*76 Decision will be entered under Rule 50.
During the taxable years, petitioner was engaged in designing and engineering special machinery to be used in manufacturing airplane wings. Its capital stock was owned by four stockholders, all of whom were regularly engaged in the active conduct of the business. Capital was not an income-producing factor. Held, petitioner is entitled to personal service classification under the provisions of section 725, I. R. C.
*511 The respondent determined deficiencies of $ 47,797.11 and $ 21,151.75 in the petitioner's excess profits tax liability for the fiscal years ended June 30, 1943 and 1944, respectively. He also determined an overassessment in income tax for those respective years in the amounts of $ 23,165.55 and $ 7,143.35.
The sole issue is whether or not the petitioner is entitled to be classified as a personal service corporation under the provisions of section 725 of the Internal Revenue Code.
FINDINGS OF FACT.
Certain facts were stipulated. In so far as they*77 are material to the issue, they are as follows:
The petitioner, hereinafter called Farnham, is a corporation organized under the laws of the State of New York on May 7, 1942, and has its principal office in Buffalo, New York. By statutory consolidation, under section 686, Stock Corporation Law of New York, as of December 27, 1946, the petitioner acquired all assets and assumed all liabilities of Paragon Research, Inc., hereinafter called Paragon, to which corporation the notice of deficiency was addressed. The returns for the taxable years were filed with the collector of internal revenue for the twenty-eighth district of New York.
Paragon had outstanding 210 shares of preferred and 10,000 shares of common stock. As of July 1, 1943, and June 30, 1944, the stock was owned as follows: *512
| Shares held July 1, | Shares held June 30, | |||
| 1943 | 1944 | |||
| Stockholder | ||||
| Preferred | Common | Preferred | Common | |
| Paul Dubosclard, president | 150 | 5,000 | 150 | 5,000 |
| Frank L. Boutet, comptroller | 60 | 3,000 | 60 | 3,000 |
| Howard C. Reimann, treasurer | 1,000 | 1,000 | ||
| Roland S. Georger, secretary | 1,000 | 1,000 | ||
| Total shares issued | 210 | 10,000 | 210 | 10,000 |
Paul Dubosclard*78 and Frank L. Boutet each owned 25 per cent of the common stock of Farnhan prior to and during the taxable years.
Engineering fees earned by Paragon for the taxable years were as follows:
| June 30, 1943 | June 30, 1944 | |
| Farnham Manufacturing Co | $ 407,934.46 | $ 331,102.26 |
| Douglas Airplane Co | 4,500.00 | 16,000.00 |
| Amphibian | 601.84 | |
| Briggs | 7,500.00 | |
| Ryan | 12,750.00 | |
| Total fees earned | 412,434.46 | 367,954.10 |
Salaries and fees paid by Paragon for the taxable years were as follows:
| June 30, 1943 | June 30, 1944 | |
| Officers' salaries | $ 43,315.34 | $ 42,132.77 |
| Commissions and fees | 136,032.67 | 82,601.53 |
| Draftsmen | 67,721.73 | 91,087.84 |
| Other salaries | 21,969.35 | 25,959.70 |
| Additional amount credited to officers and | ||
| stockholders | 43,768.42 | |
| Total | 312,807.51 | 241,781.84 |
Officers' salaries paid by Paragon for the taxable years were as follows:
| June 30, 1943 | June 30, 1944 | |
| Paul Dubosclard, president | $ 24,380.00 | $ 23,920.00 |
| Howard Reimann, treasurer | 6,481.81 | 6,080.03 |
| Roland Georger, secretary | 6,393.53 | 6,152.74 |
| Frank Boutet, comptroller | 6,060.00 | 5,980.00 |
| Total | 43,315.34 | 42,132.77 |
Paul Dubosclard and Frank Boutet, president and comptroller, *79 respectively, of Paragon received salaries from Farnham during the taxable years as follows: *513
| June 30, 1943 | June 30, 1944 | |
| Paul Dubosclard | $ 6,011 | $ 6,000 |
| Frank Boutet | 24,045 | 24,000 |
During the taxable years, Paragon employed from 20 to 40 draftsmen.
During the fiscal year ended June 30, 1943, dividends of $ 40,000 were paid, of which $ 12,000 was paid in cash, $ 21,000 was paid in preferred stock, and $ 6,400 was paid in other property, and $ 3,768.42 was declared but was undistributed.
The balance sheets of Paragon as of June 30, 1942, 1943, and 1944, were as follows:
| June 30, 1942 | June 30, 1943 | June 30, 1944 | |
| ASSETS | |||
| Cash | $ 8,000.00 | $ 4,864.09 | $ 4,930.79 |
| Accounts receivable: | |||
| Farnham Manufacturing Co | 21,791.96 | 126,657.90 | 137,337.39 |
| Douglas Airplane Co | 4,500.00 | ||
| Amphibian Car Co | 401.84 | ||
| Advanced employees | 800.00 | ||
| Organization expense | 415.00 | 415.00 | 415.00 |
| Total assets | 30,206.96 | 136,436.99 | 143,885.02 |
| LIABILITIES | |||
| Reserve for Federal tax | 2,751.38 | 29,178.95 | 9,734.26 |
| Dividend payable (common) | 10,000.00 | ||
| Notes payable (dividend): | |||
| F. L. Boutet | 1,000.00 | 1,000.00 | |
| H. Reimann | 2,700.00 | 2,700.00 | |
| R. Georger | 2,700.00 | 2,700.00 | |
| Accounts payable -- purchases | 953.35 | 1,962.65 | |
| Accrued salaries: | |||
| John R. H. Neal | 1,580.00 | ||
| Accrued taxes: | |||
| New York unemployment tax | 895.96 | 723.68 | |
| Social security tax | 199.68 | 278.16 | |
| Withholding tax | 200.00 | ||
| New York franchise tax | 2,188.42 | ||
| Accrued preferred dividends: | |||
| Paul Dubosclard | 750.00 | ||
| F. L. Boutet | 300.00 | ||
| Accrued interest: | |||
| F. L. Boutet | 50.00 | ||
| R. Georger | 135.00 | ||
| H. Reimann | 135.00 | ||
| Accrued commissions: | |||
| Theo. Jacobowitz | 2,460.10 | 39,232.79 | 23,442.83 |
| Henry Powis | 2,765.40 | 3,754.65 | 38,142.02 |
| Chas. L. Wachter | 1,284.50 | 11,190.66 | 2,748.86 |
| Wilbur Johndrew | 4,375.35 | 6,311.60 | |
| Thomas Speller | 4,375.35 | 6,311.60 | |
| Ball Zwak & Royals | 983.70 | ||
| Briggs & Weaver | 95.75 | ||
| Williams & Wilson | 1.58 | 4.40 | |
| Eichman Machy Co | 2,070.35 | ||
| Preferred stock: | |||
| Paul Dubosclard | 15,000.00 | 15,000.00 | |
| F. L. Boutet | 6,000.00 | 6,000.00 | |
| Common stock: | |||
| Paul Dubosclard | 5,000.00 | 5,000.00 | 5,000.00 |
| F. L. Boutet | 3,000.00 | 3,000.00 | 3,000.00 |
| H. Reimann | 1,000.00 | 1,000.00 | 1,000.00 |
| R. Georger | 1,000.00 | 1,000.00 | 1,000.00 |
| Surplus | (7.77) | 3,760.67 | 10,407.09 |
| Total liabilities and capital | 30,206.96 | 136,435.99 | 143,885.02 |
*80 *514 The record discloses the following additional facts:
Dubosclard presently is not a stockholder or officer of either Farnham or Paragon and has no personal interest in those corporations. He was born in France and is an American citizen. He is a graduate of the French Sorbonne, a licensed engineer of New York, and a member of the Engineering Institute of Aeronautical Sciences and of the American Society for Metals. He also is a fellow of the American Society of Mechanical Engineers, one of less than 40 among a membership of over 20,000.
During 1920 Dubosclard was a designer for the Lincoln Woods Manufacturing Co., manufacturing cranes, cables, etc. On January 3, 1921, he was made assistant engineer of that company and from 1926 to 1930 he was in charge of research, with full responsibility. In 1930 he was consulting engineer for the American Hoist & Gear Co. of St. Paul. From late in 1931 to 1933 he was chief engineer of International Milling Co. of Minneapolis. On January 1, 1934, until Paragon was organized in 1942, he was president and general manager of Farnham.
Dubosclard first became interested in designing aircraft making machinery in 1938 in connection with*81 the Bell Aircraft Co. He has lectured before the Society of Automotive Engineers, the American Society of Mechanical Engineers, the American Society for Metals, and similar groups on the subject of airplane design, with particular reference to airplane wings, and has written papers for technical societies on that subject.
Previous to the organization of Paragon, no concern in the United States other than Farnham was exclusively making such machinery for the airplane industry. Each type of plane required, in large part, its own specially designed machines. Petitioner was especially concerned with five types of machines required for aircraft production. They were the spar miller, the form roll, the counter sinker, the drill, and the router. A spar is the backbone of the wing. The spar miller is a machine which carves a piece of aluminum into the proper shape for use in the spar. By the invention of the spar millers the number of machine hours required to produce the spar was reduced from about 800 to 12, with a saving of $ 1,764 in the cost of manufacturing each spar (normally costing $ 1,800). The form roll leaded plane edges. A counter-sinker is a small machine used in drilling*82 V-shaped sinker holes for fitting rivets. A drill rivets holes in the plane wing. A router was used to cut contours.
During the taxable years, Paragon's principal income was from designing spar millers. During the same period, Farnham's manufacturing capacity was 4 spar millers, seven form rolls, and 10 counter sinkers a month, in addition to the drills and routers.
*515 Dubosclard designed and engineered each type of machine. He was assisted by Reimann and Georger. From 20 to 40 persons were employed during the taxable years. Some of these were designers or draftsmen. The work of all of them was under the direct supervision of Reimann and Georger. All plans and designs were initiated and developed by Dubosclard, who was an outstanding figure and a recognized authority in the field of airplane designing. He was responsible for the creation and invention of appropriate machinery necessary to produce the airplane parts which the plane manufacturers indicated were needed. The manufacturers furnished blueprints of spars or wings which they wished to build, but offered no drawings or blueprints relating to the machines essential to building them. The requirements of the*83 military airplane program were constantly changing and his services and skill were in continuous demand to create new designs and to redesign and reengineer machines in use.
Georger became the secretary of Paragon in 1942. He is a member of the American Society of Mechanical Engineers. He taught technical drawing at Cornell University and lectured on perspective drawing of machinery.
Reimann attended the Rochester Mechanical Institute, the University of Buffalo and the Berkshire Summer School of Art. He had been employed at the R. & H. Chemical Co. and the International Milling Co. He was employed by Farnham in 1934 under the supervision of Dubosclard. In 1945 he and Georger formed a company engaged in special machine designing, and they are now designing and manufacturing brackets and bolt lifts.
Boutet, as comptroller, had charge of the financial affairs of Paragon. He supervised the analyzing of refunds and other work done by the accountant in charge of Paragon's books.
Nothing was done in the operation of Paragon without the approval of Reimann, Georger, Boutet, or Dubosclard. Before final plans of a machine were submitted to Farnham for manufacture, they were studied and*84 checked by Reimann and Georger, whom Dubosclard had trained since 1935. They were key men in the Paragon organization.
During the taxable years Paragon's activities were limited exclusively to designing and engineering special machinery needed for the manufacture of fighter aircraft. The Government forbade its accepting any other commitments and Paragon refused such type of orders. The chief engineer of an airplane manufacturing company would ask Dubosclard, representing Paragon, if an airplane could be built with a certain type spar or wing. If Dubosclard answered affirmatively, he would work out methods and means of fashioning it, draw sketches and outline the proper procedure. Then the manufacturer *516 would ask Dubosclard to proceed with the designing and drafting of the proposed machine. He would first make a sketch of the desired machine and then pass it to Reimann and Georger for study to reduce it to scale and check for balance, proportion, counter motion, etc. After Dubosclard checked the design and was assured that it satisfied the requirements, it was turned over to the detail draftsmen, who prepared the drawings to be sent to Farnham, which manufactured the*85 machine in accordance therewith. After its completion the machine was inspected by Dubosclard and his assistants. The time required to initiate the design and to complete the engineering therefor was uncertain, varying from one-half hour to two years.
Prior to and during the process of creating and engineering the various machines which Dubosclard invented, he was in constant touch and consultation with the airplane companies. He spent half of his time away from Buffalo on such missions.
Paragon was represented by three "contact men," or field representatives -- one in New York, one in Detroit, and one in Los Angeles. Each also represented other companies. They were paid on the commission basis. The function and duties of these men were to keep in touch with the manufacturing companies, to arrange for their officers to consult with Dubosclard, to secure repair parts, to report to Paragon on matters relating to the progress of plans, to expedite orders from the manufacturers, and to facilitate cooperation between the airplane companies and Paragon in order to make available promptly and efficiently the special machinery being designed by Dubosclard and his associates. They rendered*86 no engineering or designing skill or service to Paragon. In general, they knew how to read a blueprint and were familiar with the names and purposes of the machines. The compensation of each was a commission of 15 per cent, up to $ 25,000 a year, and thereafter one-fourth of the rate. They maintained their own offices. Their contracts were later renegotiated.
As president of Farnham, Dubosclard's duties became too detailed and onerous and thus they interfered with his engineering and designing function -- his "prime work." Therefore, he resigned as president of Farnham and devoted his entire time and attention to designing specialized machinery to aid the war effort. Paragon secured larger quarters, leased from Farnham, and rented its equipment from Farnham.
By agreement with Farnham, Paragon was paid for its designing and engineering service 25 per cent of Farnham's receipts, subject to adjustment, which later was made. All machines were built and sold by Farnham. Paragon purchased no material, machinery or equipment. Its sole income was derived from designing and engineering special airplane-manufacturing machines.
*517 Paragon's initial capital was $ 10,000, but only*87 a small portion of it was utilized. From the beginning of its operation, Paragon received payments from Farnham. It drew on Farnham for its pay rolls. The contact men were paid after the machines were accepted and paid for by the Government. Capital was not a material income-producing factor in the petitioner's business during the taxable years.
The petitioner filed its tax return as a personal service corporation, under the provisions of section 725 of the Internal Revenue Code, on the accrual basis and claimed the benefits of that section. In his notice of deficiency the Commissioner held that the petitioner was not entitled to such classification.
During the taxable years the petitioner was a personal service corporation within the meaning of section 725 of the Internal Revenue Code, and it is entitled to the benefits of that section.
OPINION.
We have before us the sole question whether or not the petitioner is entitled to be classified as a personal service corporation within the purview of section 725 of the Internal Revenue Code. 1
*88 The statute itself provides a definition which sets forth the following essential elements:
(1) The income of the corporation must be ascribed primarily to the activities of its shareholders.
(2) They must be regularly engaged in the active conduct of its affairs.
(3) They must be the owners of at least 70 per cent in value of each class of its stock.
(4) Capital must not be a material income-producing factor.
Respondent raises no question as to the second and third requirements having been met. His position is twofold: (1) That the efforts of the three contact men, whom he calls "field engineers," and the services of other employees contributed substantially to petitioner's income, as shown by the amount of compensation paid to them in comparison to the salaries of Dubosclard and his associate stockholders, and (2) that capital was a material income-producing factor. The petitioner contends that it has brought itself strictly within the terms of the statutory definition.
*518 We shall first consider the respondent's second point, that capital was a material income-producing factor, since it requires little discussion, in view of the state of the record. The petitioner*89 started with a capital of $ 10,000. Dubosclard testified that the capital was an "ornament" on the balance sheet; that from the day the petitioner began its operations it drew on Farnham for its pay roll commitments and that perhaps for a day or two capital was used until the draft was covered. The petitioner had no physical assets. All equipment, including even drafting tables and tools, was rented. The large sums due to the contact men were paid after the Government accepted and paid for the machines ordered through them. Thus, at no point in the conduct of the petitioner's business was any substantial amount of capital required. Its method of doing business precluded the use of more than a nominal amount of capital.
The petitioner's balance sheets show that on June 30, 1942, its cash account was $ 8,000, while on June 30, 1943 and 1944, it was $ 4,864.09 and $ 4,930.79, respectively. The petitioner's original capital was cash, but it may have been converted to another form of asset. However, assuming that it still remained in the cash form, the amount was reduced by $ 2,000 on June 30, 1942, and by a little over a half of the original capital in succeeding years. Compared*90 with the large amounts of accounts receivable shown on the balance sheet (and there is no record of the petitioner's total yearly receipts), the amount of capital is very small. It was not a material factor in producing the petitioner's income.
The respondent's main contention, that the petitioner's income was not to be ascribed primarily to the activities of Dubosclard, Reimann, Georger, and Boutet, its sole stockholders, rests on his conclusion that the three contact men and other employees contributed substantially to the production of income.
A short and complete answer to respondent's argument might well be to point out that the word "primarily" and the word "substantially" are not interchangeable equivalents. One might admit that the three contact men contributed "substantially" to the production of income without denying or negating the fact that the income was nonetheless to be "ascribed primarily" to the activities of the stockholders. Thus it might well be said that respondent's whole argument on this phase of the case begs the question. It is our conclusion that petitioner's income was to be ascribed primarily to its stockholders and not to the contact men. While it*91 is recognized that the three contact men were paid large sums for their services, the basis of their compensation was a commission computed on a fixed percentage of the sale price of the machines. The sudden demand for such machinery to manufacture *519 airplane spars and other parts resulted in the extraordinary amount of such commissions. We note from the record that this percentage was reduced and that the contracts with the contact men were later renegotiated.
The character of the services rendered by the contact men is a much more important test than the amount of money they received. See H. Newton Whittelsey, Inc., 9 T.C. 700">9 T. C. 700. The respondent stresses the skill and efficiency which he says they possessed and argues that they were essential in obtaining the orders from the airplane manufacturers, in the proper adaptation of the machinery to the changing needs, and to the successful manufacture and delivery of the completed equipment. Again we might admit respondent's contention without fatality to petitioner's claim to personal service classification. Undoubtedly, it was necessary to have intelligent contact men, but to admit that is not*92 to establish that they were primarily responsible for petitioner's income. During the taxable years little effort was required either to sell the ideas created by the petitioner or the completed machinery manufactured by Farnham. It was a seller's market in which demand far outran supply. The three field representatives of the petitioner were stationed at strategic points in the United States in order to keep in constant touch with the current needs of airplane manufacturers, to arrange for conferences with Dubosclard, and to serve as "trouble shooters" after machines were sold and installed. Their work was important, but they contributed little to the phase of petitioner's activity that was in demand and to which its income was primarily to be ascribed, namely, designing and engineering.
The success of petitioner's business was due primarily to Dubosclard, Reimann, and Georger. In applying Dubosclard's genius and peculiar talents to the complicated problems of construction, Reimann and Georger played an important part. They were the type of men whom it would have been difficult to replace. Their services were vitally important to petitioner's smooth and efficient operation. *93 They had been carefully trained by Dubosclard in the particular field in which they were engaged. During his frequent absences from the plant (consuming perhaps one-half of each year), they took over and carried on the work. Together with Dubosclard, they constituted a team, all members of which were essential, and as a team, were primarily responsible for petitioner's success.
It is our conclusion that petitioner's income was to be ascribed primarily to the activities of its stockholders. It follows that petitioner is entitled to personal service classification.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 725. PERSONAL SERVICE CORPORATIONS.
(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; * * *↩