*3806 The petitioner held to be a personal service corporation during the years 1918 to 1921.
*444 The Commissioner has determined deficiencies against the petitioner as follows:
| 1918 | $9,025.45 |
| 1919 | 14,962.80 |
| 1920 | 10,403.29 |
| 1921 | 3,435.88 |
These proceedings, involving the taxable years 1918 to 1921, were consolidated for hearing and decision. The questions in issue are (1) whether the petitioner is entitled to classification as a personal *445 service corporation for the taxable years, (2) whether the petitioner is entitled to the deduction from gross income of each of the years 1918 and 1919 of $12,000 representing an estimate of unearned commissions.
FINDINGS OF FACT.
1. The petitioner is a New York corporation organized in 1911. It began business on May 1, 1912, with a capital stock of $10,000 divided into 100 shares of a par value of $100 each. All of the stock, with the exception of two shares, was issued to F. Merges and the two shares issued to other individuals were endorsed*3807 by them and held by F. Merges.
2. Merges started his business career as an employee of John M. Whiton, who carried on an insurance business as a sole proprietor from 1891 to 1900, when the partnership of J. M. Whiton & Co., in which Merges had an interest, was formed. In 1905 J. M. Whiton & Co. was succeeded by Whiton & Merges, a partnership, which continued the business until May 1, 1912, when Whiton retired and the petitioner began business as a corporation. Merges was president of the company from 1912 through 1921. There were four other officers of the company who received salaries and performed clerical duties. There were also approximately 60 other employees, such as stenographers, bookkeepers, typists, and office clerks. Merges died in December, 1925.
3. The capital stock of $10,000 was subscribed for and paid up in cash by Merges. The $10,000 received by the corporation was paid John M. Whiton. Merges then advanced to the petitioner an amount of money necessary to start it in business. There was no good will set up on the books of the petitioner at the time of its organization but in 1920 there were set up on the books, as an asset, plant and good will in the*3808 amount of $10,000.
4. During the taxable years 1918 to 1921, inclusive, the petitioner derived a part of its earnings from commissions on premiums covering fire, automobile fire, theft, and property damage, and tornado insurance. It was the agent for four insurance companies which it represented exclusively in certain territory comprising parts of the States of New York, New Jersey, and Pennsylvania. It was the general agent of the St. Paul Fire & Marine Insurance Co., of St. Paul, Minn., and of the National Ben Franklin Fire Insurance Co., of Pittsburgh, Pa. The business of these companies in New York State passed through the office of the petitioner. The petitioner was also local agent of the Firemen's Insurance Co., of Newark, N.J., and of the German Fire Insurance Co., of Peoria, Ill., in the Boroughs of Manhattan, Bronx and Brooklyn.
As general agent of the first two named companies the petitioner supervised the activities of approximately 300 agents throughout *446 the State of New York. These agents were appointed upon the recommendation of F. Merges. For supervising the work of these local agents the petitioner received an overwriting commission from the*3809 companies. All detail work necessarily arising after the time the agent sent in a notice of a policy written for insurance, such as the nature, character, location and local conditions concerning the insurable risk, were investigated and approved or disapproved in the petitioner's office before it was sent on to the home office. The premiums were collected from the assured by the agent and remitted to the petitioner, who, after deducting certain commissions and expenses, remitted the balance to the home office. The petitioner adjusted claims for losses for the insurance companies, paying the loss, after it was determined, by draft drawn on the insurance companies. It received no remuneration for this work other than expenses. Such business as these agents wrote for companies which the petitioner represented was required to pass through the petitioner's office.
5. The brokerage business was secured by the petitioner from other persons or firms who themselves were engaged in writing insurance but were not agents of companies which the petitioner represented.
6. The direct business was secured from the assured persons, firms, or corporations themselves and did not pass through*3810 the hands of any other insurance agent or broker. A relatively small percentage of this character of business came from relatives of Merges.
7. Merges devoted all of his time to the business of the petitioner over which he exercised exclusive charge. He was not engaged in any other business. All matters pertaining to the location and conditions that existed regarding insurance risks; the preparation of surveys of insurable property; the amount of insurance applied for and carried by the insured; the placing of insurance among companies other than those the petitioner represented; the renewal business; the adjustment of claims for losses; the remittance of amounts to insurance companies and brokers; all were either performed by Merges personally or by some one in the petitioner's office under his personal direction and supervision. He personally conducted all correspondence with the insurance companies. He supervised the employment and discharge of company employees. He signed checks individually on one bank account of the petitioner and jointly with the treasurer on the other bank account. There were no director's meetings nor meetings of officers concerning company affairs. *3811 Matters of business policy were established and determined exclusively by Merges without seeking the advice or conferring with officers or stockholders. Merges constantly directed his efforts to securing both new and renewal business. He maintained contact with agents by going into the territory and aimed to visit the important *447 agents' offices five or six times a year. The vice president occasionally made similar trips but only when directed to do so by Merges. Merges was a member of two clubs and had a large number of social friends and personal acquaintances from whom he obtained business. He solicited business from brokers through personal calls at their offices. Merges was the only solicitor for the petitioner.
8. The petitioner had written contracts with the insurance companies authorizing it to represent them either as agent or as local agent.
9. The various local agents reporting to the petitioner actually solicited and wrote policies of insurance. The policies became effective as soon as written by the agents but might later be canceled. The agents made a report to the petitioner of the business done by them monthly. The local agents had 60 days*3812 to remit and sometimes took 90 days. The petitioner made an entry upon its books that so much money was due from the agency from the reports received monthly but the funds due were not transmitted for 60 to 90 days.
10. The petitioner filed returns as a personal service corporation for the years 1919 to 1921, inclusive. Classification as a personal service corporation was disallowed by the respondent and deficiencies determined accordingly. The petitioner's returns as filed disclose the following:
| 1918 | 1919 | 1920 | 1921 | |
| Commissions from agents and | ||||
| brokers | $384,246.06 | $439,225.30 | $501,242.78 | $410,627.46 |
| Interest | 1,690.99 | 3,001.26 | 4,640.69 | 3,271.76 |
| Sundry income | 2,238.70 | |||
| Expenses | 146,609.27 | 94,825.32 | 104,626.36 | 107,805.14 |
| Salaries for officers | 12,000.00 | 12,000.00 | 12,000.00 | 12,000.00 |
| Commissions paid brokers | ||||
| and agents | 234,218.05 | 261,073.13 | 310,363.87 | 250,721.29 |
The petitioner's books of account and the returns were made upon the accrual basis. The balance sheets as of December 31, taken from the income-tax returns, are as follows:
| 1918 | 1919 | 1920 | 1921 | |
| ASSETS | ||||
| Cash | $41,523.56 | $117,115.26 | $104,382.64 | $66,515.13 |
| Accounts receivable | 225,637.46 | 273,959.12 | 247,801.28 | 255,540.32 |
| United States bonds | 18,668.00 | |||
| Loans - Advances | 2,300.00 | 380.00 | 75.00 | 1,083.00 |
| Maps and furniture | 3,522.50 | 3,447.45 | 3,291.76 | 4,355.18 |
| Good will | 10,000.00 | 10,000.00 | ||
| 291,651.52 | 394,901.83 | 365,550.68 | 337,493.63 | |
| LIABILITIES | ||||
| Accounts payable | 190,631.90 | 259,351.06 | 261,107.67 | 222,567.37 |
| Accrued expenses | 39,239.96 | 45,681.92 | 36,700.29 | 32,269.71 |
| Reserve for unearned commission | 24,000.00 | 36,000.00 | 36,000.00 | 36,000.00 |
| Capital stock - 100 shares at $100 | 10,000.00 | 10,000.00 | 10,000.00 | 10,000.00 |
| Profit and loss account | 27,779.66 | 43,868.85 | 21,742.72 | 36,656.55 |
| 291,651.52 | 394,901.83 | 365,550.68 | 337,493.63 |
*3813 *448 11. In 1917 the petitioner set up an account for unearned commissions. This practice was followed in subsequent years - 1918, 1919, 1920, and 1921, and the amount of the addition to the account was deducted from gross income for each of the years. The addition to the reserve for the years 1918 and 1919 was a lump sum in the amount of $12,000. The amount represented an estimate of the amount of commissions the petitioner figured from past experience would be returned or not earned on policies that would be canceled before they expired over a life of three years, one to three years being the life of a policy as a rule. In the years 1920 and 1921, the petitioner reported a lump sum of $12,000 in each year as an amount actually earned after three years. The reporting of $12,000 in the gross income and the deduction of a similar amount in 1920 and 1921 offset each other and did not affect taxable income. The account is shown on the balance sheets attached to the returns as a "reserve for unearned commissions." In the determination of the deficiencies herein complained of the Commissioner denied that the item of unearned commissions of $12,000 for each of the years 1918*3814 and 1919 was a proper deduction from gross income.
OPINION.
SMITH: The petitioner contends that for the years 1918 to 1921, inclusive, it was a personal service corporation within the meaning of section 200 of the Revenue Acts of 1918 and 1921. This is denied on behalf of the respondent upon two grounds (1) that the income produced by the petitioner was not ascribable primarily to the activities of the stockholders, and (2) that capital was a material incomeproducing factor. In the opinion of the Board the petitioner otherwise meets the requirements of the statute with respect to a personal service corporation. Therefore, only the objections raised thereto by the respondent will be considered.
The petitioner also contends that it is entitled to deduct from gross income of each of the years 1918 and 1919, $12,000 as a "reserve for unearned commissions."
1. The petitioner was the local and general agent of several large fire insurance companies and the exclusive territory covered by the contracts with these companies extended over the entire State of New York in the case of the companies which it represented as general agent, and the greater part of New York City in the*3815 case of two companies which it represented as local agent. All this territory was thickly populated. There were 300 or more local agents throughout the State of New York who reported their business to the petitioner and the petitioner passed upon the risks secured by such local agents. For the doing of this work the petitioner received an overwriting *449 commission from the two companies which it represented as general agent. It is the contention of the respondent that this business written by the local agents passing through the office of the petitioner, and upon which it received a commission, was not primarily produced by the stockholders or officers of the corporation but by these special agents themselves; that it would be practically impossible for F. Merges to cover this large and thickly populated territory; that the testimony discloses that F. Merges visited these agents not to exceed five or six times a year.
We can not doubt from the evidence that the contracts secured by the petitioner with the insurance companies were based upon the efforts of F. Merges individually. He was the surviving partner of the partnership of Whiton & Merges and correspondence produced*3816 in evidence warrants the conclusion that the insurance companies dealt with the petitioner by reason of the personal qualifications of F. Merges.
The petitioner was a one-men corporation. Merges owned all of the capital stock. The petitioner held no directors' meetings and Merges did not consult with anybody upon business policies. He laid down rules to govern the business of the corporation and saw to it that those rules were carried out. Any risks of an unusual nature taken by the local agents were called to Merges' personal attention. He approved or disapproved of the risks and if he disapproved of the risk the policy was immediately canceled. One of the principal employees of the petitioner was requested at the hearing to state the nature of the service performed by Merges. He answered:
A. All right. Take, for instance, if the company had to write millinery stock, which is very susceptible to damage by fire, water or smoke, although they might be willing to write that risk, if Mr. Merges' judgment was that it was too risky, he would say, "I do not want to write any insurance on millinery stocks; I do not want you to take it without my approval." And it would not be*3817 written without having his approval. In that case, we would have to take that particular risk, or anything bearing a risk of that nature, to him, and it may be so with other businesses. Take the celluloid business, or a paper box factory and a risk of that hazardous nature. He would insist upon his approval or his authorization being given.
He was further asked:
Q. Is there any other service that you can think of that F. Merges & Company might perform for either the insurance companies or the clients? Tell us in your own words, if you can. I am trying to get a description of the business as it was carried on there from all angles. Tell us in your own words, if you can.
A. Well when a risk would be submitted to our accountant, we would check it up, as regards, as I said a moment ago, seeing whether we had any liability in that particular location, what the character of the surrounding buildings was, *450 and then it went through the fire record to see whether it was a man who had a fire record or had fires at any time, and also whether he had a commercial rating. If he had not a commercial rating, we would send for a Dun report or a commercial report. There*3818 were times when the report was not satisfactory, and there were other channels by which we could get other information concerning that particular assured. Then, we would communicate with the New York Board and find out if they had anything in connection with the particular risk, and after going through those various checks, the policy then would be written up, delivered to the broker, and when the premium became due it would be collected. If the premium was not paid when due, cancellation notices were sent out by registered mail. We then had to see that the policy was gotten back from the assured, if it were possible to do so, or get a release, or if the party had moved, we would have to send a man there and have him make an affidavit that he visited the premises and made a diligent search and could not find that he had any property in the building. That would enable us then to cancel off the risk.
The same witness was also requested to state the work that F. Merges did for the benefit of the insurance companies the petitioner represented. He replied:
A. He would always be on the lookout to inquire as to the changed conditions in different localities. For instance, there*3819 might be in certain parts of Long Island a large frame center or development, and he would then advise the companies to reduce the obligations there, or give us instructions that we should not accept liability in that particular neighborhood. In other parts he might discover that the water supply was deficient. In that case, he would go over his maps to see whether a company's liability was beyond what he would think it should be, in his judgment. In other sections, owing to the character of the neighborhood or the changing character of that neighborhood, he would say, "Don't write any more for our particular companies in that locality."
With respect to the direct business, it is in evidence that F. Merges was the only solicitor for the petitioner. He had a large business and social acquaintance, and the direct business and the brokerage business were secured by the petitioner through those relationships.
With respect to the contention of the respondent that the income of the petitioner was ascribable primarily to the activities of local agents and not to the activities of F. Merges, it should be noted that the insurance companies which the petitioner represented as general*3820 agent allowed the local agents a commission upon the business produced and, in addition, allowed the petitioner an overwriting commission. The commission allowed the local agents was to compensate them for their services in obtaining the risks in the first instance. The overwriting commission allowed the petitioner was to compensate it for passing upon the risks and supervising the work of the local agents. It was allowed the petitioner for personal services performed by F. Merges and his employees. F. Merges supervised and directed the entire work of the agency. Although the details of the services rendered the insurance companies by the petitioner were in large part performed by employees those services were performed *451 under the personal direction of F. Merges. We can not doubt from the record that the overwriting commissions from the agency business were primarily ascribable to the activities of F. Merges. The record is equally clear that the commissions earned on the direct business were primarily ascribable to Merges' activities.
The facts in this case are not essentially different from those which obtained in the case of *3821 Harry S. Kaufman, Ltd. v. Commissioner, 24 Fed.(2) 44, in which the insurance agency was held to be a personal service corporation, or from those which obtained in the case of , decided by the District Court of the United States for the Western District of Pennsylvania.
2. The respondent also contends that the record in this case warrants the conclusion that capital was a material income-producing factor. He submits that the fact that premiums were not remitted by the local agents for 60 to 90 days and the petitioner had to remit the premiums within 75 to 90 days before it received its commission would apparently require the need of capital for a successful business and that the large amounts of accounts receivable and payable disclose the need of capital in the petitioner's business. We are of the opinion that this is incorrect. The only paid-in capital of the corporation was $10,000, which was apparently all paid out by the petitioner prior to the taxable year in the acquirement of the business from Whiton. The company had a considerable cash balance at the close of each of*3822 the taxable years under review, but it does not appear that this cash balance was necessary for the conduct of the business. In the ordinary operation of the business premiums were received from the local agents and from the insured prior to the time they were required to be paid over to the insurance companies. The only income of the company directly ascribable to capital was interest on bank balances as follows:
| 1918 | $1,690.99 |
| 1919 | 3,001.26 |
| 1920 | 4,640.69 |
| 1921 | 3,271.76 |
The amount of this interest for each year was a negligible part of the total gross income of the petitioner. In , the subject of the use of capital in a personal service corporation is discussed at length. Quoting from the opinion we find the subject set out as follows:
* * * 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. Holmes, *3823 Federal Taxes (6th Ed.) *452 p. 191. If capital was not in fact used, it is manifest that it was not necessary, but only incidental. 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.
We are of the opinion that in the instant case capital was not a material income-producing factor in the production of the income of the petitioner during the taxable years.
3. In view of our decision that the petitioner was a personal service corporation for the years 1918 to 1921, inclusive, it becomes unnecessary to determine the deductibility from gross income of each of the years 1918 and 1919 of $12,000 "reserve for unearned commissions."
Reviewed by the Board.
Judgment of no deficiency will be entered.