Strayer's Business College, Inc. v. Commissioner

*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:

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:

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,

First: To rent or lease rooms in the town of Frederick, Md., or elsewhere, in which a branch of Strayer's Business College may be conducted by the party of the second part, and to fix up or equip*4077 said rooms with such furniture and fixtures as the president and the business manager of Strayer's Business College may agree upon as necessary or desirable for the purpose of conducting said branch school; said rooms to be rented or leased and fitted up in July or the early part of August, 1904, and the party of the first part further agrees to change, renew, or increase the equipment of said branch school whenever, in the judgment of the president and the business manager of Strayer's Business *576 College, said change, renewal, or increase of the equipment is desirable or essential to the prosperity of said branch school.

Second: To advance such sums of money as may be necessary for the payment of rent, advertising, and other necessary expenses of the branch school prior to the opening of the branch school, it being understood and agreed that the money received by the branch school for tuition, from the sale of text-books, or from any other source, shall be used to meet the necessary running expenses of the branch school and that so much thereof as may be necessary of any money received more than enough to meet the running expenses of the branch school, shall be used*4078 to return to the party of the first part whatever money may have been advanced as hereinbefore provided; it being distinctly understood and agreed that the profit on the branch school hereinafter referred to, shall be the amount which the branch school's receipts for tuition, text-books, etc., exceeds the entire operating expenses of said branch school, all of the outlay on said branch school being considered as operating expenses, except such money as may be expended by the party of the first part for equipment of a permanent nature.

Third: To give the party of the second part, when desired and asked, the benefit of the judgment of its president or business manager on all such matters as may pertain to the successful conducting of the branch school.

Fourth: To furnish to the party of the second part, without charge, all such text-books as the president and the business manager of Strayer's Business College may agree upon as necessary or desirable for use in said branch school; it being understood that if such text-books are sold to students, the money received for them will be part of the receipts of the branch school, just as though said money was paid to the branch*4079 school for tuition.

Fifth: To pay to the party of the second part, as remuneration for his services for conducting said branch school for the party of the first part, on the last day of July 1905 and on the last day of July of each succeeding year during the continuance of this contract, from the funds of the branch school, a sum equal to one half of all the profit on said branch school during the preceding year, the amount of said profit to be arrived at in the following manner; the sum of the gross receipts of the branch school for tuition, text-books, stationery, and from every other source, shall first be found and from such sum shall be subtracted the sum of all expenditures of the branch school for rent, teachers' salaries, advertising, stationery and supplies, fuel, light, insurance, taxes, and all other expenditures of every description during the year, and the difference shall be known to the parties to this agreement, as the profit on the business during the preceding year; it being understood and agreed that at the time of a final settlement, in the event of the termination of this contract, all book accounts due the branch school, shall be counted to the extent of*4080 their probable collectable value as part of the gross receipts, and that all indebtedness of the branch school shall be counted as part of the expenditures of the branch school in determining the amount of profit on the branch school for the purpose of a final settlement by the party of the first part and the party of the second part.

Sixth: To renew this contract at the end of each term if the party of the second part wishes to renew it, provided that after the first two years the profit accruing to the party of the first part shall amount each year to a sum equal to not less than the wholesale price of the textbooks furnished to the party of the second part plus ten per cent of the original cost of the equipment in the branch school.

*577 Seventh: That in the event of the death of the party of the second part, during the continuance of this agreement, at the end of the month in which such death occurs, the party of the first part shall compute the amount of profit on the business from the time of the last prior settlement until that time, and shall and will make an equitable settlement with the estate of the party of the second part.

The party of the second*4081 part doth agree and bind himself,

First: To devote his entire time and best efforts to the up-building, developing, managing, and conducting of the branch school opened in the town of Frederick, Md., or elsewhere for him, beginning on the first day of August 1904 and continuing so long as this contract shall remain in force.

Second: To keep or cause to be kept, correct records of all cash received and all cash paid out by or for the branch school in question, said records and vouchers therefor to be kept in such manner as the president or the business manager of Strayer's Business College shall direct, and also to keep permanent records of the names and addresses of all students enrolling in the branch school, and of all persons writing to or inquiring terms of the branch school, and of all persons applying at the branch school for office help, together with all such other records as the president of the business manager of Strayer's Business College shall direct.

Third: To use due diligence in caring for the equipment, records, and any other property connected with the branch school which may be under his care.

Fourth: To give bond in whatever sum the president*4082 or the business manager of Strayer's Business College may desire from time to time, the cost of said bond to be paid out of the receipts of the branch school.

Fifth: To have no connection of any kind whatsoever, either as owner, part owner, teacher in, or in any other way with any other school in the town or within twenty-five miles of the town in which the branch school hereinbefore referred to is located during the period of five years next succeeding the termination of this contract.

It is mutually agreed,

First: That this contract shall be for a period of one year, beginning on the first day of August, 1904, and ending on the last day of July 1905, and it is further agreed that this contract shall thereafter be renewable from term to term for periods of one year each counting from the first day of August in any year until the last day of July in the next succeeding year, and that it shall stand renewed at the end of each term for the succeeding term unless it shall have been terminated in the way and manner hereinafter provided for:

Second: That the party of the first part may terminate this contract at the end of any term in which it shall be found that the*4083 profit accruing to the party of the first part is less than the wholesale price of the text-books furnished to the party of the second part, plus ten per cent of the original cost of the equipment in the branch school, provided it can be proved that the failure to make such profit for the party of the first part can justly be attributed to gross negligence or inattention to business on the part of the party of the second part, or without such proof at the end of any term when, for each of three successive terms, the profit on the business accruing to the party of the first part has been less than the wholesale price of the text-books furnished to the party of the second part, plus ten per cent of the original cost of equipment in the branch school, in either case, by giving not less than three month's notice in writing to the party of the second part that it will not renew the contract at the end of the current term, in the event of the profit on the business for said term being *578 less than the wholesale price of the books furnished to the party of the second part plus ten per cent of the original cost of the equipment in the branch school.

Third: That the party of*4084 the second part may terminate this contract at the end of any term by giving not less than three months notice in writing to the party of the first part that he will not renew the contract at the end of the current term.

Fourth: That all authority in conducting the branch of Strayer's Business College, hereinbefore referred to, shall during the continuance of this contract, be divided between the party of the first part and the party of the second part, and that in matters of importance, such as renting additional or other rooms, employing and discharging teachers, and other employees, increasing or diminishing salaries of teachers or other employees, doing extensive advertising, changing rates of tuition, or altering in any way the plan or policy of the school, nothing shall be done without the consent of the party of the second part and the consent of either the president or business manager of Strayer's Business College.

Fifth: That all proprietary interest in the branch school hereinbefore referred to, shall be vested in the party of the first part, and that the only interest in said branch school which the party of the second part shall have shall be such interest*4085 as is by this contract established.

Sixth: That the party of the second part shall have the custody of the funds of the branch school hereinbefore referred to, and that after the money advanced by the party of the first part has been refunded, if, at the end of any month after all operating expenses to date have been paid, there is a balance of cash on hand, each party to this agreement may, at his option, draw for current use the amount of profit due him, the sum of all such drafts by each party during any term not to exceed one half of the approximated profit on the business to date and all amounts so drawn to be charged against the personal account of the party making them and reckoned as cash received by said party at the time of making the annual division of the profit on the business on the last day of July in each year.

Seventh: That the party of the first part and the party of the second part, either personally or through their representatives, shall at all times have equal access to all books, accounts, records, etc., of the branch school during the continuance of this contract.

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:

*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:

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:

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.

Judgment will be entered for the respondent.

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.