DocketNumber： Docket Nos. 9594, 15349.
Citation Numbers： 10 B.T.A. 573, 1928 BTA LEXIS 4072
Judges： Lansdon, Geeen, Arundell
Filed Date： 2/7/1928
Status： Precedential
Modified Date： 11/21/2020
*4072 1. The petitioner was neither entitled to have its profits tax for the year 1917 computed under section 209 of the Revenue Act of 1917 as a trade or business having no invested capital or not more than a nominal capital nor to be classed as a personal service corporation for the years 1919, 1920, and 1921 under section 200 of the Revenue Acts of 1918 and 1921.
2. The disallowance as deductions in each of the years 1919, 1920, and 1921 of a portion of the salaries paid to T. W. Donoho, the petitioner's president,
*573 In these proceedings, which have been consolidated for hearing and determination, the petitioner seeks a redetermination of its income and profits-tax liability for the years 1917, 1919, 1920, and 1921, for which years the respondent has determined deficiencies in the amounts of $1,201.29, $3,615.84, $3,236.59, and $4,776.70, respectively.
The petitions allege that the respondent erred in not treating it (1) as a corporation having only a nominal*4073 capital in 1917, within section 209 of the Revenue Act of 1917, and (2) as a personal service corporation in the years 1919, 1920, and 1921, within section 200 of the Revenue Acts of 1918 and 1921, and that the respondent *574 further erred in disallowing as a deduction in each of the years 1919, 1920, and 1921, a portion of the salary of T. W. Donoho, the petitioner's president.
FINDINGS OF FACT.
The petitioner corporation was organized under the laws of the State of Maryland in April, 1898, by S. Irving Strayer, for the purpose of conducting and maintaining business schools for the education of young men and women, and for related purposes. Its principal office is in Baltimore, Md. During the years in controversy it operated a school in Baltimore and also a school in Washington, D.C.
The petitioner's authorized capital stock is $5,000 divided into 500 common shares of the par value of $10 each. Since May, 1910, 497 shares have been owned by Thomas W. Donoho. The remaining three shares are held as qualifying shares by Donoho's wife and two sons.
On April 13, 1898, all of the stock was issued - 496 shares to Strayer and four qualifying shares to four other directors, *4074 for the following considerations:
| Assets | |
| Equipment | $2,353 |
| Accounts receivable | 778 |
| Scholarships | 1,169 |
| Good will | 1,200 |
| Total | 5,500 |
| Less, Liabilities | 500 |
| Balance being net book value of the assets for which $5,000 capital stock was issued | 5,000 |
In 1902 Thomas W. Donoho became vice president and business manager of the petitioner at a salary equal to one-half of the net profits, if any, and with absolute powers of management. Strayer was to retire and to do nothing unless Donoho called upon him. At that time the petitioner had one poorly equipped school in Baltimore. In 1904 and 1905 it opened branch schools in Philadelphia and Washington, and subsequently a third school in Camden, N.J. About 1905 Donoho sent Strayer to Philadelphia to take charge of the Philadelphia school. Donoho remained in Baltimore and operated the remaining three schools, over which he exercised general authority.
During the period from 1902 until 1910, the petitioner's operations as a whole were not successful. It lost money in its Philadelphia and Camden schools but was doing better in its Baltimore and Washington schools. It was being pressed by its banks to pay its*4075 notes and *575 withdraw its account. It indebtedness was about $20,000 on notes, all of which bore Donoho's personal endorsement.
As of January 1, 1910, its financial condition was as follows:
| Assets | Liabilities | ||
| Cash | $654.74 | Notes payable | $19,836.52 |
| Accounts receivable | 542.38 | Accounts payable | 6,468.45 |
| Equipment, less depreciation | 7,949.76 | Capital stock | 5,000.00 |
| Good will | 1,200.00 | ||
| Deficit | 20,958.09 | ||
| Total | 31,304.97 | Total | 31,304.97 |
Under pressure of this situation, Donoho and Strayer executed an agreement dated March 15, 1910, whereby the Philadelphia and Camden schools (with certain obligations appertaining thereto) were transferred to Strayer and Strayer transferred his 499 shares of stock in the petitioner (which shares carried the Baltimore and Washington schools) to Donoho, who agreed to be solely responsible for and pay all of the petitioner's liabilities, except those specifically assumed by Strayer, as above stated. From that time on, Donoho was the sole owner of the petitioner except for the qualifying shares.
The petitioner gave resident instructions only. It did not board or lodge any of its students. The Baltimore*4076 school had an average attendance of approximately 200 day students and 175 night students; the Washington school about 150 day students and 200 night students. Instruction was given by a corps of ten to twelve regular teachers in each school. None of the teachers participated in the management or was in control or charge of any course or group of courses, these being directly and exclusively under the control of Donoho and P. J. Harman, who was employed as resident principal of the Washington school, at a salary equal to one-half of the net profits of that school, if any. The contract with Harman reads as follows:
THIS AGREEMENT, executed in triplicate this 19th day of April, 1904, by and between Strayer's Business College of Baltimore City, party of the first part, and Pinckney J. Harman of Baltimore City, party of the second part,
WITNESSETH that in consideration of the promises and agreements herein-after set forth: -
The party of the first part doth agree and bind itself,
*577
The party of the second*4081 part doth agree and bind himself,
It is mutually agreed,
Signed, sealed, and delivered this 19th day of April 1904.
WITNESS Lena M. *4086 Bell SIGNATURE Strayer's Business College, Inc., per S. Irving Strayer, Pres.
WITNESS Lena M. Bell SIGNATURE & per T. W. Donoho, Business Mgr.
WITNESS Lena M. Bell SIGNATURE Pinckney J. Harman.
In order to make plain beyond a doubt the intention of the parties thereto in an agreement by and between Strayer's Business College, of Baltimore City, party of the first part, and Pinckney J. Harman, now of Washington, D.C., party of the second part, said agreement having been executed at Baltimore, Md., on the nineteenth day of April, 1904, said parties hereby agree that notwithstanding anything in said agreement which might be construed to the contrary, it was and is the intention of the parties hereto that all money at any time advanced by the party of the first part to the branch of Strayer's Business College at Washington, D.C., for operating expenses or for any other purpose, shall and will be returned to the party of the first part out of the tuition and other similar receipts of the branch of Strayer's Business College at Washington, D.C., before said branch school shall be considered to have made any profits even though at times a number of years may elapse *579 before*4087 said money has all been returned, or said branch school is considered to have made any profits.
It is further agreed that notwithstanding anything in the original contract which might be construed to the contrary, it was and is the intention of the parties hereto that if at the end of any year or term it shall be found that there have been no profits on the business during the said year or term, in that event no settlement shall be made between the parties hereto, and in order to determine whether or not there have been profits at the end of the text year or term, the sum of all of the expenses for the two preceding years shall be deducted from the sum of all of the receipts for the two preceding years, and in the event of there then being no profits found, the method of computing profits at the end of succeeding years or terms shall be similar to the method just described, so that in no case shall the branch school be considered to have made profits at any time when the total of the tuition and other similar receipts of the branch school, from the time of the last settlement until that time, do not exceed the total of the operating expenses of the branch school during the same*4088 period.
It is mutually agreed by and between the parties hereto that this agreement shall be and is an interpretation on the points to which it refers of the original agreement of April nineteenth, 1904, hereinbefore referred to, and that it shall be and is a part of said agreement.
Witness our hand and seal at Baltimore, Md., this seventeenth day of July, 1905.
WITNESS Lena M. Bell SIGNATURE Strayer's Business College, Inc., per S. Irving Strayer, President
WITNESS Lena M. Bell SIGNATURE & per T. W. Donoho, Business Mgr.
WITNESS Pearle Harman SIGNATURE P. J. Harman
The petitioner never owned any real estate. It leased and occupied four floors of a building in Baltimore at the corner of Charles and Fayette Streets, and one floor and a part of another in a building in Washington at Ninth and F Streets. Its rooms were equipped with the usual school room paraphernalia and office furniture. Occasionally the petitioner rented typewriters to students as an accommodation to them, but this was an infrequent practice and the income therefrom was negligible.
The petitioner carried in stock, textbooks, stationery and school supplies, which it sold exclusively to its students. *4089 This was done in order to insure uniformity in texts and materials, and promptness of supply, as well as to meet the convenience of the students. It was not practicable to require the students to purchase texts and supplies outside. The petitioner did not own or publish any books or texts, and had no income from, nor investment or interest in, any facilities for the publication, manufacture or production of books, material or supplies, but made its purchases in the general market.
Students were required to pay cash monthly in advance for tuition, texts and supplies. The petitioner did not carry to any extent the accounts of the students. Credit was given only in rare instances, and then only under special circumstances such as illness in the student's family, parents out of work, etc. Such credits bore a *580 negligible proportion to the total fees, and usually had to be charged off eventually as bad debts.
The petitioner conducted an employment or "placement" department through which it undertook to obtain positions for its graduates. This department, as to the Baltimore school, was conducted by Donoho or under his immediate supervision.
The petitioner held*4090 no stockholders' or directors' meetings after 1910 except a verbal meeting in 1920 which authorized a salary of $30,000 for Donoho. There were no officers other than Donoho and no form of corporate organization or activity. The petitioner's income for the years in question is reflected in the following statement which both parties have stipulated is correct:
| 1917 | 1919 | ||
| INCOME | |||
| Tuition | $76,849.46 | $110,483.11 | |
| Sale of textbooks, supplies, and stationery - $10,336.65 and $17,163.98, less cost of sales - $7,272.88 and $10,515.92, respectively | 3,063.77 | 6,648.06 | |
| Rental of typewriters, lockers, etc | 547.43 | 367.22 | |
| Gross income | 80,460.66 | 117,498.39 | |
| Income school located at Washington, D.C | 41,661.07 | 64,131.41 | |
| Income school located at Baltimore, Md | 38,799.59 | 53,366.98 | |
| Gross income | 80,460.66 | 117,498.39 | |
| DEDUCTIONS | |||
| Salaries, principal of schools, teachers, etc. (nonstockholders): | |||
| Washington school | $24,046.93 | ||
| Baltimore school | 17,661.61 | ||
| 41,708.54 | |||
| Washington school | 38,156.05 | ||
| Baltimore school | 22,487.53 | ||
| 60,643.58 | |||
| Salaries, stockholders' | 11,105.24 | 16,972.51 | |
| Rent paid | 7,700.04 | 8,900.04 | |
| Repairs | 421.94 | 465.13 | |
| Advertising | 3,873.14 | 3,957.24 | |
| General expenses | 5,434.52 | 4,147.62 | |
| Losses | 223.55 | ||
| Depreciation | 642.16 | 626.46 | |
| Taxes | 104.07 | 116.68 | |
| Interest paid $1,650.02, less interest in excess of limitation, Act of 1917, $883.38 | 766.64 | 752.26 | |
| Bad debts | 1,038.52 | ||
| Light, telephone | 1,667.50 | ||
| Legal | 700.00 | ||
| Total deductions | 71,979.84 | 99,987.54 | |
| Taxable net income | 8,480.82 | 17,510.85 | |
| 1920 | 1921 | ||
| INCOME | |||
| Tuition | $133,190.71 | $155,517.26 | |
| Sale of textbooks, supplies, and stationery - $16,024.05 and $17,356.95, less cost of sales - $12,959.38 and $11,575.83, respectively | 3,064.67 | 5,781.12 | |
| Rental of typewriters, lockers, etc | 656.38 | 339.92 | |
| Gross income | 136,911.76 | 161,638.30 | |
| Division of gross income between Washington and Baltimore schools | |||
| Income school located at Washington, D.C | 67,142.43 | 83,167.15 | |
| Income school located at Baltimore, Md | 69,769.33 | 78,471.15 | |
| Gross income | 136,911.76 | 161,638.30 |
| DEDUCTIONS | |||
| Salaries, principal of schools, teachers, etc. (nonstockholders): | |||
| Washington school | $33,820.95 | ||
| Baltimore school | 30,687.04 | ||
| $64,507.99 | |||
| Washington school | 39,675.27 | ||
| Baltimore school | 33,873.36 | ||
| $73,548.63 | |||
| Salaries, stockholders' | 25,000.00 | 25,000.00 | |
| Rent paid | 8,900.04 | 9,091.70 | |
| Repairs | 2,107.19 | 11,146.83 | |
| Advertising | 12,154.53 | 11,275.26 | |
| General expenses | 6,384.93 | 6,838.42 | |
| Losses | |||
| Depreciation | 876.94 | 2,088.18 | |
| Taxes | 133.56 | 279.40 | |
| Interest paid, less interest in excess of limitation, Act of 1917 | 52.50 | 73.50 | |
| Bad debts | |||
| Light, telephone | 1,384.83 | 1,293.87 | |
| Legal | 1,200.00 | 1,300.00 | |
| Total deductions | 122,702.51 | 141,935.79 | |
| Taxable net income | 14,209.25 | 19,702.51 |
*4092 Since 1910, Donoho, the owner of practically all of the shares of the petitioner's stock, has been regularly engaged in the active conduct of the affairs of the petitioner. He was president, general manager and treasurer, there being no other corporate officers unless Donoho's wife, who performed some duties as secretary, might be classed as such. He devoted all of his time to the conduct of the petitioner's affairs. Practically the entire business of the petitioner was conducted, and every corporate activity was performed or directed, by Donoho. He gave no classroom instruction. Among the duties performed by Donoho as president and principal stockholder of the petitioner were the following:
(a) Organizing, planning and supervising the courses of study.
(b) Selecting and changing texts to be used.
(c) Selecting, employing and discharging teachers; fixing their compensation.
(d) Directing all teaching and classroom methods.
(e) Borrowing on his personal endorsement such money as was needed for financing the petitioner's current operations.
(f) Conferring with prospective students.
(g) Obtaining employment, through the placement division, for trained graduates.
*4093 Donoho visited the Washington school two or three times a week.
The contract with Harman provided that he should consent to all major changes in the conduct of this school. During the year 1919, O. S. Schester was employed as manager of the Washington school.
Donoho did no teaching during the years in question. Prior to his connect on with the petitioner he had been for 14 years manager of the mid-southern territory of the Smith-Premier Typewriter Co. He was an expert on the typewriter. His education was obtained in a *582 high school and at a private school in Baltimore. He is a member of the University Club of Baltimore and also a member of the board of directors of education of the Methodist Protestant Church, and chairman of the finance committee of this board.
During the period from 1910 to 1918, while Donoho was paying off the indebtedness of approximately $20,000 which he assumed at the time he purchased the stock of the petitioner, he drew as little by way of salary or other compensation as he could get along with. During the years 1917 to 1919 no salary was formally voted to him as such, but he drew out from time to time such amounts as he needed. *4094 In 1920 and 1921 salaries aggregating $30,000 for each year were authorized and approved, as being commensurate with his work and responsibilities, and these salaries were actually credited to his account and paid him at various times during each of said years. No minutes of this meeting were written up.
The amounts of cash actually drawn by Donoho from the two schools in each of the years under review were as follows:
| 1917 | 1919 | 1920 | 1921 | |
| Baltimore school | $7,300 | $19,224 | $26,435 | $40,491 |
| Washington school | 5,104 | 6,510 | 9,030 | 8,322 |
| Total drawings | 12,404 | 25,734 | 35,465 | 8,813 |
The petitioner deducted as ordinary expenses, paid or incurred during the taxable years, the following amounts paid as salaries to T. W. Donoho, its president: $25,000 in 1919, $35,000 in 1920, and $36,000 in 1921, and for these years the respondent allowed as deductions $15,000 in the years 1919 and 1920 and $25,000 in the year 1921.
The petitioner filed its income and profits-tax return for 1917 as an ordinary corporation. In 1919 it filed an amended return for 1917 under the provisions of section 209 of the Revenue Act of 1917. Its returns for 1918, 1919, 1920, *4095 and 1921 were filed as a personal service corporation. The respondent held that the petitioner was entitled to a personal service classification for 1918 and settled its taxes for that year accordingly. The respondent denied that the petitioner was a nominal capital corporation for 1917 or a personal service corporation for 1919, 1920, or 1921.
The respondent subsequently made an assessment of an alleged deficiency of $2,296.22 for the year 1917, in respect of which the petitioner seasonably filed its claim in abatement. After further conferences the deficiency for 1919 was reduced by the respondent to $3,615.84, and $1,095.53 of the additional assessment for 1917 was abated, the effect of which was to assess a net deficiency of $1,201.29 for the year 1917.
*583 The deficiencies determined by the respondent are as follows:
| 1917 | $1,201.29 |
| 1919 | 3,615.84 |
| 1920 | 3,236.59 |
| 1921 | 4,776.70 |
| Total | 12,830.42 |
OPINION.
GREEN: The principal questions presented in these cases are whether the petitioner comes within the provisions of section 209 of the Revenue Act of 1917, and section 200 of the Revenue Acts of 1918 and 1921.
Section 209 of the Revenue*4096 Act of 1917 is as follows:
That in the case of a trade or business having no invested capital or not more than a nominal capital there shall be levied, assessed, collected and paid, in addition to the taxes under existing law and under this Act, in lieu of the tax imposed by section two hundred and one, a tax equivalent to eigher per centum of the net income of such trade or business in excess of the following deductions: In the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000; in the case of all other trades or business, no deduction.
Section 200 of the Revenue Acts of 1918 and 1921 is in part 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, *4097 or income derived from trading 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.
The petitioner has invested capital, so we are confronted with the question whether it had "not more than a nominal capital" under the provisions of section 209 of the Revenue Act of 1917. Under this section capital is considered as merely nominal if it is used solely as a fund from which to advance salaries, wages, etc., and to provide office furniture, accommodations and equipment. Under such circumstances it plays no integral part in the actual production of income. It is incidental to the earning power of the corporation which functions independently of it. See . But where the use of capital serves a direct and necessary function in carrying on the business as it was in fact carried on, it is not to be classified as merely nominal. See .
*584 For the year 1917 it has been stipulated that textbooks, supplies and stationery, *4098 which were purchased at a cost of $7,272.88, were sold for $10,336.65, resulting in a net gain of $3,063.77, while in addition $547.43 was received from rentals on typewriters, lockers, etc. The record shows that the petitioner had approximately $5,000 invested capital, and that the taxable net income for the year 1917 was $8,480.82. As the above mentioned $3,610.20 resulted from the use of capital, we are of the opinion that the petitioner is not entitled to be classed as a corporation, having "not more than a nominal capital."
The statutory definition of a personal service corporation contains three elements, all of which must be present before the corporation may be said to come within the definition. First, the income must be ascribed primarily to the activities of the principal stockholders; second, such principal owners or stockholders must be regularly engaged in the active conduct of the corporation's affairs; and, third, capital must not be a material income-producing factor.
T. W. Donoho, who owned 497 shares of the 500 shares of stock of the petitioner, was regularly engaged in the active conduct of the affairs of the petitioner. However, his duties were administrative*4099 and executive. The record shows conclusively that the income can not be ascribed primarily to his activities. The tabulation of the gross income discloses that in all the years under consideration more than 50 per cent of this income was derived from the Washington branch school. This Washington branch was established and operated by a nonstockholder, operating under a contract which gave him a voice in the management and policy of this school. It is true that Donoho was a frequent visitor to Washington and was constantly in telephonic communication, but there is nothing in the record to show that his connection with this school was other than administrative.
The petitioner is here seeking a personal service exemption where the personal service rendered was teaching business courses. It is doubtful if the principal stockholder was qualified to teach anything but typewriting and in any event he did no teaching. The teaching was done by nonstockholder employees and the salaries paid to such employees varied from $60,643.58 in 1919 to $73,548.63 in 1921. In addition the Washington branch, operated by a nonstockholder, was practically as large as the Baltimore school and produced*4100 more income in each of the years under consideration.
In the , where the question of to whom the income should be primarily ascribed was raised, we said:
In our opinion this clause means more than that the stockholders shall obtain the clients and supervise the work, or that clients shall look to their experience; it means, among other things, that the corporation may not rely upon nonstockholders to do a substantial amount of the work which produces the income whether such work be detailed or supervisory. Just as another clause *585 excludes from personal service classification those corporations where capital contributes materially to the income, so does this clause exclude corporations where the services of employees so contribute.
As to the third requisite that capital be not a material income-producing factor, we find that in the three years that the petitioner is seeking personal service classification, its income to be ascribed to the use of capital is as follows: 1919, $7,035.28; 1920, $3,721.05; and 1921, $6,121.04, while the taxable net income for these years was $17,510.85, $14,209.25, and $19,702.51, *4101 respectively. This income from the sale or rental of merchandise bears far too great a proportion to the net income of the petitioner to be termed immaterial.
The petitioner further alleges that the respondent erred in disallowing as a deduction in each of the years 1919, 1920, and 1921, a portion of the salaries paid to T. W. Donoho, its president. The proof offered in support of this allegation consists principally of statements of the witnesses as to the nature and quality of the services rendered by Donoho. This proof establishes beyond question that Donoho possesses all of the qualifications necessary to the success of the petitioner corporation and that due to his ability and activity it has been successful. But there is little, if any, proof of the dollar value of the services rendered in the taxable year. The respondent determined that a reasonable salary for the years 1919 and 1920 was $15,000 and for the year 1921, $25,000. The presumption is that such determinations are correct and there is not in the record evidence sufficient to overcome this presumption.
Reviewed by the Board.
LANSDON dissents.
ARUNDELL: *4102 I am of the opinion that the petitioner is entitled to have its tax for the year 1917 computed under the provisions of section 209 of the Revenue Act of 1917.