*2631 Personal service classification denied.
*225 Petitioner brings this proceeding for a redetermination of deficiencies in income and profits taxes of $2,151.70 for 1919, $4,107.99 for 1920, and $7,022.45 for 1921. The deficiencies arise from a denial of personal service classification.
FINDINGS OF FACT.
The petitioner incorporated under the laws of Delaware on January 24, 1914, with a capital stock of $50,000, consisting of $15,000 of preferred and $35,000 of common, conducts an advertising agency in Philadelphia, Pa. The par value of the stock was $100, the preferred being cumulative as to dividends and paying not more than 7 per cent. Only the common stock carried voting rights and it was issued to J. H. Cross for his contracts, leases, good will and entire existing business. On November 20, 1920, by proper corporate action, the preferred capital stock was increased from $15,000 to $65,000. This increase was consummated because of a larger volume of business and upon the insistence of the Curtis Publishing Co.
J. H. Cross gave certain*2632 of his former employees shares of common stock. These employees were V. A. Harries, D. D. Chrisman and H. J. Kane. Cross also made arrangements to issue common *226 stock as a bonus on the purchase of preferred, the bonus being one share of common with each two shares of preferred. With the exception of 20 shares of preferred issued for services, 10 shares on January 22, 1915, and 10 shares on February 1, 1916, divided equally between D. D. Chrisman and H. J. Kane, the preferred stock, up to the years in question, was sold for cash.
The following table shows the ownership of stock on or about the first of the year:
| 1919 | 1920 | 1921 | ||||
| Preferred | Common | Preferred | Common | Preferred | Common | |
| J. H. Cross, president | 25 | 272 | 70 | 270 | 330 | 265 |
| V. A. Harris, treasurer | 16 | 18 | 20 | 20 | 70 | 20 |
| D. D. Chrisman, secretary | 10 | 25 | 10 | 25 | 10 | 25 |
| H. J. Kane | 10 | 25 | 10 | 25 | 10 | 25 |
| W. W. Cross | 10 | 5 | 10 | 5 | 10 | 5 |
| S. A. Crosby | 10 | 5 | 10 | 5 | 10 | 5 |
| H. R. Lathrop, trustee | 10 | 10 | 10 | |||
| W. P. White | 10 | 10 | ||||
| W. L. Day | 5 | |||||
| Total | 101 | 350 | 150 | 350 | 450 | 350 |
J. H. Cross, Harris, Chrisman, and Kane devoted their entire time*2633 to the business during the taxable years. These four held more than 97 per cent of the voting stock at all times. J. H. Cross solicited between 85 and 95 per cent of petitioner's business. Chrisman looked after the business department, bought space, handled the printing and estimating. He solicited new business when not otherwise engaged. Kane handled the art work, engraving, and copy. Harris was responsible for the auditing, filing, and checking. W. W. Cross, Crosby, Lathrop and White were inactive. Lathrop, however, as president of another corporation brought to petitioner a large amount of advertising. Day was gratuitously issued five shares of common stock for qualifying purposes on February 3, 1920. He immediately endorsed the certificate in blank and the same remained in petitioner's stockbook. Day was elected vice president of petitioner and devoted his entire time to the business.
Petitioner, wherever possible, entered into a contract with the advertiser whereby the former was appointed agent for all the latter's advertising in magazines and newspapers. The next step was the assembling and accumulating of information relative to the proposition to be advertised. *2634 A conference or conferences were held with the leading members of petitioner's organization to determine the best recommendation to submit to the advertiser. Petitioner's decision was submitted to the advertiser by a member of its staff, who explained the conclusions reached and offered suggestions as to *227 the form of advertising that should be used. When the advertiser approved the suggestions and estimates offered, the petitioner reserved the needed space in the advertising medium which had been selected.
The reservation of space was made on a special order form which was made up in quadruplicate. The original was sent to the publisher, while the three carbons were used by petitioner. The first carbon was used by the auditing department for the billing record, the second carbon was the checking record, and the third was the work sheet for the space-buying department. The space ordered was for and in the name of the advertiser, and space was reserved only after a definite order therefor had been given by the advertiser. When the order was received petitioner debited the advertiser and credited commissions and the publishers.
Petitioner then had to provide the*2635 necessary copy and art work for the advertiser. The production department made suggestions, generally the result of conferences, and worked up a rough sketch of the proposed advertisement. The sketch was submitted to the advertiser for approval and after the same had been approved, the advertisement was worked up in final form. It was then plated and sent to the publisher, who submitted a proof for petitioner's approval, prior to publication. After publication another department checked the insertion.
In billing the advertiser, the petitioner followed the practice of collecting from the advertiser prior to the time remittance had to be made to the publisher. The advertiser was billed on the last day of the month in which the services were rendered. The bill rendered the advertiser was based on the publisher's rate card and if paid by the tenth of the following month a 2 per cent discount was allowed. In some instances the petitioner collected for advertising more than two months in advance of the date of publication. Some of the advertisers paid their bills by notes which were discounted at the bank by petitioner. In such cases, the advertisers paid the discount charges*2636 and petitioner accepted the notes as cash and allowed the discount for cash payments. The publisher billed the petitioner for each advertiser, itemizing the advertisers where a composite bill was sent. The due date of bills from publishers vary with the publication. In some cases the publisher billed the advertiser direct. In the few cases where the advertisers failed to remit to petitioner prior to the time the publishers had to be paid, petitioner would make the payments to retain the good will of the advertisers and to maintain its reputation and secure the discount allowed by the publishers.
The income and deductions shown on petitioner's returns for the taxable years were as follows:
| 1919 | 1920 | 1921 | |
| Income | |||
| Gross income from operations | $80,974.20 | $144,084.31 | $219,450.98 |
| Income from other sources | 9,420.43 | 561.50 | 672.16 |
| Total | 90,394.63 | 144,645.81 | 220,123.14 |
| Deductions | |||
| Ordinary and necessary expenses | 58,143.64 | 80,556.60 | 108,106.10 |
| Compensation to members | 22,400.00 | 34,320.00 | 41,860.00 |
| Commissions | 10,431.60 | 42,675.50 | |
| Taxes, bad debts, depreciation | 1,465.74 | 2,303.40 | 2,912.64 |
| Total | 82,009.38 | 127,838.60 | 195,554.24 |
| Net income | 8,385.25 | 17,034.21 | 24,568.90 |
*2637 *228 The schedules attached to the returns show the following items as ordinary and necessary expenses:
| 1919 | 1920 | 1921 | |
| Salaries | $31,117.53 | $53,455.93 | $55,496.59 |
| Advertising | 2,096.58 | 6,564.89 | 6,178.25 |
| Traveling and entertainment | 5,048.80 | 4,736.01 | 5,262.10 |
| Miscellaneous expense | 4,268.38 | 5,451.81 | 7,608.39 |
| Rent | 2,000.04 | 2,000.04 | 2,733.41 |
| Office expense | 1,668.88 | 1,489.27 | 3,499.03 |
| Stationery | 1,305.26 | 1,439.05 | 1,634.84 |
| Postage and expressage | 1,727.41 | 2,174.80 | 2,596.47 |
| Telephone and telegraph | 676.62 | 835.75 | 1,332.45 |
| Art works and cuts | 396.14 | 406.23 | 697.66 |
| Insurance | 178.96 | 226.48 | 192.41 |
| Commissions | 7,887.24 | ||
| Excess and deficiency account in trial balance | 366.83 | 74.26 | |
| Club dues and expenses | 1,636.51 | 1,878.24 | |
| Professional services, legal and accounting | 8,750.00 | ||
| Service expense, research department | 10,172.00 | ||
| Total | 58,371.84 | 80,783.60 | 108,106.10 |
The salary items in the schedules were exclusive of salaries paid the officers. These amounts were paid to an unknown number of employees. The advertising items represented petitioner's own advertising. Traveling and entertainment expenditures were*2638 for contacting clients. The commissions paid in 1919 were paid to Chrisman and Cross for servicing certain clients. Miscellaneous expenses for 1921 represented additional compensation to employees, $3,315, car fares and suppers, electric light and cleaning office, drinking water, etc., $4,293.39. The item of service expenses, research department, represented the cost of equipping a statistical department which entailed the work at all times of as many as three people. This department was furnished with every conceivable service having a bearing on the business and maintained a library of 1,500 volumes for reference work.
Petitioner's balance sheets for the years 1919, 1920, and 1921 were as follows:
| BALANCE SHEET | ||||
| December 31, 1918 | December 31, 1919 | |||
| ASSETS | ||||
| Cash | $10,194.55 | $11,944.22 | ||
| Notes receivable | 50.00 | $4,577.37 | ||
| Less, notes receivable discounted | 1,772.66 | |||
| 2,804.71 | ||||
| Accounts receivable | 49,520.63 | 64,116.47 | ||
| Investments: | ||||
| United States Liberty loan bonds - | ||||
| Third loan | $500.00 | 500.00 | ||
| Fourth loan | 1,000.00 | 1,000.00 | ||
| Stock, National Outdoor Advertising Bureau | 100.00 | 300.00 | ||
| 1,600.00 | 1,800.00 | |||
| Deferred: | ||||
| Cash surrender value | 736.00 | |||
| Life insurance | 768.29 | |||
| Prepaid auto insurance | 75.36 | |||
| 811.36 | ||||
| Fixed: | ||||
| Furniture and fixtures | 4,349.46 | 5,086.57 | ||
| Less reserve for depreciation | 574.19 | 1,337.17 | ||
| 3,775.27 | 3,749.40 | |||
| Automobile | 1,031.00 | 2,812.46 | ||
| Less, reserve for depreciation | 200.00 | 112.50 | ||
| 831.00 | 2,699.96 | |||
| Stationery inventory | 100.00 | 100.00 | ||
| Good will | 37,000.00 | 35,000.00 | ||
| 103,839.74 | 123,026.12 | |||
| LIABILITIES | ||||
| Accounts payable | 53,972.37 | 61,396.64 | ||
| Reserve for accounts payable | 2,000.00 | |||
| Reserve for depreciation | 774.19 | |||
| Accrued salaries | 986.25 | |||
| 54,746.56 | 64,382.89 | |||
| Capital stock: | ||||
| Preferred | 10,100.00 | 15,000.00 | ||
| Common | 35,000.00 | 35,000.00 | ||
| Surplus | 3,993.18 | 8,643.23 | ||
| 103,839.74 | 123,026.12 | |||
| December 31, 1920 | December 31, 1921 | |||
| ASSETS | ||||
| Cash | $4,843.63 | $42,356.27 | ||
| Notes receivable | $37,552.11 | $24,150.27 | ||
| Less, notes receivable discounted | 22,552.11 | 20,604.66 | ||
| 15,000.00 | 3,545.61 | |||
| Accounts receivable | 118,354.21 | 179,872.86 | ||
| Investments: | ||||
| United States Liberty Loan bonds - | ||||
| Third Loan | 500.00 | |||
| Fourth Loan | 1,000.00 | |||
| Stock, National Outdoor Advertising Bureau | 300.00 | 300.00 | ||
| 1,800.00 | ||||
| Deferred: | ||||
| Cash surrender value life insurance | 880.00 | 1,040.00 | ||
| Prepaid auto insurance | 194.32 | 171.51 | ||
| 1,074.32 | ||||
| Prepaid discounts | 34.42 | |||
| Prepaid service expense | 235.00 | |||
| Prepaid postage | 42.00 | |||
| 1,522.93 | ||||
| Fixed: | ||||
| Furniture and fixtures | 6,398.20 | 7,817.35 | ||
| Less, reserve for depreciation | 2,198.50 | 3,158.50 | ||
| 4,199.70 | 4,658.85 | |||
| Automobile | 2,812.46 | 2,812.46 | ||
| Less, reserve for depreciation | 1,049.94 | 1,987.38 | ||
| 1,762.52 | 825.08 | |||
| Stationery inventory | 1,500.00 | 500.00 | ||
| Good will | 35,000.00 | 35,000.00 | ||
| 183,534.38 | 268,581.60 | |||
| LIABILITIES | ||||
| Accounts payable | $84,422.03 | $141,686.56 | ||
| Reserve for accounts payable | 2,000.00 | |||
| Accrued salaries | 305.14 | 568.05 | ||
| Accrued commissions | 775.73 | |||
| W.L. Day trust fund | 1,882.36 | |||
| 86,727.17 | 144,912.70 | |||
| CAPITAL STOCK AND SURPLUS | ||||
| Preferred | $45,000.00 | $65,000.00 | ||
| Common | 35,000.00 | 34,100.00 | ||
| 80,000.00 | 99,100.00 | |||
| Surplus | 16,807.21 | 24,568.90 | ||
| 96,807.21 | 123,668.90 | |||
| 183,534.38 | 268,581.60 |
*2639 *230 Notes receivable less notes receivable discounted represents promissory notes of advertisers which were accepted in payment in lieu of cash. In the balance sheet for December 31, 1920, the $15,000 item was a note of J. H. Cross in payment for additional shares of preferred stock. The accounts receivable represent amounts due from advertisers, 15 per cent of which represents petitioner's commissions. The accounts payable represent amounts due the various publishers, art dealers, and engravers.
OPINION.
MORRIS: The question raised is whether the petitioner is entitled to personal service classification which is defined in section 200 of the Revenue Acts of 1918 and 1921 as follows:
* * * A corporation whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or borrowed) is not a material income-producing factor; but does not include * * * any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits, or income derived from trading as a principal, or * * *2640 *.
The petitioner claims the benefit of an exception to the general method and extent of taxing corporations. The burden is upon it to show that it clearly comes within the terms of such exception. . As the principal stockholders were regularly engaged in the active conduct of the business the second element of the definition would seem to be fully met. It is necessary, however, not only that they shall be regularly engaged, but the income from the corporation must be derived primarily from their activities. Examining the record in connection with this element of the definition we are unable to find that the petitioner *231 has sustained the burden of showing that it clearly comes within it. With respect to the duties of those connected with the corporation, there is but little evidence in the record except as to the principal stockholders. We do not know how many employees made up the staff, or what kind of service such employees performed. J. H. Cross in the course of his testimony stated that all the employees outside of the principal stockholders were merely clerical employees, but on cross-examination*2641 he said that a sales plan or copy plan of any client was never decided by any individual but always in conference with the members of the organization, and that some of the employees who were competent members of the organization were taken into the conference. This would seem to indicate that there were some employees who were not merely engaged in routine clerical work. If the services and value thereof, which should be attached to the employees, are to be measured in dollars of salaries paid, it is very apparent that the income can not be primarily ascribed to the principal stockholders. In each of the taxable years the salaries paid employees exceeded the salaries paid the officers and stockholders.
In the where the question of to whom income should be primarily ascribed was raised, we said:
In 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*2642 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.
A further ground, which standing by itself might not be fatal to the petitioner's contention, but which is cumulative, is that capital was an income-producing factor. For the year 1919 the return shows interest, trade discounts and miscellaneous income of $9,420.43 whereas the gross income from operations was only $80,974.20. Although the petitioner was fairly successful in collecting from the advertisers prior to the time of its payments to the publishers, the evidence shows that in order to retain the good will of the publishers payments were made to them in sufficient time to secure the discount although the amounts had not been received from the advertisers. The balance sheet as of December 31, 1920, shows accounts receivable of $118,354.21, which includes the 15 per cent commission, and accounts payable of $84,422.03, indicating an advance by the petitioner, exclusive of commission, of approximately $16,000. The*2643 accounts receivable on the balance sheet of December 31, 1921, are $179,872.86 and the accounts payable $141,686.56, indicating an advance at that time exclusive of commission of approximately $11,000.
*232 Petitioner relied upon , as a precedent for granting personal service classification. In that appeal it appeared that Massengale prepared the cuts and drawings and also drafts of advertising matter, made a print and offered suggestions as to the best medium or mediums of advertising and gave a statement of the costs thereof. Two or three artists were employed for the purpose of making drawings, some of which had been roughly sketched by Massengale. All the business was done through the personal services of the principal stockholders. The absence of any such showing in the instant proceeding clearly distinguishes the two cases. Evidence that the principal stockholders supervised and directed the services performed, without more detail as to their duties or the nature of the services rendered by an unknown number of employees, does not bring the case within the Massengale decision. Cf. *2644 .
Judgment will be entered for the respondent.
Considered by TRAMMELL, MURDOCK, and SIEFKIN.