*3000 Petitioner, an advertising agency serving a few large advertisers, all of whom were procured and serviced by petitioner's stockholders, held to be entitled to classification as a personal service corporation.
*234 The Commissioner determined a deficiency of $10,605.27 in income and profits taxes for 1918. Petitioner instituted this proceeding for a redetermination of its liability. It is alleged in the petition that the Commissioner committed error (1) in holding that petitioner was not a personal service corporation as defined in section 200 of the Revenue Act of 1918; and (2) in refusing to compute petitioner's tax liability under sections 327 and 328 of the Revenue Act of 1918. The second assignment of error has been waived.
FINDINGS OF FACT.
Petitioner was incorporated on November 13, 1911, under the laws of New York, and on January 1, 1912, began business as an advertising agent at 11 Broadway, New York City. Continuously from its incorporation and throughout the year*3001 1918 it conducted business as an advertising agent, with its principal office in New York City. The five incorporators of the petitioner were H. K. McCann, R. W. St. Hill, Harrison Atwood, J. P. Hallman and Thomas Nast, Jr. The four last named had been associated with McCann in the advertising department of the Standard Oil Co. in New York City in 1911 and for several years prior thereto, McCann *235 at all such times having been the manager of that advertising department.
In 1911 the Standard Oil Co. was broken up into several subsidiary corporations. Its advertising department was discontinued. At that time McCann secured appointments as advertising agent from thirteen of the subsidiary corporations which had composed the Standard Oil Co. Petitioner was organized in 1911 to furnish advertising service to the subsidiary companies. Its capital stock was $100,000, divided into 1,000 shares of a par value of $100 each. At the time of incorporation all of the authorized stock was subscribed and issued for $10,000 in cash and for assignment to the corporation of agreements, evidenced by letters which McCann had received from the subsidiary Standard Oil companies, authorizing*3002 him to act as their advertising agent. No other capital had been paid in for stock prior to December 31, 1918.
In 1913 petitioner opened a branch office in San Francisco, Calif. In 1915 it opened a branch office in Cleveland, Ohio, and prior to 1918 it organized The H. K. McCann Company, Ltd., a Canadian corporation. Petitioner owned all of the stock of such Canadian corporation, except directors' qualifying shares.
The stockholders of petitioner and the number of shares held by each on January 1, 1918, and December 31, 1918, were as follows:
| Jan. 1, 1918 | Dec. 31, 1918 | |
| Shares | Shares | |
| Harrison Atwood | 75 | 75 |
| William Cochran | 50 | 50 |
| L. W. Ellis | 50 | |
| J. P. Hallman | 25 | 25 |
| K. H. Kelley | 5 | 5 |
| H. K. McCann | 640 | 590 |
| E. W. Mann | 5 | 5 |
| G. F. Murnane | 75 | 75 |
| Sarah Nast, in trust for Thomas Nast St. Hill | 50 | 50 |
| R. W. St. Hill | 75 | 75 |
| 1,000 | 1,000 |
On December 27, 1918, H. K. McCann transferred 50 shares to L. W. Ellis. There were no other transfers during the year. Ellis was brought into petitioner's organization when the Cleveland branch was opened in 1915. McCann had known him personally and professionally for five years. During*3003 1918 Ellis was in charge of petitioner's branch office in Cleveland. When he joined the petitioner in 1915 McCann agreed to set aside for him 50 shares of its stock from his personal holdings. On January 25, 1916, McCann wrote Ellis as follows:
This is to advise you that I have applied toward the payment of the fifty shares of The H. K. McCann Company set aside for you, the dividend of ten per cent on same.
The attached statement indicates the exact status of this transaction.
*236 The memorandum attached to this letter was as follows:
January 26, 1916.
| MEMORANDUM. | |
| 50 shares of the capital stock of The H. K. McCann Company at $62.85 | $3,142.50 |
| January 21st, 1916 - credit of 10% dividend | 500.00 |
| Balance due | 2,642.50 |
Subsequent dividends on such 50 shares of stock were applied by McCann toward the payment of the purchase price and it was transferred to Ellis on December 27, 1918. Prior to that date it remained in McCann's name on the books of the company. Prior to December 27, 1918, McCann exercised all control over such stock and voted it at stockholders' meetings. Prior to December 27, 1918, Ellis was not a stockholder of record and did*3004 not vote at stockholders' meetings. The use of the word "stockholders" throughout the balance of the findings of fact includes Ellis, unless the contrary is indicated.
Petitioner rendered services to advertisers, whom it designated as clients. This service varied according to the requirements of the particular case. In some instances it undertook an advertising campaign on an extensive scale to create a market for particular products or to extend a market already created. In such a campaign petitioner's services included a survey of the client's advertising situation at that time, a study of the market for its products, its sales policy, competitive market conditions, the classification and selection of media for advertising, the formation of a basic advertising plan, and the preparation of estimates of its cost. It sometimes included the recommendation and selection of package designs, labels, trade-marks, trade names and trade slogans, and the selection of the particular product to be used as a leader in the advertising. In some instances it would involve a study of the availability of raw material for the production of the articles to be advertised and a study of their*3005 cost to make certain that profits could be produced which would make advertising profitable. Throughout the campaign petitioner frequently consulted and advised with its clients. Results were checked and the advertising campaign changed as might seem advisable.
In many cases petitioner acted as the advertising agent for large corporations and directed and prepared practically all their advertising. With such clients advertising was a matter of careful planning and budgeting. Petitioner would submit at least annually a plan of advertising for the year with an estimate of its cost. The preparation of such a plan involved continued consideration of the advertising *237 and merchandising needs of the advertiser. Many clients were retained from year to year and the service to them was in its nature continuous.
After a basic plan for the campaign had been prepared and agreed upon, petitioner's services varied with the particular case and the media selected. Where advertising was to be placed in newspapers and periodicals a list of those to be used, with an estimate of the cost, would be submitted to the client. After approval by the client, the petitioner would issue*3006 an order to the publisher, reserving the necessary space. Such orders specified the name of the advertiser whose advertising was to be inserted in the space ordered. When necessary, this was supplemented by an insertion schedule.
Petitioner's service included the preparation of the advertising to be used, including copy and any drawings. A rough draft of the advertisement, known as a layout, would be submitted to the client. After the advertisement had been approved by the client, any drawings would be sent to an engraver. The finished engraving with the copy for the advertisement would be sent to a printer to be set into type. Proof would be sent to the client for his approval. After that had been received, electrotype plates or mats of the advertisement would be made and sent to the publisher. Where an order for space had already been sent the publisher, the plate or mat would be accompanied by instructions with respect to its insertion.
Where the media consisted of show cards and booklets, petitioner's service included the outlining of the text; the preparation of a dummy to indicate the character of the booklet; the preparation or purchase of drawings for the booklet; *3007 the preparation of art work, layout and text; and the preparation of the original design for show cards, including art design and text. Where the advertising was to be done on billboards or out of doors, petitioner's service included a survey of the territory to determine the location of the billboards, preparation and submission of designs for the advertising, and arranging with the outdoor advertising companies for the erection and painting of the billboards. In a publicity campaign the petitioner selected the media, drafted and prepared the advertisements, and prepared or directed the preparation of pamphlets and show cards.
Finished drawings were usually made by outside artists, but occasionally by employees. All engraving, composing, and electrotyping was done outside petitioner's organization.
Petitioner had been granted recognition as an advertising agency by publications and publishers' associations. As a recognized advertising agency, petitioner was allowed by publishers a rebate or commission on advertising placed with them. These commissions were usually 15 per cent of the schedule rates for advertising. The *238 principal source of petitioner's income*3008 for the taxable year was from such commissions and from service fees which were charged on special work such as booklets, folders, signs and miscellaneous advertising matter or where the amount expended was small in proportion to the work required of petitioner.
Bills for advertising were generally rendered to the petitioner, but occasionally were sent to the advertiser. Separate bills were required for the advertising of each client. In most instances the name of the client was stated in the bill. Sometimes the name of the product advertised would be stated in the bill. Occasionally neither the name of the advertiser nor the name of the product would be stated. In all cases such bills and all bills for drawings, engraving, composition, electrotyping, printing, or other services were checked. Petitioner made certain that the advertising had been inserted and checked the measurement of the space used. The amount of the deductions allowed petitioner was subtracted from the amount of each bill and the client would be billed for the net amount plus 15 per cent.
In addition to the agency commission it was customary for publishers to allow a discount, usually 2 per cent, for*3009 payment of their bills within a certain time. It was customary for petitioner to take advantage of this discount. Such cash discounts were deducted from the amounts billed to clients by the petitioner. Petitioner billed its clients for magazine advertising in advance of the billing by the publisher, in order that petitioner might receive payment before it made payment to the publisher. During each month of the year, petitioner's collections from its clients exceeded its disbursements for their account.
Publishers required that the name of the advertiser should be disclosed in all orders for space. The petitioner purchased no advertising space in bulk and no space for its own account, except a small amount in a trade journal in which it inserted advertisements of its own business. Petitioner never ordered space for a client unless the client knew the cost and approved it. Space ordered for one advertiser could not be used by or for another.
Petitioner's relationship with a client was not to run for any fixed length of time, but was cancelable by either at will. Upon the termination of the relationship between petitioner and a client, unused space belonged to the client*3010 and was used by him, with or without another agent. Petitioner turned over to the client copies of outstanding contracts, and advertising material such as drawings, layouts, booklets, and records. Publishers did not require new orders from new agents for unused space that had been reserved for the advertiser by a former agent, but would deal with a new *239 agent in the same way they had dealt with the former agent. Publishers made no objection to the changing of an agent by an advertiser.
Publishers used one of two kinds of rates; flat or scale. A flat rate was one charged regardless of the quantity of space used. A scale rate was one which varied with the quantity of space used, decreasing per line as the number of lines increased. When an advertiser used more space than had been ordered for him and thereby became entitled to a lower rate per line, the advertiser was given the benefit of this lower rate. Contracts for advertising were usually cancelable by the advertiser. Said contracts sometimes were noncancelable.
An advertising agent or agency must be recognized as such by the publisher or by a publishers' association of which the publisher is a member before*3011 it receives any commissions or discounts on advertising placed by it with such publisher. In granting recognition the major factors considered are professional skill, experience, character and volume of business transacted. Financial responsibility of the agent is a minor factor in granting recognition, but a major and controlling factor in granting credit to any agent.
Before any step in an advertising campaign was taken the advertiser agreed to accept the petitioner as his agent. Petitioner's arrangements with new clients usually took the form of an exchange of letters stating what petitioner was to do, what compensation it was to receive and the terms of payment of that compensation. The petitioner refused to serve competing advertisers.
Petitioner's balance sheets as of January 1, 1918, and December 31, 1918, were as follows:
| Jan. 1, 1918 | Dec. 31, 1918 | |||
| ASSETS | ||||
| N.Y., cash in bank | $7,877.19 | $5,023.13 | ||
| N.Y., petty cash fund | 450.00 | 450.00 | ||
| San Francisco, cash in bank | 6,000.00 | 5,655.57 | ||
| Cleveland, cash in bank | 500.00 | 800.00 | ||
| $14,827.19 | $11,928.70 | |||
| Accounts receivable | 199,149.68 | 140,616.60 | ||
| Black Medicine Co., 1917 note | 2,334.61 | |||
| Gleason Murphy judgment | 5,109.03 | |||
| Loans and advances: | ||||
| H. K. McCann Co., Ltd. (Canada) | 5,000.00 | 10,000.00 | ||
| Sundry stockholders | 4,662.50 | 7,500.00 | ||
| Sundry employees | 1,365.00 | 2,177.50 | ||
| L. S. Briggs mortgage | 2,375.00 | |||
| G. F. Murane current account | 5,513.72 | |||
| Sundry expense funds | 645.00 | |||
| 11,027.50 | 28,211.22 | |||
| Investments: | ||||
| Liberty bonds | 28,652.50 | 59,316.50 | ||
| H. K. McCann Co., Ltd. (Canada) | 4,633.11 | 4,633.11 | ||
| Seaview Golf Club | 200.00 | |||
| Seaview and Scarsdale Golf club | 400.00 | |||
| 33,485.61 | 64,349.61 | |||
| Office furniture and fixtures: | ||||
| New York | 3,994.12 | 5,526.22 | ||
| San Francisco | 1,734.95 | 1,727.44 | ||
| Cleveland | 469.42 | 1,002.44 | ||
| 6,198.49 | 8,256.1 | |||
| Automobile | $620.00 | |||
| Contract rights (acquired for capital stock) | $90,000.00 | 90,000.00 | ||
| Deferred debit: Liberty bond interest adjustment | 63.25 | |||
| Suspense items rechargeable: | ||||
| Paid to craftsmen | $5,777.23 | $26,634.99 | ||
| Unpaid craftsmen | 6,924.45 | 6,885.11 | ||
| 12,701.68 | 33,520.10 | |||
| Prepaid expenses | 1,154.80 | |||
| Total | 375,988.59 | 377,565.58 | ||
| LIABILITIES AND CAPITAL | ||||
| Liabilities: | ||||
| Accounts payable to publishers | 24,579.54 | 22,997.66 | ||
| Unexpended publicity fund for clients | 5,900.00 | |||
| Black Medicine Co. note discounted | 2,334.61 | |||
| Notes payable | 21,600.00 | 20,000.00 | ||
| Payable to craftsmen | 6,924.45 | 6,885.11 | ||
| Sundry accounts payable | 317.94 | |||
| 61,338.60 | 50,200.71 | |||
| Deferred credit: Adjustment, Liberty-bond interest | 51.18 | |||
| Capital: | ||||
| Capital stock issued and outstanding | 100,000.00 | 100,000.00 | ||
| Surplus before provision for taxes | 214,598.81 | 227,364.87 | ||
| 314,598.81 | 327,364.87 | |||
| Total | 375,988.59 | 377,565.58 |
*3012 *240 The Gleason Murphy judgment was due from a man who had formerly been connected in business with petitioner. It did not result from services to clients. The loan or advance to H. K. McCann Co., Ltd., of $5,000 at the beginning of the year represented amounts of money on deposit in Toronto, Canada. The investment in H. K. McCann Co., Ltd., of $4,633.11 represented $3,000 paid by petitioner for capital stock of that corporation and $1,633.11 paid by petitioner for office furniture and fixtures supplied to the Canadian branch. On January 1, 1918, the Canadian company had a deficit of $653.25 and at December 31, 1918, a surplus of $129.81. During 1918 it earned a net profit of $783.06. No dividends were declared during 1918 and no part of its profits was paid, credited or transferred to petitioner. The item of Liberty bonds $28,652.50, at the beginning of the year, and $59,316.50, at the close of the year, represented the debit balances on various Liberty Loan accounts, both in the name of the company and for its employees, the company having subscribed.to every Liberty Loan issue and having allowed its employees to place their subscriptions through it and to make payments*3013 by deductions from their compensation. The item of notes payable, $21,600 at the beginning of the year and $20,000 at the close of the year represented notes given to finance Liberty bond subscriptions, which notes were secured by a deposit of the Liberty bonds as collateral. The item of contract rights $90,000 represented the agreements appointing petitioner as advertising agent, for which 900 shares of petitioner's stock were issued to McCann at organization. The item of suspense items rechargeable represented the cost of art and mechanical work ordered by petitioner *241 for clients but not yet billed to clients because the various advertisements involved had not been completely prepared. It was petitioner's practice to hold such items in abeyance until they could be conveniently billed to each client at one time. The totals were composed of many small items. The amounts paid by petitioner and the amounts due or unpaid are separately stated. The item of accounts payable to publishers represents balances due to publishers for advertising which had been billed to clients and for which checks had not yet been drawn. In order to distribute more regularly the work of preparing*3014 checks, it was customary to prepare such checks in advance of the date of payment and to hold them for mailing until a day when they would be received by the publisher in the ordinary course of the mail at or just prior to the discount day. Checks were entered in the books as of the date when drawn and not when mailed. The amount due publishers for which checks had not been mailed or had not been paid was in excess of the amount shown on the annual statements. The item of unexpended publicity fund for clients represented the unexpended balance of cash received by petitioner from a client to be expended for the client in its advertising. The item of Black Medicine Co. note, included in both assets and liabilities, represented a note given to the petitioner in December, 1917, by the Black Medicine Co. in payment of its account. This note was discounted by petitioner at its bank and paid by the maker at maturity in March, 1918. Black Medicine Co. was taken as a client of the San Francisco office as a courtesy to a director of another client. Little advertising was done by it and petitioner resigned from handling the account when the client began to be slow in paying its bills. *3015 This note was the only note receivable held by petitioner at any time during 1918. The item of L. S. Briggs mortgage, $2,375, included as an asset at the close of the year, represents a loan to an employee secured by a mortgage on his home. The amount due from G. F. Murnane, $5,513.72 at the close of the year, represents advances or loans to a stockholder.
Accounts receivable at the beginning and at the end of the year represent the amounts charged by petitioner on its books to its clients and unpaid. Petitioner's accounts receivable represented the amounts charged to clients on its books, whether or not payment therefor was due to the publisher and whether or not payment had been made by petitioner. During the first 20 days of January, 1918, petitioner collected from all clients $161,920.64, and during the first 20 days of 1919 it collected from all clients $104,534.05. These collections included certain items charged to clients during those 20 days and all *242 of the accounts receivable on the respective dates mentioned were not collected during such 20 days.
The total amount receivable from all clients at April 1, 1918, was $146,359.34, and on October 1, 1918, $110,828.29. *3016 The total amount of collections from all clients during the first 20 days of April, 1918, was $157,849.78 and the collections for the first 20 days of October, 1918, were $110,541.43. These collections included certain items charged to clients during such 20 days. All of the accounts receivable on the respective dates mentioned were not collected within such 20-day period.
No client asked petitioner to prepay bills for its advertising or to extend credit to the client. Petitioner never offered to do either of these things and never guaranteed payment of advertising bills to publishers. When a prospective client inquired whether petitioner would do so one of petitioner's stockholders answered that it would not. No publisher asked petitioner to guarantee any bill for advertising and petitioner never did so. Petitioner never furnished a statement of its financial condition to any publisher and publishers did not inquire about petitioner's financial condition. The general practice was for advertisers to pay petitioner before petitioner paid the publisher. It was the practice of petitioner to pay all bills within the discount period, whether or not payment had been received*3017 from advertisers, with the result that in some cases payments were made to the publishers before payment had been received by petitioner from the advertiser.
Petitioner's income and expenses for 1918 were as follows:
| Income: | ||
| Advertising commissions | $328,442.10 | |
| Fees | 55,104.62 | |
| Interest on bank account | 972.46 | |
| Interest on Liberty bonds | 2,284.26 | |
| Sale of old papers | 176.62 | |
| Sale of old auto | 515.00 | |
| $387,495.06 | ||
| Expenses: | ||
| Advertising | 3,418.49 | |
| Directors' fees | 700.00 | |
| Entertainment | 6,729.64 | |
| Exchange on checks | 76.39 | |
| General expense | 15,865.20 | |
| Interest | 992.71 | |
| Legal expense | 311.11 | |
| Postage | 3,572.44 | |
| Rent | 27,667.55 | |
| Telephone and telegraph | 3,134.80 | |
| Traveling expense | 4,778.63 | |
| Supplies and stationery | 6,094.55 | |
| Special service | 4,087.43 | |
| Dues | $3,007.00 | |
| Branch office expenses | 13,382.93 | |
| Depreciation | 2,375.27 | |
| Taxes | 1,653.00 | |
| Losses from bad debts | 6,618.30 | |
| Salaries of stockholders | 57,116.00 | |
| Salaries of employees | 181,487.36 | |
| $343,068.80 | ||
| Net income | 44,426.26 |
*243 The item, advertising commissions $328,442.10, represented commissions earned by the petitioner upon advertising of its clients. The item, fees $55,104.62, represented*3018 service fees charged by petitioner to its clients for handling certain types of advertising. The expense item, advertising $3,418.49, represented the cost of petitioner's own advertising, being chiefly for the insertion of its card in Printers' Ink. The item, entertainment $6,729.64, represented various charges, mostly for entertainment of clients when they were in New York or in cities where the petitioner maintained its offices. The item, general expense $15,865.20, represented general expenses that could not be allocated to other detailed accounts. The item, traveling expense $4,778.63, represented expenses incurred by stockholders in traveling. The item, special service $4,087.43, represented the expense of studies made by petitioner which involved hiring outside investigators. The item, dues $3,007, represented dues to the American Association of Advertising Agencies, Audit Bureau of Circulation and other associations to which the petitioner or its stockholders belonged for business purposes. The item, losses from bad debts $6,618.30, represented the amount of debts ascertained to be worthless and charged off in the taxable year. Of this amount less than $500 represented*3019 payments made by the petitioner on account of the advertising of clients which petitioner was unable to collect from such clients. A small portion of the balance represented commissions and fees charged which petitioner was unable to collect, and a part represented various bookkeeping adjustments. The major portion represented amounts due to petitioner from those formerly in its employ or otherwise associated with it in the advertising business.
None of petitioner's income during 1918 was received on Government contracts made at any time.
During 1918 petitioner paid salaries of $181,487.36 to its employees, exclusive of the salary paid to Ellis. The number of employees at any one time varied from 97 to 117. Of these 69 were in its employ continuously throughout the year. The average number employed was 103. The total number of those employed by the petitioner at *244 any time during the year, whether for one day or for one year, was in excess of 170. None of these employees were stockholders. These employees were variously classified as service assistants, visualizers and layout artists, copywriters, investigators, bookkeepers, clerks, stenographers, and miscellaneous*3020 employees.
In all advertising campaigns a study of the situation and the preparation of the plan of advertising, as well as supervision of the advertising and some of the more important details, were performed by stockholders. Any trade or summary investigation to be made in connection with the advertising of the client would be planned and supervised by stockholders and any recommendations based on such investigation would be those of a stockholder. Any recommendations to clients as to the markets to be reached, the methods of reaching such markets, the type of media to be used, the amount to be expended at any particular time in a certain territory or in a certain field of advertising, or the type of copy to be used in the advertising, would be made by stockholders, as a result of a study of the situation made by them or under their direction. During 1918 all contracts between petitioner and its clients were made through stockholders.
Atwood was in charge of petitioner's branch office at San Francisco during the taxable year and planned and supervised the advertising of clients of that office. Ellis was in charge of petitioner's branch office in Cleveland during 1918 and*3021 planned and supervised the advertising of clients of that office. Mann, St. Hill, and Cochran were in the New York office of the petitioner and planned and supervised the advertising of clients of that office. Cochran resigned as an officer and ceased to render active service on September 30, 1918. McCann served all of the petitioner's clients in a consulting capacity. Clients and petitioner's stockholders conferred with him on all matters of major importance affecting the advertising. In 1918 he planned and supervised the advertising of one client. He made trips periodically to the San Francisco and Cleveland offices. Hallman had charge of the accounting, billing, collecting, and finances of petitioner's business and supervised the media statistics. Murnane was engaged in Red Cross work in 1918. He had formerly been in charge of the advertising of some of the clients of the New York office but resigned in October, 1917, to enter upon Red Cross work. It was not contemplated that his separation from the petitioner should be permanent. Petitioner paid Murnane's salary during 1918. During the early part of 1918 he was stationed at Washington, D.C., and occasionally while in*3022 New York he consulted with stockholders concerning petitioner's business. During the remainder of 1918 he was in Europe. Sarah Nast was not actively engaged in petitioner's business in 1918. She held 50 shares of petitioner's stock under an *245 oral trust for Thomas Nast St. Hill, who was a stepson of R. W. St. Hill and was being supported by him. She was represented by R. W. St. Hill as proxy at stockholders' meetings. Miss K. H. Kelly was confidentail secretary to McCann. She rendered no direct service to clients during 1918.
The employees of the petitioner who were classified as service assistants acted as assistants to the stockholders in charge of the advertising of clients. They were capable, efficient men whose functions were to handle routine matters of the service of clients. They received instructions from the stockholders in charge of the advertising with respect to particular phases of such advertising which it was their duty to carry out subject to the supervision, suggestion and approval of the stockholders. Their function was to see that the preparation of the advertising of the client was progressing satisfactorily and to assist the stockholder with*3023 such advertising in any manner he might direct. During the taxable year there were 10 service assistants in the New York office, 3 in the San Francisco office and 2 in the Cleveland office. The function of the visualizers or layout artists employed by the petitioner was to reduce to a rough drawing, layout, or dummy, the idea which it was sought to embody in the advertising. Their work was performed under the direction and supervision of the stockholder in charge of the account. Employees called copyrighters were used to prepare the text of the advertisements, although this was frequently done by the stockholders. The type and subject matter of the advertising having been determined by the stockholder, a copyrighter would be called in to prepare the text of the advertisement. Typical headlines and typical finished copy might be prepared by the stockholders, which the copyrighter would follow in preparing further advertisements along the same general lines. No copy for advertisements was submitted to advertisers until it had received the approval of the stockholder in charge of the advertising. Investigators were employed to ascertain facts and gather data to be used in connection*3024 with the formation and checking of the advertising campaign or in the advertisements. This information had to do with facts related to the things to be advertised such as the market for the material or the nature of competition. It sometimes took the form of a canvass of the territory to be covered and interviews with dealers and consumers. Sometimes information was sought as to the reaction of the dealer or consumer to the advertisements. Eight investigators were employed at the New York office in 1918 and similar work was done by employees in the branch offices. Bookkeepers, clerks, stenographers, checkers and mechanical employees performed routine duties such as those indicated by their designation. One Plamer, an employee, was a *246 director of the petitioner during 1918, although not a stockholder. He had the title of general manager and was in charge of the personnel and office routine of the New York office. No solicitors or salesmen were employed by the petitioner.
During 1918 the expenditures of petitioner's clients for advertising exceeded $2,750,000. Two of such clients expended over $550,000 each. Another expended over $400,000. Two others expended*3025 approximately $200,000 each, while five others expended over $50,000 each. All of such clients had excellent credit ratings. Approximately one-half of the total so expended was for advertising of the Standard Oil companies which had been the original clients of the petitioner.
OPINION.
PHILLIPS: Petitioner filed its income-tax return for the calendar year 1918 and claimed classification as a personal service corporation within section 200 of the Revenue Act of 1918. The respondent denied personal service classification and determined the deficiency here in question.
Section 200 of the Revenue Act of 1918 defines a personal service corporation as follows:
The term "personal service corporation" means 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 foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits or income derived from trading*3026 as a principal, or (2) of gains, profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive.
Section 218 of the Revenue Act of 1918 provides for the taxation of the income of a personal service corporation in the following manner:
Personal service corporations shall not be subject to taxation under this title, but the individual stockholders thereof shall be taxed in the same manner as the members of partnerships. All the provisions of this title relating to partnerships and the members thereof shall so far as practicable apply to personal service corporations and the stockholders thereof: Provided, That for the purpose of this subdivision amounts distributed by a personal service corporation during its taxable year shall be accounted for by the distributees; and any portion of the net income remaining undistributed at the close of its taxable year shall be accounted for by the stockholders of such corporation at the close of its taxable year in proportion to their respective shares.
Petitioner was not a foreign corporation, nor was 50 per centum or more of its gross income*3027 derived from trading as a principal or *247 from gains, profits, commissions or other income derived from Government contracts. The principal stockholders were regularly engaged in the active conduct of the affairs of the corporation. It remains then to determine (1) whether its income is to be ascribed primarily to the activities of the principal stockholders and (2) whether capital, invested or borrowed, was a material income-producing factor.
Petitioner was engaged during the taxable year in rendering service as an advertising agent. These services consisted in the giving of expert advertising counsel and advice to advertisers whom it designated as clients; the investigation and study of the manufacturing, marketing and advertising situation of its clients; the drafting of a comprehensive advertising plan to meet the needs of its clients; the selection of the advertising media; the preparation of special advertising and the execution in detail of the advertising plan; the checking of advertising results and making changes, when necessary, in the plan of advertising during the progress of a campaign.
Its income was derived from commissions on advertising placed in*3028 publications, and fees for service. The commissions, usually 15 per cent, were based on the cost of work which petitioner performed for its clients or had executed for them by outside parties under its direction or supervision, such as art work, engraving, electrotyping and miscellaneous production work. Service fees were charged for special work such as the preparation of booklets, folders, signs, and miscellaneous advertising matter, or where the amount expended for advertising was small in proportion to the work required of petitioner. There were also certain minor items of income not material in determining this issue.
Petitioner's original stockholders had been associated in the advertising department of the Standard Oil Co., and upon dissolution of that company in 1911, petitioner was organized to take over the advertising of the subsidiary Standard Oil companies. Approximately 50 per cent of its business was received from these Standard Oil companies and substantially all of the balance from a few large advertisers who had been procured by the stockholders of petitioner. In 1919 petitioner's principal stockholders, who were actively and regularly engaged in its business, *3029 were expert advertising men of many years' experience in the advertising business, and included four of its five original stockholders.
The evidence establishes that what the advertisers sought was the expert advertising advice and marketing counsel of petitioner's stockholders. They were all trained advertising men. Their judgment as to the market to be reached and the best means of reaching *248 that market was the foundation of all advertising service rendered by petitioner. Counsel and advice on all matters relating to advertising and marketing problems were given by the stockholders. The number of clients was so small and the amount expended by each was so substantial that it was possible for the stockholders to give their personal attention to the problems of these advertisers. They procured all of petitioner's clients, surveyed their advertising and marketing situation, formulated the basic plans of advertising, prepared estimates of its cost, and directed and supervised the execution of these plans by petitioner's organization. They advised as to the type of advertising to be used, whether magazine, newspaper, bill board, street-car cards, pamphlets, or booklets. *3030 They advised as to the particular publications or type of publication most likely to reach the prospective purchaser of the articles to be advertised, as to the article to be advertised in various types of publications and the nature of the advertising to be followed. They made recommendations as to the field in which in their judgment, the articles to be sold could be most advantageously advertised. They prepared budgets for their clients, which stated the amount which they believed could be advantageously expended in advertising and showed the method in which they proposed the amount be expended. They followed up the results of the advertising and recommended such changes, either in the publications used, the field covered or the type of advertising, as seemed desirable. They supervised the preparation of the advertisements and frequently prepared such advertisements themselves. Details were performed by employees under the supervision of the stockholders. These employees assisted in the preparation of the advertisements, sent them on to the various publications for insertion, checked the publications to see that advertisements were inserted as ordered and that bills rendered*3031 were correct, attended to the necessary bookkeeping and correspondence, kept records as to the various publications, their circulation, rates, field covered, and other such matters. The number of the employees was large. The duties performed by all have been explained. In this respect, this proceeding differs from .
We have no doubt that there is a point beyond which the services of employees may not be used without creating an organization which overshadows its supervisors in producing income, or so materially assists that income can no longer be said to be produced primarily by those who originate the business and supervise its execution. Whether that point has been reached must be decided in each case upon the facts in such case. In a business such as that conducted by the petitioner, the decision must turn upon the duties *249 performed by the employees rather than upon their number or the salaries paid to them. Where, as here, employees function only under the direction of the stockholders who are the active creative force in the business and whose judgment and planning are the foundation of the service rendered; *3032 where the service for each client is performed according to an original plan created by the stockholders who give their personal attention to the carrying out of the service, the presence of employees who assist in the execution of the plan does not negative the primary function of the stockholders in the production of income. ; ; ; .
We have already pointed out that substantially all of petitioner's work was done for a few large advertisers, all of whom had been procured by the stockholders. These clients were primarily interested in securing the personal advice and attention of these stockholders and the situation was such that the stockholders were able to give detailed personal attention to the advertising of each client; something which might not be possible in the case of an agency handling a great number of small accounts.
In our discussion above we have considered Ellis as a stockholder. Technically he was not until December 27, 1918. Until then all*3033 he had was an executory agreement with McCann for the acquisition of stock. Before the year expired his stock had been paid for and he was the owner of record. The accounts which he handled contributed about 11 per centum of petitioner's gross income. Some of this came from accounts formerly handled by McCann and it appears that McCann consulted and advised with Ellis concerning the service rendered from the Cleveland branch. It would be contrary to the spirit, it not to the letter of the statute, to deny personal service classification on the basis of this situation.
We come then to consider whether capital was a material income-producing factor. The balance sheets at the beginning and end of the year are set out in the findings and are apparently submitted as representative of the situation throughout the year. At the beginning of the year assets of $375,988.59 are shown, $90,000 of this amount represents so-called contract rights; the letters from the Standard Oil companies authorizing McCann to serve as their advertising agent. These were terminable at will and the continuance of the relationship depended not upon these letters but upon satisfactory service. We do not*3034 conceive that in 1918 these letters were a material income-producing factor. We also eliminate from further consideration loans and advances and investments set out in the balance sheets at the beginning and at the end of the year. While *250 some small income may have resulted from the Briggs mortgage and the Liberty bonds, it was certainly not a material part of the whole. The use of capital for furniture and fixtures in such a business as that conducted by the petitioner is necessary, but is only incidental to the production of income. The same is true of so much as may be necessary to pay current expenses.
The use of capital to pay accounts of craftsmen and publishers was relied upon by the respondent as one ground for denying personal service classification. At the beginning of the year the books showed $199,149.68 charged to clients and $5,777.23 paid to craftsmen but not charged to clients. At the end of the year these amounts were respectively $140,616.60 and $26,634.99.
All of the amount charged to clients did not represent advances to publishers and craftsmen for their account. Approximately 15 per cent represented commissions. How much of the balance*3035 had been paid to publishers can not be determined, for the amounts shown in the liabilities as payable to publishers, $24,579.24 on January 1, and $22,997.66 on December 31, are inaccurate because of the system of bookkeeping employed. It was customary to draw checks to publishers before the dates when they would be mailed. They were posted in the cash account and in the accounts payable as of the date when drawn, and not as of the date when mailed or when paid at the bank. The result is that both the amount of cash in bank, on the asset side of the balance sheet, and the amount of accounts payable to publishers, on the liability side, are understated. How the accounts payable to publishers would correspond with the accounts receivable from clients is not known. It is clear, however, that payments were sometimes made to craftsmen and publishers before payment was received from advertisers, although this was not the usual procedure. Petitioner endeavored to send statements to its clients in such a manner that payment would be made to it before it made payment to the publisher. It was the custom to make payment to the publishers within the cash discount date, whether or not payment*3036 had been received from clients. All cash discounts were passed on to the clients and no such discounts were retained by the petitioner.
The total advertising placed through petitioner during 1918 was over $2,750,000. There is nothing which would lead us to believe that the amount paid to publishers or craftsmen in advance of payment by the client ever exceeded $100,000 at any one time in 1918, and much which would indicate that the average was substantially less. It would appear that by a change in its routine petitioner might have operated its business in such a manner as to have paid *251 publishers only after payment had been made to it, without decreasing its income. The bulk of petitioner's business came from large corporations which had no need to rely upon any credit which the petitioner could have extended to them. We are satisfied that neither the business nor the income of the petitioner were obtained because of the use of capital or credit and that capital was not a material income-producing factor. ; *3037 ; ;; ; ;.
We conclude that the petitioner was a personal service corporation in 1918 and that its income is to be taxed to its stockholders rather than to the corporation. There is no deficiency.
Reviewed by the Board.
Decision will be entered accordingly.