*3834 The petitioner during the years 1918 and 1919 was not a personal service corporation as defined by Section 200 of the Revenue Act of 1918.
*309 These proceedings are for the redetermination of deficiencies in income and profits tax for the calendar years 1918 and 1919, in the amounts of $41,600.10 and $18,029.78, respectively.
The petitioner appealed from a separate notice of deficiency as to each year, and upon motion duly made, the proceedings were consolidated for hearing and disposition.
The sole issue presented is whether during the years 1918 and 1919 the petitioner was a personal service corporation as defined by section 200 of the Revenue Act of 1918.
FINDINGS OF FACT.
The petitioner is a corporation organized and existing under the laws of the State of Illinois.
Prior to the organization of the petitioner, Harvey, who was a graduate of the Massachusetts Institute of Technology, had before the close of the year 1890 taken out eight patents, all relating to steel cars and three having special*3835 reference to draft riggings for such cars. He then organized the Harvey Steel Car Co. which engaged in the manufacture of steel cars under his patents. Harvey was the designer and in charge of construction. Between 1892 and 1897, additional patents covering railway car construction were taken out. In 1897, the Harvey Steel Car Co. failed and went out of business.
Soon after that time Harvey began concentrating his attention on friction springs for railroad draft gear which, as its name implies, is the mechanism on a railroad car by which the car is pulled. From an early day, springs of one form or another have been used in railroad draft gear to absorb shock. Such springs are situated under the car back of the coupler in what is called a draft rigging. Early in the twentieth century the ordinary springs which had theretofore been used in railroad draft gears began to be superseded by various forms of friction devices.
*310 On April 26, 1904, United States patents Nos. 758,066 and 758,067 were issued to Harvey for a "friction device" for railroad draft gears. This device consisted of two coil springs, one coiled within the other, the frictional area of one coil*3836 coming into contact with the frictional area of the other.
On October 26, 1904, Harvey caused to be incorporated under the laws of Illinois a corporation known as Harvey Friction Spring Co., the petitioner herein. Its articles of incorporation stated its purpose as being "to manufacture, buy and sell springs, railroad supplies, appliances and equipment, and articles of like nature." The authorized capital stock was fixed at $100,000, consisting of 1,000 shares of the par value of $100 each. Nine hundred ninety-eight of these shares were issued to Harvey in exchange for United States patents Nos. 758,066 and 758,067 on "friction device" for railroad draft gears. These patents were thereupon assigned by Harvey to the petitioner. Harvey was elected a director and also president and treasurer of petitioner and held those offices continously until his death in August, 1923. Except for a secretary who has from time to time signed the necessary corporate papers and given advice, and except the two other directors whose duties were very light, the activities of petitioner ever since its organization have been carried on by Harvey, assisted from time to time by a part-time stenographer*3837 in his employ and an occasional draftsman.
Notwithstanding the provisions in the charter, petitioner did not itself set out to manufacture the friction springs. On the contrary, on November 14, 1904, petitioner entered into a contract with the Detroit Steel Products Co. (hereinafter called "the Detroit Co.") providing for the manufacture and sale by the Detroit Co. of friction springs under patents Nos. 758,066 and 758,067. The Detroit Co. by a contract of February, 1905, granted to the Frost Railway Supply Co. (hereinafter referred to as "the Frost Co.") the exclusive selling rights for the friction springs. This contract ran for five years and was renewed from time to time until the last contract expired in 1923.
The contract of November 14, 1904, between petitioner and the Detroit Co. was superseded by another contract, dated March 27, 1905, which among other things provided:
That, whereas, said party of the first part is the sole and exclusive owner of Letters Patent of the United States, Nos. 758,066 and 758,067, each issued April 26th, 1904, to George Lyon Harvey, for certain improvements in Friction devices, and has filed an application for patent for attachments*3838 collateral thereto; * * *
WHEREAS, said party of the second part is desirous of obtaining from said party of the first part an exclusive license under said patents to manufacture and sell, for the full term of said patents and each of them, and of any extension *311 or extensions or reissues thereof, the appliance known as the Harvey Friction Draft Gear, or the Harvey Friction Spring; and of any subsequent improvements thereon, it being expressly agreed and understood that the cost of obtaining such patents is to be borne by the party of the second part.
NOW, THEREFORE, it is agreed, between the parties hereto, in consideration of the royalties hereinbefore mentioned to be paid by said party of the second part, to said party of the first part, and of the agreements hereinafter set forth to be kept and performed by said party of the second part, that said party of the first part does hereby grant to said party of the second part the exclusive right, under all of the above mentioned patents and applications for patents, and any improvements which said Harvey has or shall hereafter acquire on friction devices to manufacture and sell for the full term of said patents and*3839 each of them, and any extensions or reissues thereof, said appliance known as the Harvey Friction Draft Gear or Harvey Friction Spring, containing said inventions or any part of them:
* * *
Said second party agrees that it will make and sell said device known as Harvey Friction Draft Gear, or Harvey Friction Spring, and, subject to reserve for defense, will pay to said party of the first part a royalty amounting to thirty-three and one-third (33 1/3) per cent of net proceeds from sales. (Italics ours.)
Thereafter the Detroit Co. manufactured the springs under the two patents and the Frost Co. sold them for about a period of one year, but the springs sold proved defective in operation in that, as a result of repeated compressions and releases, the outer coil spring unwound from the inner coil spring and after unwinding the end of the outer coil would break off. Thus, the spring was mechanically defective.
To remedy this defect, Harvey hit upon an entirely new idea, that of placing a "stop" shoulder device at each end of the inner coil to prevent the unwinding of the outer coil. He communicated this idea to the Detroit Co. and thereafter, on July 10, 1905, filed an application*3840 for a patent thereon. On April 10, 1906, United States patent No. 817,482 was issued to him for this "stop" invention and this patent was not assigned by Harvey to petitioner. The "stop" device, however, was an integral part of the Harvey spring and was not used on other springs prior to the expiration of the patent in 1923. The manufacture and sale of the product embodying the "stop" device began in 1905, all springs manufactured prior thereto being recalled and replaced by "stop" springs. The spring embodying the "stop" device was perfected in 1906, and no further change was made in the manufactured article.
The contract of March 27, 1905, between petitioner and the Detroit Co. remained in effect until April 11, 1923, the date of the expiration of the "stop" patent and was the only contract between petitioner and the Detroit Co. regarding the manufacture of springs. No change in the contract was made as the result of the adoption of *312 the "stop" device nor did petitioner or Harvey ever raise any objection to or suggest any change in the contract.
Much work was performed by Harvey in connection with perfecting the manufacture of the spring and also in making it*3841 adaptable for a more widespread use. He wrote numerous letters and also spent much time helping the Detroit Co. get the manufacture of springs under way. He prepared plans and blueprints and advised concerning manufacturing processes.
During the early years the Detroit Co. relied on Harvey for engineering advice in connection with production of the springs and voluminous correspondence passed between them. By the middle of 1906, practically all obstacles had been overcome and the method of manufacture was perfected to such an extent that from that time on the efforts of Harvey and the Detroit Co. were directed no longer to making changes in the method of manufacture but in doing their best to keep the manufacture up to the highest standards, in accordance with the method already developed. Harvey assisted in this by examining test cards and otherwise checking up on springs reported as defective and making suggestions as to the best way to avoid such defects in the future. During the years 1918 and 1919, in rendering assistance in the manner just indicated, Harvey visited the plant of the Detroit Co. occasionally. There were other engineers in the employ of the Detroit Co. *3842 who worked on matters in connection with the manufacture of the springs, which was continuous and not confined to specific orders.
Much correspondence passed between Harvey and the Frost Co., who sold the manufactured product. The Frost Co. was frequently confronted with engineering problems which arose in connection with its attempts to sell the friction spring. At first these problems were referred to the Detroit Co. but later to Harvey. Harvey attended the conventions held from time to time by the Master Car Builders Association, at which conventions the railway supply men would exhibit their devices and at which he acted as engineer, answering questions with respect to the friction spring.
In 1910 the Wilmerding test was put on by the Westinghouse Co. This test showed that the Harvey spring was little better than the ordinary helical spring of similar size. As a result of investigation, Harvey was instrumental in brining about a test at the Armour Institute of Technology which showed that the Wilmerding test did not simulate service conditions. The results of the Armour test were used thereafter in attempting sales of the friction spring. In 1917 or 1918, the Government*3843 Committee on Standards for Railroad Cars specified a certain standard for spacing of sills on railroad cars and *313 Harvey, thereafter, devised what was known as the "Interchange Casting" which fills the space adopted as standard. He also devised an entirely new draft rigging known as "unit tandem" to fit the new standard. He made trips to Washington to interview officials of the Railroad Administration. He received no compensation from the Frost Co. for his services except where it was necessary for him to hire a draftsman whose services the Frost Co. paid for.
It was not necessary for the Frost Co. to get from Harvey a drawing or bill of material for sale, unless it got into difficulty with the railroad about the economies of using the Harvey spring. Sales were made without conferring with Harvey and numerous orders were received which were covered by previous bills of material or specifications and in connection with which it was not necessay to consult with Harvey.
Harvey's expenses in connection with the services rendered to the Detroit Co. and in attending conventions, etc., were borne by the petitioner. Prior to April 11, 1923, Harvey was in no way obligated*3844 to give advice or render any services to the Frost Co. On that date, which marked the expiration of the contracts, an agreement was entered into between Harvey and the Frost Co. under the terms of which Harvey was employed as consulting engineer by the Frost Co. Shortly afterward, in 1923, Harvey died. Since his death, the Frost Co. has not had anyone from the petitioner to consult with them or render any services in connection with the sale of the springs. From 1920 to 1926, the number of springs sold by the Frost Co. was as follows:
| 1920 | 47,744 |
| 1921 | 32,908 |
| 1922 | 34,134 |
| 1923 | 48,378 |
| 1924 | 44,952 |
| 1925 | 34,219 |
| 1926 (to Oct. 31) | 38,046 |
Fairbank was secretary and a stockholder and director of the petitioner from July, 1905, to the present time. Fairbank kept in touch with the business in a general way. During 1918 he called at the office of the petitioner once or twice a month and occasionally consulted on some of the correspondence and drafted letters in consultation with Harvey. His visits were less frequent in 1919. Harvey handled all the finances of the corporation.
Any collateral attachments which Harvey devised did not affect the spring itself*3845 nor the method of making the spring and the royalties which petitioner received were in connection with the springs. The use of the springs did not depend on these collateral devices or attachments, the attachments merely providing for use as occasion demanded.
*314 The office of the petitioner and Harvey, as an individual, were one and the same. One stenographer was employed and was the sole employee, except temporary draftsmen, once in a great while. During 1918 and 1919, Harvey spent some time each day in connection with another patent of his, the exposure meter, a celluloid article for use of amateur photographers. The inventory of stock was carried in Harvey's office. The sales and expenses in connection with the exposure meter were reported by Harvey on his individual returns for 1918 and 1919. For 1919 the sales amounted to $5,838.63. The return also shows material and supplies, merchandise bought for sale, inventory and expenses such as rents, taxes, repairs and bad debts. This was Harvey's personal business and had no connection with the corporate business other than that both businesses were carried on in the same office. During 1918 and 1919, Harvey spent*3846 several weeks on some architectural work in the office in connection with buildings he had worked on. He also worked a little in 1918 on a truck which he had patented.
During 1918 and 1919, the stock of the petitioner was held as follows:
| Shares. | |
| George L. Harvey | 649 |
| Mabel S. Martin (divorced wife of Harvey) | 75 |
| Mary C. Streeter (sister of Mabel S. Martin) | 50 |
| Marjorie S. Hamill (sister of Mabel S. Martin) | 35 |
| E. C. Streeter (brother of Mabel S. Martin) | 100 |
| Eleanor R. Belmont | 5 |
| Kellogg Fairbank | 40 |
| Wm. A. Pusey | 20 |
| L. L. McArthur | 25 |
| Belle H. Ward | 1 |
| 1,000 |
In 1918 Harvey held and voted at the annual meeting proxies for 231 additional shares and in 1919 held and voted at the annual meeting proxies for 266 additional shares. Fairbank, Pusey and McArthur had all purchased their stock from Harvey in the early days of the company, some for $100 a share, and some for $150 a share.
Petitioner owned United States patents Nos. 758,066 and 758,067, covering the spring device manufactured; also United States patent No. 806.972, covering a collateral device which was never manufactured by anyone. Aside from the patents, the only assets consist of current*3847 cash and bank balances. The balance sheets as at the beginning of the taxable years were as follows:
| Dec. 31, 1917 | Dec. 31, 1918 | Dec. 31, 1919 | |
| ASSETS | |||
| Patents | $99,800.00 | $99,800.00 | $99,800.00 |
| Less depreciation | 30,000.00 | 36,000.00 | 42,000.00 |
| 69,800.00 | 63,800.00 | 57,800.00 | |
| 42,277.05 | 24,274.71 | 3,987.61 | |
| 112,077.05 | 88,074.71 | 61,787.61 | |
| LIABILITIES | |||
| Capital stock | 100,000.00 | 100,000.00 | 100,000.00 |
| Accrued Federal taxes | 11,957.33 | ||
| Surplus | 119.72 | (11,925.29) | (38,212.39) |
| 112,077.05 | 88,074.71 | 61,787.61 |
*315 On its return for each of the taxable years 1918 and 1919, petitioner claimed a deduction of $6,000 for depreciation of patents. The net income reported was accepted by the Commissioner except for 1919, for which year depreciation of $129.41 on patents was disallowed.
The only income of the petitioner with exception of a small amount of interest on cash in bank consisted of royalties received from the Detroit Co. under the contract of March 27, 1905, amounting to $95,611.34 in 1918, and $68,904.37 in 1919. In addition to amounts claimed for exhaustion of patents, deductions were made each year for Harvey's salary amounting*3848 to $7,200 and also for ordinary and necessary expenses amounting to a little over $5,000 for each year.
The petitioner for each of the years 1918 and 1919 filed a return as a personal service corporation. Upon audit of the return, the Commissioner denied personal service classification and asserted the deficiencies herein, having computed the profits tax for each year under section 328 of the 1918 Revenue Act. The petitioner, in addition to the allegation of error with respect to the denial of personal service classification, alleged that insufficient relief had been granted under section 328. This assignment of error, however, was abandoned at the hearing and no evidence relative thereto was adduced.
OPINION.
LOVE: Section 200 of the Revenue Act of 1918 defining a personal service corporation sets forth four conditions, all of which must concur to entitle a corporation to classification thereunder, and these conditions are each a question of fact. ; *3849 .
The conditions which must be concurrently met by a corporation in order to entitle it to personal service classification are: (1) Its income is to be ascribed primarily to the activities of the principal owners or stockholders; (2) the principal owners or stockholders *316 must be engaged in the active conduct of the affairs of the corporation; (3) capital (whether invested or borrowed) must not be a material income-producing factor; (4) must not be a foreign corporation, or any corporation 50 per cent or more of whose gross income consists of gains, profits, or income derived from trading as a principal, etc.
Petitioner is and was a domestic corporation and also met the other requirements of the fourth condition above enumerated. Our inquiry, therefore, is limited to the questions as to whether its income was derived primarily from the activities of its principal stockholders who were regularly engaged in the active conduct of its affairs and whether capital was a material income-producing factor. In this connection, petitioner contends that its income was, during the years in question, ascribable primarily to*3850 the activities of Harvey, who was its principal stockholder, owning 649 shares of its capital stock of 1,000 shares, and who was regularly engaged in the conduct of its affairs. It further contends that capital was not a material income-producing factor. The Commissioner, on the other hand, denies both of these contentions and urges that petitioner does not come within the terms of the statute.
The Board is of the opinion that petitioner was not during 1918 and 1919, a personal service corporation for the reason that it did not meet the first three requirements of the statute, which are above enumerated.
It seems clear to us that petitioner's income, instead of being ascribed primarily to the activities of Harvey, was ascribable primarily and directly to the royalties received from the Detroit Co. It is true that Harvey rendered some service during the years in question both to the Detroit Co. and to the Frost Co. which service might in some degree have been reflected in increased royalties due to greater sales. Harvey's connection with the income of petitioner would, it seems, be remote and it may be pointed out, that no attempt was made to show the volume of increased sales, *3851 and, consequently, royalties, attributable to Harvey's services in 1918 and 1919 in making estimates, plans, blueprints, etc., and in providing collateral attachments.
The method of manufacturing the springs has been practically stabilized since the invention of the "stop" device in 1906. The Detroit Co. manufactured under the two basic patents belonging to petitioner and under the "stop" patent which was not assigned but of which, ever since 1906, petitioner has had the beneficial use. A patent is property and in this case the property was acquired in and before 1906. We are of the opinion, therefore, that the petitioner's income was derived primarily from property acquired long before the years in question.
*317 While it is unnecessary for us, in order to dispose of the issue presented, to discuss the other requirements of the statute in relation to the facts herein, we believe that it would not be improper to do so in view of the fact that it is our opinion that petitioner failed to meet them.
Harvey, during 1918 and 1919, owned 649 shares of petitioner's capital stock of 1,000 shares, or 64.9 per cent thereof. The remaining stock was held by several persons*3852 among whom was Fairchild who owned 40 shares. Fairchild was secretary and a director of petitioner and he gave a little attention to its business. None of the other stockholders gave any attention to the business. Under such circumstances, we believe that the principal stockholders were not regularly engaged in the active conduct of the business.
The petitioner argues, however, that only the principal stockholder need be actively engaged in the conduct of the business. With this we can not agree.
The Board has heretofore held that a corporation was not entitled to personal service classification where the principal stockholders were not regularly engaged in its affairs. ; . The court in , said with respect to principal owners or stockholders engaged in the conduct of a corporation claiming personal service classification:
It is not necessary under the law that each stockholder shall be engaged in rendering the personal service, but the letter and spirit of the law both require that the great body*3853 of the stock shall be in the hands of those who are rendering this service.
The United States Circuit Court of Appeals for the Fifth Circuit, in the case of , in holding that the petitioner therein was a personal service corporation stated:
It follows that Mayer should be included among the active stockholders. When he is so included, it appears that the stockholders owning more than 80 per cent. of the capital stock were regularly and actively engaged in the conduct of petitioner's business. In our opinion, the percentage of stock so represented was large enough to constitute the owners thereof the principal stockholders.
It is clear that the holding of that court is consistent with the holding in the Matteson case. In the Kaufman case the court merely found a percentage which it considered to constitute the principal stockholdings.
As above-stated, the Board is of the opinion that the principal stockholders of petitioner were not engaged in the regular conduct of its business and we must hold that petitioner fails to meet the statutory test in this respect.
*3854 *318 The last point to be considered is whether capital is an income-producing factor.
The original patents were owned by petitioner, having been assigned to it by Harvey in exchange for stock. It is true that the "stop" patent was not assigned to it but nevertheless petitioner had the beneficial use thereof in that it received royalties from the Detroit Co. which manufactured the springs under the basic patents and the "stop" patent. Without the basic patents the "stop" device was of little value. Each was dependent upon the other. We can not say, therefore, that the patents which petitioner actually owned were worthless. And, as evidence of the fact that petitioner did not so consider them, it will be observed that they were valued at $99,800 and depreciation thereon was claimed for 1918 and 1919.
The Board is of the opinion that the patents owned by petitioner were important capital elements and were material factors in producing profits in the years in question. ;*3855 .
From the foregoing it is evident that petitioner was not a personal service corporation during the years 1918 and 1919.
Judgment will be entered for the respondent.