Trout-Ware, Inc. v. Commissioner

*505 The Commissioner determined deficiencies in excess profits tax of $ 8,475.33 for 1943 and $ 2,841.85 for 1944. The only issue for decision is whether the petitioner was a personal service corporation during the taxable years within the meaning of section 725 of the Internal Revenue Code.

FINDINGS OF FACT.

The petitioner, a corporation, filed its returns for the taxable years with the collector of internal revenue for the eighteenth district of Ohio.

The petitioner is engaged in the business of portrait photography. Its outstanding stock during the taxable years consisted of 61 shares of no par value common stock, 45 of which were owned by Alice A. Trout, hereinafter called Alice.

Alice and M. K. Ware organized the petitioner in 1929 and did all the work during the first years *72 of its existence. Ware took the pictures and both he and Alice were capable of doing most of the things necessary to produce a finished picture. Alice had studied art and for six years prior to the formation of the petitioner she had painted miniatures and done finish retouching for a photographer. Ware was in the military service during the taxable years and had not been very active in the petitioner's business for about ten years prior thereto.

Alice was president and treasurer of the petitioner during the taxable years and held either one or the other of those offices at all times material hereto.

Most of the petitioner's business is obtained through appointments made by telephone solicitation. Alice was responsible for the petitioner's first business contacts, she originated its method of telephone solicitation, and trained the other employees who make such solicitations.

The petitioner employed two photographers, John Barkovich and Bernard Lombard. Barkovich worked chiefly in the studio of the petitioner and Lombard took pictures in customers' homes. Lombard started working for the petitioner in 1933 and Barkovich in 1937. Lombard had had prior experience in photographing*73 children, but *506 Barkovich had had very little prior experience in photography. Both were trained for their work with the petitioner by Alice and she continued to criticize their photographs. The work of the photographers required a knowledge of lighting and posing subjects and a pleasant personality for dealing with customers. Alice never took any pictures herself.

After a picture was taken by the photographers, the negatives had to be developed. That work required considerable skill in handling materials and was done by Ted Hall and his assistant, Carl Eysenbach. Hall entered the petitioner's employ about 1940. He had had prior experience.

Various corrections such as softening heavy shadows and blocking out harsh lines and blemishes were then made with pencils on every negative. That work was done chiefly by Alice. Barkovich did some of it during rush hours and Alice was training a girl to assist her with it during the taxable years.

Photographs called proofs were printed by Hall and Eysenbach from those corrected negatives and Alice made further corrections with pencils on those proofs. That work was a very important income-producing factor because the corrected*74 proof was the thing on which a customer based his order and the guide or standard for the work of all the other employees. The proof correcting was done only by Alice, except in extreme situations, and in those cases the results were not as good as those obtained by her.

The next step was to transfer to the negatives the corrections that had been made on the proofs by Alice. The finish retouching had to follow precisely the corrections indicated on the proofs. That work requires skill and some artistic talent. It was done by Barkovich and William Schnitzbauer. The latter was employed by the petitioner in 1931. Barkovich had had twelve years experience at finish retouching before coming with the petitioner, but Schnitzbauer had had none. Both men were taught the petitioner's methods of finish retouching by Alice and Ware, and Alice continued to supervise their work.

Test prints were made from the negatives after they had been worked on and they were checked by Barkovich and Schnitzbauer to see if all the required changes had been made on the negative.

A final print was then made and the last step was to make additional delicate corrections with brush and india ink on that print. *75 It took considerable artistic ability to do that work in such a fashion as to copy the changes indicated on the corrected proof and still make the finished portrait look natural. Alice hired girls from art schools and taught them how to finish the final prints. Florence Bene did that work during the taxable years.

*507 Alice did her work at a table in the reception room of the petitioner's studio so that she could help customers as they came in and so that people passing the studio window could see her at her work. Many of the petitioner's customers visited its studio only when they could talk to Alice personally. She was the only one who handled complaints. She did very little selling herself during the taxable years. The chief sales girl, bookkeeper, and office manager was Antoinette Sberna. Alice worked at the studio every day during the taxable years, took work home with her at night, and had not taken a vacation in five years.

The following table shows the total salaries paid by the petitioner during the taxable years to its officers and all but one of its full time employees:

*76 Nine other employees were paid a total compensation of $ 4,934.62 during the taxable years.

The petitioner's annual net income after income taxes for the years 1943 and 1944 was about $ 11,000. Its depreciable assets after depreciation were $ 358.94 for 1943 and $ 127.31 for 1944. Its physical assets consisted of furniture, cameras, paper, film, and holders. It had no borrowed capital.

Capital was not a material income-producing factor in the petitioner's business during the taxable years.

The petitioner did not derive any of its income during the taxable years from trading as a principal.

The Commissioner gave the following explanation for determining the deficiency:

In filing your returns for the years 1943 and 1944 you claimed to be a personal service corporation and elected not to be subject to the excess profits tax under Subchapter E of Chapter 2 of the Internal Revenue Code. It is held that you are not a personal service corporation within the provisions of Section 725 of the Internal Revenue Code and are subject to excess profits tax under Subchapter E of Chapter 2 of the Internal Revenue Code.

The income of the petitioner for each of the taxable years is to be ascribed*77 primarily to the activities of Alice A. Trout.

*508 The petitioner was a personal service corporation within the meaning of section 725 (a) of the Internal Revenue Code during the taxable years.

OPINION.

Section 725 exempts corporations from the excess profits tax under subchapter E if they so elect and come within the definition of a personal service corporation as defined in section 725 (a). The provisions of supplement S to chapter I then apply to the shareholders of the corporation. A personal service corporation is defined in (a) as "a corporation whose income is to be ascribed primarily to the activities of shareholders who are regularly engaged in the active conduct of the affairs of the corporation and are the owners at all times during the taxable year of at least 70 per centum in value of each class of stock of the corporation, and in which capital is not a material income-producing factor."

The petitioner in this case made the election provided in section 725 (b). The respondent argues, feebly, that capital was an income-producing factor, but the evidence shows that it was not. The only other argument of the respondent is that the income of this corporation can*78 not be ascribed primarily to the activities of Alice Trout. She was regularly engaged in the active conduct of the affairs of the petitioner and she owned during the taxable years in excess of 70 per centum of the stock. The other stockholder, Ware, was not regularly engaged in the active conduct of its affairs during the taxable years and had not been for several years. The contention of the petitioner is that Alice "controlled the quality of each portrait by her skillful work in retouching negatives and correcting proofs." The petitioner concedes that other employees had skill, but argues that they merely carried out her ideas, suggestions, and corrections in order to bring each finished photograph up to the standards which she set.

This case presents a rather close question as to whether the petitioner has sustained its burden of proof, that is, whether it has shown that its income is to be ascribed primarily to the activities of Alice Trout. She and a number of the other employees of the petitioner testified, in effect, that she was the dominant personality in the organization, the correcting and retouching she did was the most important single step in giving the portraits*79 quality and distinction, and she, by her criticisms and suggestions to her subordinates, caused them to do the work which was necessary to assist her in creating the finished product. There is also evidence that customers came to the petitioner because of the quality and distinction which Alice Trout gave to the photographs produced by the petitioner.

On the other side there is the determination of the Commissioner that this was not a personal service corporation, evidence that a number *509 of the other employees were making substantial contributions to the success of the petitioner, and the amount of compensation paid to Alice and the other employees, which indicates that the corporation itself in fixing salaries did not regard Alice as so important as the testimony might indicate. However, after carefully analyzing all of the evidence, a finding has been made that this was a personal service corporation during the taxable years. The Commissioner made no effort to overcome the prima facie showing of the petitioner. He undoubtedly knows much of the affairs of many photographers in Cleveland and other cities of the United States, and if the activities of Alice were not relatively*80 as important as the testimony in this case indicates, the Commissioner could have brought in countervailing evidence. This case, of course, must be decided upon the evidence in the record, and that evidence preponderates slightly in favor of the petitioner.

Decision will be entered for the petitioner.

Black, J., dissenting: I respectfully dissent from the majority opinion wherein it holds that petitioner was a personal service corporation within the meaning of section 725 (a) of the Internal Revenue Code during the taxable year. I readily agree with the majority opinion that the facts show that capital was not a material income-producing factor in petitioner's business. But I am unable to agree with the conclusion that petitioner's income in the taxable year is to be ascribed primarily to the activities of one of its stockholders, namely, Alice Trout.

It is unnecessary, of course, to emphasize that the excess profits tax statute is a complicated one and Congress has conferred upon the Treasury Department authority to promulgate regulations in its enforcement. The Treasury has done that in Regulations 112, section 35.725-2 (c) of which reads in part as follows:

* *81 * * If employees other than shareholders contribute substantially to the services rendered by a corporation, such corporation is not a personal service corporation unless, in every case in which services are so rendered, the value of and the compensation charged for such services are to be attributed primarily to the experience or skill of the shareholders and such fact is evidenced in some definite manner in the normal course of the business or profession. The fact that the shareholders give personal attention or render valuable services to the corporation as a result of which its earnings are greater than those of a corporation engaged in a like or similar business or profession, the shareholders of which are not regularly engaged in the activities of the corporation, does not of itself constitute the corporation a personal service corporation.

So far as I am able to see the foregoing is a reasonable and valid regulation in the enforcement of section 725. I do not think that petitioner *510 has borne the burden of proof in bringing itself within the ambit of the foregoing regulation. In fact I would say that the facts as found in the majority report affirmatively show that*82 petitioner does not bring itself within the foregoing regulation. Therefore, I think that the ultimate finding of the majority that "The petitioner was a personal service corporation within the meaning of section 725 (a) of the Internal Revenue Code during the taxable year" is not justified and therefore should not be made.