.
Petitioner was not a personal service corporation in either of the years 1942 and 1943.
OPINION.
Although petitioner had originally engaged only in the business of selling on commission, it was also, during the instant tax years, a manufacturer of hosiery. This central fact seems to us a significant point of departure for a consideration of the sole issue as to petitioner's status under section 725 (a) of the code as "a personal service corporation." 2
*244 *504 One would not normally expect a manufacturing corporation, even though engaged in other lines of business, to be considered a personal service company. See Hubbard-Ragsdale Co. v. Dean, 15 Fed. (2d) 410, 411; affd. (C. C. A., 6th Cir.), 15 Fed. (2d) 1013. The employment of capital as a material income-producing factor would ordinarily be thought of as an essential element in such a business. Because of petitioner's peculiar method of operation, it is enabled to make a superficially plausible argument that such was not the case in its unique situation. But a more careful analysis of the actualities seems to us to result in the conclusion that, even as to the technicalities, compliance with the statute is more apparent than real.
Even if we assume, as petitioner so strenuously contends, that the use of current earnings does not constitute "capital," the fact remains, as petitioner concedes, that in at least one of the months before us cash or borrowed capital 3*246 of $ 6,500 was required; 4 and, in addition, a floating inventory ranging in cost from about $ 1,500 to $ 20,000, and apparently averaging over the *245 two years about $ 15,000, was likewise essential. 5 That petitioner contracted for the various manufacturing processes to be carried on by others, and that it hence avoided such capital requirements as plant, machinery, and tools, cf. Fairfax Mutual Wood Products Co., 5 T. C. 1279, does not overcome either the fact that the inventory in course of production belonged to it, or that capital invested in it was both material in size, and essential in character. 6George A. Springmeier, 6 B. T. A. 698; Denver Livestock *505 v. Commissioner (C. C. A., 8th Cir.), 29 Fed. (2d) 543.
*247 We recognize the force of petitioner's complaint that from the conclusion of liability for excess profits tax will flow the necessity of taxing its entire income and not merely that secured from the manufacturing business. The issue before us, however, and the inescapable language of the applicable provisions remove such considerations from those of which we may properly take account. The deficiency seems to us to have been correctly determined.
Decision will be entered for the respondent.
Footnotes
1. So stipulated.↩
1. So stipulated.↩
2. (a) Definition. -- As used in this subchapter, the term "personal service corporation" means a corporation whose income is to be ascribed primarily to the activities of shareholders who are regularly engaged in the active conduct of the affairs of the corporation and are the owners at all times during the taxable year of at least 70 per centum in value of each class of stock of the corporation, and in which capital 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 of gains, profits, or income derived from trading as a principal. For the purposes of this subsection, an individual shall be considered as owning, at any time, the stock owned at such time by his spouse or minor child or by any guardian or trustee representing them.↩
3. In the profit and loss statements attached to the stipulation of facts, certain expense items, particularly one of over $ 5,000 for each year, described as "Factoring commission," are attributed exclusively to the manufacturing operations. If this attribution is proper, it must presumably be on the theory that this was the cost of procuring the capital for the manufacturing business, since, if it had possessed the requisite capital, it would not have had to resort to discounting its receivables with the factor. This is itself inconsistent with petitioner's claim of the relative unimportance of the use of capital in that business.↩
4. Petitioner's treasurer testified in answer to the question:
"Suppose you had not advanced the money to the contractor for the lace, would he have bought it?
"The Witness: No, sir.
"The Court: And you would not have had any stockings?
"The Witness: No, sir."↩
5. As in most manufacturing operations, petitioner's inventory had two aspects, raw materials on the one hand and finished goods or work in process on the other. By using the proceeds of the sale of its accounts receivable, it eliminated much of the investment in the former, although the sum of $ 6,500 referred to was required for this purpose. See footnote 4, supra↩. But the inventory in which petitioner could not apparently avoid an investment was the undyed and unshipped completed stockings, and the returns and rejects which had to be worked over.
6. A comparison of material elements in the Springmeier case and the instant one reveals the following:
Springmeier 1918 1919 1920 Closing inventory $ 0.00 $ 11,151.96 $ 0.00 Commissions (gross) 26,470.96 26,826.38 Other business (gross) 8,815.17 4,910.85 ↩
Petitioner 1941 1942 1943 Closing inventory $ 1,450.83 $ 20,923.14 $ 19,206.84 Commissions (gross) 106,492.64 100,529.65 Other business (gross) 24,242.06 37,517.74