*3851 1. Personal service classification denied.
2. Evidence held insufficient to prove the value of patents for purposes of invested capital and exhaustion.
*169 This is a proceeding for the redetermination of deficiencies in income and profits taxes for the calendar years 1919 and 1920 in the respective amounts of $4,766.41 and $2,732.89. The petitioner alleges that the Commissioner erred in disallowing it a classification as a personal service corporation, or, if such classification was properly denied, that the Commissioner erred in disallowing (1) certain invested capital, and (2) exhaustion of patents in the amount of $2,941.17 for each of the above years.
FINDINGS OF FACT.
The petitioner is a corporation of the State of New York, having its principal office in New York City. It was incorporated in March, 1909, by George J. Mashek, for the purpose of carrying on the business in which he had been engaged as an individual. This consisted of performing the services of consulting engineer, principally in designing*3852 briquetting plants and machinery and superintending *170 the construction of such plants after they had been designed. The business of designing briquetting plants and equipment is one requiring a high degree of technical knowledge, skill and experience. Mashek was a consulting engineer of some years' experience and an expert in designing briquetting plants, well-known in this country and in Europe for his ability along these lines. The petitioner rented small offices in the City of New York, and maintained a permanent office force consisting of Mashek as president and general manager, a treasurer, a secretary, and a stenographer, the latter two positions during a great part of the time being assigned to the same person. There were in addition one to four draftsmen as the needs of the business warranted. Certain men were also employed from time to time as superintendents, to supervise the construction of plants designed by the petitioner, but during the taxable years no such superintendents were needed or employed.
In designing briquetting plants and superintending their construction, the petitioner operated under two kinds of contracts. The majority of its contracts*3853 were with firms located in the United States, and in these the petitioner agreed for a specific sum to perform all the engineering services, including the furnishing of plans and specifications, the securing of quotations as to prices of machinery and equipment, the placing of orders for the same with the consent of the clients, and the superintending of the construction of the plants and their operation for a limited time. As to other contracts with firms outside the United States, it was the petitioner's custom to draw up plans for the plant and to order the necessary machinery and equipment billed to the petitioner's account. In such cases the contract with the client would include the whole price of the machinery and equipment as billed, plus an amount to cover the engineering costs and fees. The machinery was shipped to the foreign client and a sight draft was attached to the bill of lading. After the sight draft was accepted and the amount received by the petitioner, the latter paid for the machinery billed to it by the manufacturers.
The petitioner manufactured no machinery or equipment, but employed one man having a small shop in Jersey City to build certain small rolls*3854 which were used in one of the processes for fashioning briquettes. The total equipment used to manufacture these rolls did not cost more than $125 and no profit was charged or made on this phase of the business. The whole profit of the petitioner consisted in its charges for engineering services. In some cases where briquetting plants had been in operation the owners would require special parts for the equipment built under the petitioner's *171 designs and would order them from the petitioner which in turn would order these parts from the foundry or machine shop and charge the client for its services, in purchasing and inspecting, a sum to cover overhead expenses in excess of the price paid by the petitioner to the manufacturer. The gross business carried on in such sales for 1919 was approximately $2,000, and for 1920, approximately $700, while the petitioner's gross income from its business in those two years amounted to approximately $43,000 and $37,000, respectively.
In performing its engineering services the petitioner operated under the following plan: When a client came with a proposition for the erection of a briquetting plant he was interviewed by Mashek, who*3855 then made an inspection of the ground and submitted a report as to the most desirable plant, preparing preliminary drawings, showing the location and equipment of the proposed plant and an estimate of its cost. All of this work was done by Mashek personally in accordance with his own ideas. After approval by the client of the preliminary plans, final plans, detail drawings, and specifications for the plant and machinery were prepared under Mashek's direction. He then ordered the machinery required for the plant and personally inspected it before shipment to the client. In cases where a superintendent was employed to see that the plans and specifications were followed in the construction of the plant and equipment, Mashek, from time to time visited the plant and inspected the building and machinery until it was finally turned over in operation to the client. The duties performed by Mashek in designing the plant and equipment and in directing the preparation of detailed drawing and specifications could be performed by no one else in the organization due to the fact that he alone possessed the requisite technical knowledge and experience.
On January 1, 1919, the capital stock*3856 of the petitioner consisted of 500 shares of which 359 1/2 were issued and outstanding in the names of the following persons as noted on the corporation's stock book:
| Stockholder | Number of shares |
| George J. Mashek | 180 |
| Eleanor J. Mashek | 50 |
| M. B. Mashek | 50 |
| James H. Cullen, jr | 75 |
| Howard G. Arnold | 2 1/2 |
| L. M. Adami | 2 |
| Total | 359 1/2 |
The stock of Eleanor J. Mashek and M. B. Mashek, wife and daughter, respectively, of George J. Mashek, was kept in the latter's *172 possession in his safe deposit vault and was endorsed in blank. This was a "family arrangement." Some time during the year 1920 Mashek acquired the 75 shares of stock standing in the name of James H. Cullen, Jr. The latter had been secretary of the petitioner for a few months in 1910, but since that time had no connection with the petitioner except as a stockholder. Eleanor J. Mashek and M. B. Mashek rendered no services to the petitioner, while Arnold was treasurer and office manager, Adami was secretary, and George J. Mashek was president and general manager. George J. Mashek, the president and general manager, died in May, 1926, before the hearing in this case.
During the year 1919*3857 the corporation had three employees regularly employed for the whole year whose total salaries amounted to $7,380, and ten part-time employees whose total salaries amounted to $4,597.15. One of these thirteen employees was the secretary of the corporation while the remainder were draftsmen. During the year 1920 there were four employees regularly employed for the whole year whose total salaries amounted to $7,226.05, and one man employed from January 1 to April 30 at a salary of $900 for this period. One of these five employees was the secretary of the corporation and the remainder were draftsmen.
Comparative balance sheets and ordinary and necessary expenses of the petitioner for the years 1919 and 1920, as reported for those years in its income-tax returns, which were offered in evidence by the respondent, were as follows:
| Schedule E: Comparative balance sheet | |||
| January, 1919 | Dec. 31, 1919 | Dec. 31, 1920 | |
| ASSETS | |||
| Cash in bank and on hand | $12,844.55 | $46,703.24 | $11,509.42 |
| Office equipment | 215.00 | 233.45 | |
| Accounts receivable | 8,212.28 | 4,472.09 | 17,182.84 |
| Materials on hand | 2,121.66 | 2,180.50 | 5,672.02 |
| Catalogues | 650.00 | ||
| Patterns | 2,000.00 | 2,000.00 | 1,500.00 |
| Subscriptions | 1,750.00 | 1,750.00 | |
| Commissions deferred | 2,000.00 | ||
| Loans receivable | 53.11 | 100.00 | |
| Patents | 50,000.00 | 47,058.83 | 44,117.66 |
| Liberty bonds | 10,000.00 | 10,000.00 | |
| Accrued interest on Liberty bonds | 318.21 | ||
| United States certificates | 10,000.00 | ||
| Contract No. 66 | 260.00 | ||
| Grinding room equipment | 410.05 | ||
| Total | 79,578.49 | 114,692.77 | 101,043.65 |
| LIABILITIES | |||
| Accounts payable | 8,003.16 | 30,017.88 | 13,347.69 |
| Uncompleted contracts | 14,775.00 | 11,150.00 | 9,816.04 |
| Capital stock | 42,900.00 | 42,900.00 | 39,514.37 |
| Surplus | 13,900.33 | 30,624.89 | 38,365.55 |
| Total | 79,578.49 | 114,692.77 | 101,043.65 |
| Schedule A-13. - Ordinary and necessary expenses. | |||
| 1919 | 1920 | ||
| Patterns | $3,678.56 | Blue prints and drawings | $4,602.35 |
| Commissions | 2,000.00 | Pattern repairs | 741.93 |
| Traveling expenses | 833.97 | Pattern cost | 1,195.43 |
| Advertising | 672.17 | Drafting supplies | 42.31 |
| Catalogues | 686.75 | Draftsmen's salaries | 2,433.31 |
| Experimental expense | 41.25 | Small tools | 110.50 |
| Legal and professional | 375.00 | Engineering expenses | 121.01 |
| Difference in balance | 62.09 | Commission | 852.00 |
| Telephone | 114.05 | Traveling expenses | 1,471.12 |
| Telegraph | 89.42 | Advertising | 979.90 |
| Stationery and supplies | 158.35 | Legal and professional | 830.80 |
| Office expenses | 210.49 | Telephone | 161.48 |
| Rent | 1,100,04 | Telegraph | 45.12 |
| Shop rent | 206.66 | Stationery and supplies | 197.19 |
| Bank exchange | 4.26 | Office expenses | 802.64 |
| Postage | 65.17 | Rent, office | 1,100.04 |
| Expressage | 8.68 | Office salaries | 2,377.08 |
| Grinders' wages | 5.50 | Rent, shop | 354.20 |
| Insurance | 61.05 | Bank exchange | 10.21 |
| Merchandise expense | 11.70 | Expressage | 16.19 |
| Office salaries | 1,335.00 | Insurance | 101.39 |
| Draftsmen's salaries | 4,053.05 | Discounts | 2.27 |
| General salaries | 1,480.22 | ||
| Total | 17,253.43 | Total | 18,548.47 |
*3859 *173 The business of the petitioner was spasmodic with one good year sometimes followed by several poor ones and the cash on hand and Liberty bonds and United States certificates shown in the balance sheets were carried for the purpose of paying the office expenses and employees during those years in which there was little business.
On June 5, 1909, Mashek assigned to the petitioner two patents, one for the process of preparing pulverulent materials for briquetting and the other for equipment to be used in carrying out the process. The considerations recited upon the assignments were for each patent the sum of $1 and other considerations. In some cases certain of the machinery to be used by the petitioner's clients was manufactured under these patents and in other cases the patents were not used. One of the petitioner's contracts offered in evidence provided as follows in respect to patents:
8th. On completion and payment for plant, we will issue you a license for the right to operate this plant without payment of any further royalty, and use our patented machinery and processes covered by five United States patents issued and other patent applications pending, with*3860 the exception as specified below.
* * *
The processes and machinery equipment specified to be furnished are covered by five United States patents with other patents pending as stated above, and the rights to use this equipment in Newark are included on completion of the *174 payments of the fixed sum mentioned above and payment of all other bills. We will then issue you a license giving you the right to use this equipment free from any further royalty charge, reserving the right, however, to refer to and show this plant to others at any reasonable time upon written request to you signed by an officer of this company, with the understanding that any such portion of the Binder Plant you desire to keep secret need not be shown or disclosed to others. Also that you will order from us and pay for all necessary wearing and repair parts for the plant during the life of these patents, which will be furnished you at our regular prices which are based on cost plus 20% net profit to us.
No royalties were ever received by the petitioner from the two patents.
OPINION.
MURDOCK: The petitioner has advanced two contentions: (1) That within the provisions of section 200 of the*3861 Revenue Act of 1918 it should be classified as a personal service corporation, or (2) that if it is not classified as a personal service corporation then it should be allowed a valuation of two patents for the purpose of invested capital and a deduction of $2,941.17 for exhaustion of the two patents in each of the taxable years.
In our findings of fact we have described at some length the general practice of the petitioner in carrying on its business since the time of its organization. However, it does not appear that all of these facts apply to the taxable years in question.
In order to be classified as a personal service corporation under the above Act, the petitioner must meet the three requirements set forth in section 200, namely: (1) the principal stockholders must be regularly engaged in the active conduct of the business, (2) the income must be attributable primarily to their activities, and (3) capital must not be a material income-producing factor.
When we come to consider the first requirement we are met with the fact that the corporation's books at the beginning of the first taxable year show that 175 shares of its stock out of a total of 359 1/2 outstanding shares*3862 were in the names of persons not regularly engaged in the active conduct of the business of the corporation. Seventy-five shares were held by James H. Cullen, Jr., who during the taxable years had no business connection with the petitioner save his stockholding. Mashek, the majority stockholder, purchased Cullen's 75 shares during the year 1920, but the evidence does not show the date of this purchase.
Mashek's wife and daughter each having 50 shares of the stock were not at all engaged in the active conduct of the business. These shares had been endorsed in blank by the owners thereof and were kept in Mashek's safe deposit vault under a "family arrangement," which was not explained. We have heretofore held that the endorsement in blank and delivery of certificates by a wife to her husband *175 is not sufficient to vest title thereto in the latter in the absence of evidence showing that there was an intent to pass title. . In respect to these shares the petitioner has not produced evidence to show that the title thereto has passed to the majority stockholder from his wife and daughter.
*3863 Where three stockholders who are not regularly engaged in the active conduct of the petitioner's business, and whose activities do not contribute to its income, hold such a large percentage of the outstanding stock, two of the requirements of the Act are not met and the petitioner can not be classified as a personal service corporation. See , in which case the opinion was in part as follows:
Any corporation claiming to be a personal service corporation must bring itself fairly within the requirements of such an organization, as provided by law. Every corporation has full control of its own activities. It knows what the requirements of a personal service corporation are. It may comply therewith and casily keep within the limits thereof if it so choose, or it may not if it otherwise prefers. If it does not fairly observe and keep within the requirements of the law, it should not claim the benefits which the law confers. To nearly comply with the law, or to come within hailing distance thereof, is not enough.
* * * It is necessary, not only that the income of the corporation shall be derived from personal service, *3864 but also that it shall be derived primarily from the activities of those who principally are to share in that income, and therefore in the benefits of the law. If this were not so, the personal service in such cases might be rendered by one or two, or a few only, and others largely interested in the corporation, but rendering no service, might be capitalizing the efforts of these few and realizing a profit therefrom.
The petitioner has also failed to prove its contention in regard to invested capital and exhaustion. The Revenue Act of 1918 contains the following provision in respect to invested capital:
Sec. 326(a) That as used in this title the term "invested capital" for any year means (except as provided in subdivisions (b) and (c) of this section):
* * *
(4) Intangible property bona fide paid in for stock or shares prior to March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corporation outstanding on March 3, 1917, whichever is lowest.
*3865 No satisfactory evidence was presented as to any of the three measures of value set forth in this section, and in the absence of such evidence no valuation for invested capital purposes can be allowed. .
The sole evidence to show the March 1, 1913, value of the two patents in question for the purpose of exhaustion was contained in the deposition of a consulting engineer. At the time the deposition was taken the respondent objected to the competency of the witness' *176 opinion as to the March 1, 1913, value, one of the reasons given for the objection being that the witness had not shown himself to be qualified to testify as to value. This deposition was offered in evidence at the trial of the case before the Board and was accepted subject to the objections raised at the time the deposition was taken, with the understanding that the Board should reserve its ruling on the objections until the case was taken up for a decision. We doubt seriously whether it has been shown that this witness was qualified to give an opinion as to the March 1, 1913, value of the patents and even if the objection to his testimony*3866 be overruled we think that little or no weight can be attached to his opinion. The witness in qualifying himself stated that he had been a consulting engineer for various iron and steel companies, a by-product coke oven company, smelting and refining companies, a coal and iron company and some other industrial concerns. He stated that he was familiar with the two patents and had seen three plants equipped with machinery covered by the patents and the product of a plant so equipped. He then gave it as his opinion that the fair valuation of these two patents as of March 1, 1913, was $50,000.
The evidence in this case shows that the designing of briquetting plants and equipment requires a high degree of technical knowledge, skill and experience, and the petition alleged that "as consultant engineer in this field [designing and constructing briquetting plants], special technical training experience and expert knowledge are necessary and essential." The witness has undoubtedly qualified as a consulting engineer of experience and his opinion as to values of plant equipment, or product of those businesses with which he was familiar by experience would undoubtedly be acceptable but*3867 for the purposes of this particular case the witness has not shown that he has such a familiarity with the briquetting business, or that he has been informed sufficiently in regard thereto to give an intelligent and reliable opinion as to the value on March 1, 1913, of the two patents in question.
The respondent offered in evidence the petitioner's corporation excise and income-tax returns from the year 1909 to the year 1922, which showed that for a period of five years from its incorporation up to and including the year 1913 its losses far exceeded any profits realized.
It also appeared from the evidence that in designing briquetting machinery and plants the two patents in question were used in some cases and in others were not used. These facts would seem to indicate also that the patents had no such March 1, 1913, value as the petitioner would claim for them but in fact that they had little value if any at all.
Judgment will be entered for the respondent.