*3243 Held, the during the year 1920, the petitioner was a personal service corporation, as that term is defined by section 200 of the Revenue Act of 1918, and was therefore exempt from taxation under the provision of section 218(e) of said Act.
*449 This proceeding is for the redetermination of a deficiency in income and profits taxes for the year 1920 in the amount of $12,191.62. Petitioner in its original pleading also sought the redetermination of a deficiency for the year 1921 in the amount of $500.17, but prior to the hearing, the appeal, in so far as it involved the latter year, was abandoned. The only issues presented are (1) whether the petitioner is entitled to classification as a personal service corporation for the year 1920, and, if not, (2) whether the petitioner is entitled to special assessment of its profit tax for said year under the provisions of sections 327 and 328 of the Revenue Act of 1918.
FINDINGS OF FACT.
The petitioner is a New Jersey corporation, with its principal office at Trenton. *3244 It was organized January 10, 1920, with an authorized capital stock of $75,000 divided into 750 shares of $100 each, all common stock. On August 13, 1920, the authorized capital stock of the petitioner was increased to $500,000. Prior to October 8, 1920, the total amount of $18,500 cash was paid in for capital stock of the petitioner as follows: January 27, $2,000; March 8, $13,000; April 24, $2,000; May 4, $1,000; and July 21, $500. On October 8, 1920, the additional amount of $35,000 in cash was paid in for stock. This was all the cash that was paid in for stock during 1920. On October 7, 1920, the four stockholders executed notes of $25,000 each, or in the aggregate amount of $100,000, to the petitioner for additional stock, but none of these notes were paid during 1920, nor were they discounted at the bank. They are still in the possession of the petitioner.
*450 During 1920 the petitioner's stock issued and outstanding was held as follows:
| Stockholders | Jan. 27 to | May 8 to | Oct. 7 to | Dec. 30 to |
| May 8 | Oct. 7 | Dec. 30 | Dec. 31 | |
| T. A. Karno | 50 | 50 | 387 1/2 | 516 2/3 |
| Simon Belli | 50 | 50 | 387 1/2 | 516 2/3 |
| Thomas V. Smith | 50 | 50 | 387 1/2 | |
| John F. Friebele | 50 | 387 1/2 | 516 2/3 |
*3245 Each stockholder of the petitioner devoted his whole time to its affairs. The petitioner employed no solicitors to obtain business for it; all soliciting was done by the stockholders.
During the year 1920 the petitioner was engaged in the business of designing and supervising the erection of industrial buildings on a commission or fee basis. The stockholders were architects and engineers, and while the agreements with the owners contemplated the erection of completed buildings, they were unlike the ordinary building contract wherein the contracts agrees to erect a building according to plans and specifications for a guaranteed price or lump-sum consideration. The petitioner refrained from entering into lump-sum contracts, because of the risk involved and lack of capital. Its plan of operation was to render a personal service to the owner, and its compensation was a flat fee dependent largely on the cost of the building, or a commission measured by a certain percentage of the cost of labor and materials.
The petitioner did not secure any of its contracts with owners by competitive bidding. The stockholders secured all of its business by personal contact and by reason of*3246 the peculiar services to be performed by them. They consulted with the owners with respect to their needs and designed the buildings best suited to them. They prepared the plans and specifications, hired the labor and purchased the material one behalf of the owners, and supervised the construction of the buildings. For this service, the petitioner was paid a flat fee or a commission.
The bills for labor and material were paid with checks of the petitioner, but in each instance during 1920 the owner advanced the necessary money to the petitioner. The petitioner handled the accounts with respect to labor and material for the owners, to relieve them of this detail. The owner in every case got the benefit of all discounts for such in the purchase of materials. The petitioner at all times acted under the direction of the owners, and secured their approved with respect to the hiring of labor and purchase of material; also, in the letting of subcontracts for the owners. The petitioner made no profit on the cost of labor or materials. In these matters, the petitioner acted in each case as the agent of the owner. *451 In the purchase of material, the materialman was advised*3247 in each instance for whom the material was ordered, this being stated on the order form, and it was understood that the owner was to be responsible for the payment of the bill. In no case was the petitioner liable in any event for payment of the bill. The required material was ordered separately for each particular job. The petitioner did not carry any material on hand.
The petitioner performed services in connection with 12 agreements with owners during the year 1920. Under 2 of the agreements, the compensation of the petitioner was a flat fee, and under the others the petitioner was paid as a commission for its services a certain percentage of the cost of the labor and material. In 3 agreements provision was made for the payment by the owners to the petitioner of an additional 1 per cent of the cost of labor and material as rental for the use of the petitioner's equipment in the erection of the building.
There was no time specified in any of the agreement for the completion of the work, and there was no penalty or bonus clause in any agreement. The petitioner did not guarantee the cost of the buildings, and was not required to give any bond. The commissions and fees*3248 were paid as compensation for the services rendered to the owners by the stockholders of the petitioner.
The commissions and fees earned during 1920 under the agreements entered into in that year were as follows:
| Contract number | Name | Date of contract |
| 101 | Lennox, Incorporated | Feb. 27, 1920 |
| 102 | Pocono Rubber Cloth Co | Mar. 18, 1920 |
| 103 | Thermoid Rubber Co | Mar. 20, 1920 |
| 104 | Joseph Stokes Rubber Co | May 12, 1920 |
| 1,2 | Joseph Stokes Rubber Co | May 12, 1920 |
| 105 | Hamilton Rubber Mfg. Co | July 22, 1920 |
| 106 | Joseph Ashton, jr | July 15, 1920 |
| 107 | Joseph Stokes Rubber Co | Aug. 9, 1920 |
| 108 | Wilson & Stokes Lumber Co | Oct. 14, 1920 |
| 109 | Luzerne Rubber Co | Aug. 27, 1920 |
| 110 | New Jersey Tile Co | Sept. 23, 1920 |
| 112 | Thermoid Rubber Co | Sept. 8, 1920 |
| Total |
| Rate of fee | Commission earned |
| 10 per cent | $28,081.40 |
| 10 per cent | 3,434.85 |
| Flat | 25,654.88 |
| 1 See note | 509.42 |
| 10 per cent and 1 per cent | 118.13 |
| 10 per cent | 968.96 |
| 10 per cent | 5,115.39 |
| 10 per cent | 7,562.51 |
| 15 per cent | 38.61 |
| 10 per cent 1 per cent | 1,332.47 |
| 10 per cent and 1 per cent | 3,709.34 |
| $1,100 | 1,024.10 |
| 77,550.06 |
*3249 The petitioner received income during 1920 from the rental of machinery and equipment in the total amount of $1,084.21. It also derived income during said year in the amount of $750.33, representing appraisal fees.
Practically all the cash paid in for capital stock of the petitioner prior to October 8, 1920, in the sum of $18,500 was expended for *452 the purchase of machinery and equipment used in the construction of buildings. By furnishing the equipment, the petitioner was enabled to render better service to the owned by avoiding the possibility of delays which would ordinarily result from the use of secondhand equipment. The average rental basis for such equipment on the class of work done by the petitioner was about 2 per cent of the cost of the work. Petitioner's rental, where it made such a charge, was 1 per cent. It made no profit on the rental of its equipment, in most cases making no charge therefor.
During 1920, all of the petitioner's outstanding stock was owned by four individuals, who constituted its board of directors and were also its officers.
T. A. Karno was president of and devoted his entire time to the affairs of the corporation. Prior to*3250 the organization of the petitioner, Karno was connected with the John W. Ferguson Co. of New York, contractors and builders of industrial buildings. He was with that company for approximately 7 years, and devoted himself to the procuring of contracts. With the petitioner, he interviewed owners, was in charge of the office so far as bookkeeping and financial management was concerned, and purchased material on behalf of the owners.
John F. Friebele was vice president, and also devoted his full time to the affairs of the petitioner. He was an engineer and had been connected with the Ferguson Company for approximately 10 years. As a stockholder and officer of the petitioner, he consulted with owners, prepared plans and specifications, purchased material for the owners and made supervising trips to the jobs.
Thomas V. Smith was secretary and treasurer, and devoted his full time to the affairs of the petition. He was formerly connected with the Ferguson Company for approximately 10 years, and while there performed the services of an architect and engineer, and prepared plans and specifications. During 1920, with the petitioner, he prepared plans and specifications under the supervision*3251 of Friebele.
Simon Belli was superintendent of construction for the petitioner, and devoted his full time to its affairs. He was formerly employed by the Ferguson Company for approximately 15 years. With the petitioner, he inspected material, hired the labor on behalf of the owners, and supervised the construction of the buildings.
In addition to its stockholders, the petitioner had three persons in its service during 1920. It employed a stenographer, a bookkeeper and a draftsman, to whom it paid salaries or wages in the aggregate amount of $3,681.70. The salaries paid by the petitioner to its stockholders in said year were as follows: Karno, $7,890; Friebele, $7,440; Belli, $7,800; and Smith, $7,500.
*453 The gross income and ordinary and necessary expenses for the year 1920 as shown in the petitioner's tax return were as follows:
| GROSS INCOME | ||
| Commissions on contracts | $77,500.06 | |
| Miscellaneous revenue | 750.33 | |
| Rental of equipment | 1,084.21 | |
| $79,384.60 | ||
| ORDINARY AND NECESSARY EXPENSES | ||
| Office salaries | $3,681.70 | |
| Professional services | 2,055.48 | |
| Destructible tools and machinery supplies | 2,970.78 | |
| Rent | 630.00 | |
| Telephone, telegraph and postage | 417.51 | |
| Printing and stationery | 819.98 | |
| Drawing materials | 756.69 | |
| General expense | 482.50 | |
| Advertising | 299.88 | |
| Insurance | 278.89 | |
| Automobile expense | 232.38 | |
| Office expense | 216.01 | |
| Traveling expenses | 120.53 | |
| Selling expenses | 34.80 | |
| $12,997.13 |
*3252 The balance sheet of the petitioner as of December 31, 1920, was as follows:
| Assets | ||
| Cash | $7,483.89 | |
| Accounts receivable (commissions) | 35,676.35 | |
| Investments | 1,005.00 | |
| Stockholders accounts | 99,738.24 | |
| Machinery and equipment | $17,496.48 | |
| Furniture and fixtures | 1,037.41 | |
| Tool shed | 565.68 | |
| 19,099.57 | ||
| Less: Reserve for depreciation | 3,391.50 | 15,708.07 |
| Accrued commissions | 32,999.38 | |
| Total assets | 192,610.93 |
| Liabilities | |
| Advances on contracts | $1,677.64 |
| Capital stock | 155,000.00 |
| Surplus | 35,933.29 |
| Total | 192,610.93 |
The item of $7,483.89 on the balance sheet above set out represented cash on hand and in the bank. The item of $35,676.35 comprised the sum of $10,176.35 due on completed work, and an accrued commission in the sum of $25,500 on the Thermoid Ruber Co. job, which was practically completed on December 31, 1920. The item of $1,005 represented an investment in the stock of the Stacy Trent Hotel of Trenton, N.J. The item of $99,738.24 represented the balance of an account with the stockholders of the *454 petitioner, and was a consolidation of several accounts. It consisted*3253 of an account receivable in the amount of $19,932.24, styled the Karno, Friebele, Belli joint account, representing money advanced by the petitioner to those stockholders for the purpose of buying the stock of Smith; notes receivable in the amount of $100,000, representing four notes of $25,000 each, given by the stockholders for additional stock; and an account of $1,500 representing subscriptions to stock, totaling $121,432.24. From this amount, there were deducted an item of $11,500 representing a note in that sum given to Smith in part payment for his stock, and an item of $10,194 representing salaries due Karno, Belli and Friebele, leaving a balance of said amount of $99,738.24. The item of $15,708.07 on said balance sheet represented the depreciated cost of the machinery and equipment, furniture and fixtures, and tool shed. The item of $32,999.38 represented accrued commissions on work in progress at December 31, 1920. Under liabilities, the item of $1,677.64 represented the amount of unexpended funds in the petitioner's possession at December 31, 1920, which had been advanced by clients for the payment of labor and materials.
OPINION.
TRAMMELL: For the year 1920, the*3254 petitioner filed an appropriate return of its income and claimed classification as a personal service corporation. The respondent denied such classification to the petitioner, and determined the deficiency involved herein. The correctness of the respondent's action in this regard forms the basis of the sole issue presented, except that the petitioner alleges that, in the event it is held not to have been a personal service corporation in 1920, it is entitled to special assessment of its profits tax for that year under the provisions of sections 327 and 328 of the Revenue Act of 1918.
In section 200 of the Revenue Act of 1918, the term "personal service corporation" is defined as meaning "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 incomeproducing factor." And in section 218(e) of said Act, it is provided that "personal service corporations shall not be subject to taxation under this title, but the individual stockholders thereof shall be taxed in the*3255 same manner as the members of partnerships"
It is clearly established by the evidence that the petitioner's income for 1920 was derived primarily through the activities of the principal owners or stockholders, who were themselves regularly engaged in *455 the active conduct of the corporation's affairs, and the respondent makes no contention on these points. Thus, the petitioner possessed the first two qualifications prescribed by the statute as constituting a personal service corporation. However, the respondent contends that the petitioner is not entitled to personal servcice classification as claimed by it, for the reason that capital invested in its business in 1920 was a material income-producing factor, and hence it fails to mmet the third requirement of the statute.
The respondent's contention, as set forth in his brief, is predicated largely upon the argument that the amount of the authorized capital stock, or the possession of capital assets by a corporation, is an element in determining its right to exemption from taxation as a personal service corporation. The respondent urges that -
To argue that the use of capital was not necessary and material in the*3256 production of the plaintiff's income is to ignore the fact that the officers of the petitioner as prudent business men saw fit to increase the capitalization of petitioner to $500,000 during the year 1920, of which $80,000.00 was issued and on October 8, 1920, paid $35,000.00 in cash for stock. This caused an additional expense to petitioner in state taxes and fees, and if invested capital was unnecessary in the production of income, there could have been no reason for incurring the expense of increased capitalization. Manifestly such actions can be accounted for only on the hypothesis that the use of such capital in the business as it was in fact carried on was necessary for the production of its income.
We are not impressed by the cogency of this argument. While it is undoubtedly true that, in the case of a corporation seeking personal service classification, an unduly large authorized capital stock or the possession of capital assets in large amounts would raise suspicion and invite a careful scrutiny to ascertain whether the use of capital in the business was a material income-producing factor, such facts of themselves are not material. The only inhibition of the statute*3257 is that capital, whether invested or borrowed, must not be a material income-producing factor, and it is with the consideration of the facts on this point that we are directly concerned.
An analysis of the facts in evidence shows that this petitioner was incorporated January 10, 1920, with an authorized capital stock of $75,000, which, on August 13, 1920, was increased to $500,000. On January 27, the amount of $2,000 in cash was paid in for stock, and on various subsequent dates up to and including July 21, 1920, additional amounts in cash aggregating $18,500 were paid in for stock. On October 8, 1920, an additional $35,000 in cash was paid in for stock, which was all the cash paid in for stock in 1920.
On October 7, 1920, the four stockholders executed notes to the petitioner in the total amount of $100,000 for additional stock, but these notes were neither paid during 1920 nor discounted at the bank. *456 They did not constitute working capital of the petitioner, and are still in its possession. In determining the deficiency herein, the respondent computed the petitioner's invested capital at $53,500, and it is thus apparent that the respondent refused to recognize*3258 said notes as capital assets.
Of the $18,500 cash paid in for stock on and prior to July 21, 1920, practically all was expended by the petitioner in purchasing office furniture and fixtures, and machinery and equipment, which was used in its business to the extent and under the circumstances set out in our findings of fact above.
The principles by which we may determine whether the use of capital in a given case was such as to defeat personal service classification, have been clearly defined by the courts.
In , the court said:
The real criterion is in the fact finding of whether money as an income producer played any real and substantial part in producing the income to be taxed.
In (affd. ), the court, in its opinion, said:
We come then to the second element of the definition; that is, whether capital (invested or borrowed) is a material income producing factor. Here the test is not exclusively whether the corporation bought and sold on its own account, or did a strictly commission business; it is whether*3259 it necessarily requires capital for, and in fact uses it in, the conduct of the business. If the nature of the business is such that it could not be carried on at all without the constant use of capital, and such use of capital plays a vital part in the successful conduct of the business, it can not be said that its use in the business is merely incidental.
* * *
So also under the Revenue Act of 1918, it is necessary to consider the kind of service rendered by the corporation, as assisting in the determination of whether the use of capital ordinarily plays an important part in rendering such service, and then to consider whether, in the particular case under consideration, the use of capital was necessary, and whether it was in fact used. * * * If capital was used, the inquiry is whether such use was vital and necessary to the conduct of the business, or merely an incidental convenience for more orderly fiscal operation.
Otherwise expressed, where the intrinsic nature of the business is the rendition of a "service" to another, as in the case of real estate brokers, lawyers, doctors, or even artisans, who need not supply materials, the use of capital is merely incidental. *3260 The individual thus sells only experience, knowledge, or skill, intangible in its nature and existing independent of capital, either in the sense of money or other tangible property. But where the business is manufacturing or mercantile in its nature, and the individuals conducting it must of necessity procure and use, and do so procure and use for its conduct, either funds or merchandise, such capital becomes a material income-producing factor, and the source from which it is procured is immaterial under the Act of 1918.
*457 That the business of the petitioner in this proceeding, during the year 1920, was in its nature essentially the selling of the personal services of its four stockholders is irrefutably established by the proof. They were architects and construction engineers, with many years' experience in the designing and erection of industrial buildings.
During 1920, the petitioner entered into 12 contracts or agreements with owners relating to the erection of buildings, all of which contracts were procured through the personal contact and solicitation of its stockholders and because of the peculiar nature of the services to be rendered by them.
The stockholders*3261 conferred with the owners regarding their requirements, and designed buildings best suited to their needs. Detailed plans and specifications were then prepared, the necessary labor hired and materials purchased by the petitioner for the owners, and the construction of the buildings supervised by its stockholders. In all these matters, the petitioner acted as the agent or employee of the owner. In purchasing material, it was stated on the order form for whom it was purchased, and it was distinctly understood that the owner was to be responsible for the payment of the bill.
While it is true that bills for material were paid for with checks of the petitioner, substantially all such payments were made from funds advanced to the petitioner for that purpose by the owners, solely as a matter of convenience and to relieve the owners of the burden of keeping detailed records of the transactions. The owners advanced funds to the petitioner to meet not only the payment of bills for material, but to cover the pay rolls for labor, including the cost of workmen's compensation insurance required under the New Jersey law. At December 31, 1920, the petitioner had in its possession unexpended*3262 funds in the amount of $1,677.64 so advanced by owners. For these services the petitioner received either a flat fee, based upon the cost of the building, or a commission of 10 per cent of the cost of the labor and material.
The petitioner obtained no contracts by competitive bidding; there was no time specified in any of its contracts for the completion of the work, and there was no penalty or bonus clause in any agreement. It did not guarantee the cost of the buildings, and was not required to give any bond. The fees and commissions received by it represented compensation for the personal services of its stockholders, with the exception of a commission of 1 per cent paid under three of the contracts as rental for the use of machinery and equipment furnished by the petitioner.
The aggregate amount of income derived by the petitioner in 1920 from the rental of machinery and equipment was $1,084.21. It had invested in such machinery and equipment $17,496.48, and in a storage *458 shed the amount of $565.68, or a total investment in capital assets used in the business of $18,062.16.
The income received by the petitioner from this source did not represent any profit*3263 to it, as the total amount received was less than the depreciation sustained. It is further indicated by the record that the possession of these assets did not contribute to the procurement of contracts, and was not essential to the successful conduct of the petitioner's business, but was wholly incidental thereto.
In these circumstances, we are unable to concur in the conclusion of the respondent that invested capital was a material factor in the production of the petitioner's income. It is our opinion, therefore, that the petitioner is entitled to exemption from taxation as a personal service corporation for the year 1920.
Reviewed by the Board.
Judgment of no deficiency will be entered.
Footnotes
1. NOTE. - Original contract for $1,420.60 guaranteed price. Additional work orders totaling $1,311.35 were on a commission basis. ↩