Fairfax Mut. Wood Products Co. v. Commissioner

Fairfax Mutual Wood Products Company, Fairfax, South Carolina, Petitioner, v. Commissioner of Internal Revenue, Respondent Fairfax Mut. Wood Products Co. v. Commissioner Docket No. 7784 United States Tax Court 5 T.C. 1279; 1945 U.S. Tax Ct. LEXIS 20; December 19, 1945, Promulgated *20 Decision will be entered under Rule 50. 1. Where a corporation's gross income appears to have been entirely derived from trading as a principal and it appears that the use of capital in the business was a material income-producing factor, held, such corporation is not entitled to the classification of a personal service corporation under section 725 (a) of the Internal Revenue Code. 2. In the circumstances here present a penalty of 25 percent under section 291 (a) of the Internal Revenue Code for failure to file an excess profits tax return may not be imposed. George Warren, Esq., and J. W. Hunt, C. P. A., for the petitioner. F. L. Van Haaften, Esq., for the respondent. Arundell, Judge. ARUNDELL *1279 This proceeding involves a deficiency in excess profits taxes*21 for the calendar year 1941 in the amount of $ 819.92, and a delinquency penalty of $ 204.98. The main issue is whether the petitioner is a personal service corporation as defined by section 725 (a), Internal Revenue Code, and thus entitled to the election provided for by section 725 (b), under which it may be exempt from excess profits tax. If not a personal service corporation, the further question arises of whether petitioner is subject to a penalty of 25 percent of the tax under section 291 (a), Internal Revenue Code, for its failure to file an excess profits return for the year in question. *1280 FINDINGS OF FACT. The petitioner company was organized under the laws of the State of South Carolina on March 13, 1940, with a total capital stock of $ 1,000, represented by common stock at $ 1 per share. Its business was the manufacture of fine furniture dimensions from wood. The output was composed of articles such as bed posts, table legs, table borders, cabinet parts, etc., made to the specification of a customer to fit his particular needs. Production required a high degree of craftsmanship and skill. Originally the plant, then known as the Dimension Plant, had been owned*22 solely by Charles W. Brewer. In the latter part of 1939 it was agreed between Brewer and a number of his employees that a corporation, in which the employees would subscribe for stock, should be formed to carry on the business. That agreement resulted in the formation and incorporation of the petitioner company. Of the authorized capital stock of 1,000 shares, 565 were paid for on January 1, 1941, and a total of 625 shares were subscribed and paid for at the end of that year. Two hundred and fifteen shares were owned by C. W. Brewer, president of the company, a total of 200 shares were owned by his four minor children, 100 shares were owned by Ella Goethe, secretary and treasurer of the company, and the remaining outstanding shares were owned by 22 employees, each of whom held 5 shares. The total capital paid in amounted to $ 625. The balance of the stock was held in the treasury. The petitioner corporation leased the plant and equipment from Brewer at an annual rental which was intended to represent 10 percent of the value per year of the plant. New equipment and improvements installed by Brewer were to be paid for at the rate of 10 percent per year. For the year in question*23 the total rent amounted to $ 5,022. Brewer loaned the petitioner money from time to time. While the record discloses that interest in the amount of $ 676.06 was paid during 1941, it does not disclose to whom the payments were made. The petitioner company bought logs which it cut into lumber and also bought lumber. The lumber, after being kiln-dried, if necessary, was taken into the finishing plant, where it was cut into dimensions according to the order of a customer, usually a furniture manufacturer. In the taxable year 1941 gross sales amounted to $ 101,618.11. The cost of goods sold amounted to $ 74,974.45, leaving a gross profit of $ 26,643.66 from sales. Inventory at the beginning of the year was $ 2,619.75. Material or merchandise bought for manufacture or sale during the year amounted to $ 55,362.78, while salaries and wages totaled $ 19,036.23. Other costs per the books of the company were $ 2,796.08. The closing inventory, at cost, was $ 4,840.39. *1281 During 1941 approximately 50 persons were employed by petitioner. Of that number about 24 were stockholders. Stockholder employees were given periodic wage bonuses, comprising a given percentage of their salaries, *24 when profits permitted. The remaining profits were distributable as dividends at the end of the year. Petitioner classed a majority of its employees as skilled workers. Petitioner attached a statement to its corporation income and declared value excess profits tax return filed for the year 1941, in which it explained the organization and operations of the corporation and indicated that it considered itself to be a personal service corporation within the meaning of the statute. Petitioner further stated that it elected to be classed as a personal service corporation and that the stockholders had included their share of the profits in their individual income tax returns. Brewer, the president of petitioner, discussed the matter with the collector and his representatives at the time the return was being prepared and was advised that a return as set out above would be satisfactory. Petitioner's failure to file an excess profits tax return was due to reasonable cause and not to willful neglect. The respondent, in his notice of deficiency, determined that petitioner was not a personal service corporation as that term is defined in the applicable statute and that petitioner was subject*25 to excess profits tax. He further determined that, since petitioner had failed to file an excess profits tax return on Form 1121 for the taxable year 1941 within the time prescribed by law, 25 percent of the tax should be added thereto in accordance with the provisions of section 291(a), Internal Revenue Code. OPINION. The principal question is whether the petitioner was a personal service corporation in 1941. Under the applicable statute, section 725 (a) of the Internal Revenue Code, 1 certain requirements must be met before a corporation is entitled to be so classified. In the main, the standards set are that the corporate income must be ascribed primarily to the activities of shareholders who are regularly engaged in the business and at all times own at least 70 percent *1282 of the corporation's capital stock. Capital must not be a material income-producing factor. Any corporation 50 percent or more of whose gross income is derived from doing business as a principal is excluded. *26 In our opinion the petitioner does not meet the requirements of the statute. In the first place, its entire gross income appears to have been derived from trading as a principal. Petitioner bought and sold only for its own account, and not as agent or broker for another. It is true that the processing and finishing by petitioner of logs and lumber purchased by it contributed to the sale prices received. However, even though such processing and finishing were on the basis of specifications submitted by a customer, petitioner's services were not those of an agent, nor was its business conducted on a commission basis. Petitioner assumed all the risks of business. Its gross profit was not measured by the value of the services it performed, but by the difference between the sale prices of the products and the cost of manufacturing them. Though it produced only "parts," petitioner was nevertheless a primary trader. One of the requirements of the statute is that capital (whether invested or borrowed) 2 is not a material income-producing factor. Here it appears that it was. The processing and finishing of fine furniture from logs or lumber, on the scale undertaken by the petitioner*27 company, obviously required the use of a plant and equipment. The use of such facilities, valued at around $ 50,000, was obtained by petitioner under a lease in consideration of an annual rental payment. The plant and equipment were necessary to the conduct of the business. When the use of capital plays a vital part in the carrying on of the business, it can not be said that its use is merely incidental thereto. Hubbard-Ragsdale Co. v. Dean, 15 Fed. (2d) 410; affd., 15 Fed. (2d) 1013. It has been held that a valuable leasehold constitutes capital, Cotton Hotel Co. v. Bass, 7 Fed. (2d) 900; Bowe-Burke Mining Co. v. Willcuts, 22 Fed. (2d) 204; Vermillion Coal Co., 12 B. T. A. 1161; and, while we do not have access to the terms and conditions of the lease here involved, it appears that the same ruling should apply. Moreover, though its paid in capital was small, petitioner enjoyed the use of borrowed capital and credit upon which it paid interest. Petitioner also extended credit. *28 Only about 24 of petitioner's 50 employees were shareholders. Most of the employees were skilled. It does not appear that the value of and the compensation charged for the services of the skilled nonshare holder employees were attributable to the skill or supervision of the shareholders. The circumstances herein preclude petitioner from obtaining the benefits of the statute in question. *1283 Cocks-Clark Engraving Co., 8 B. T. A. 468, and Innes-Behney Optical Co., 7 B. T. A. 982, relied upon by the petitioner, are clearly distinguishable from the instant case. While we have concluded that the petitioner corporation did not, in 1941, fall within the statutory definition of a personal service corportation, we believe the record amply supports the view that petitioner's failure to file an excess profits tax return was due to reasonable cause and not due to willful neglect. Petitioner's president, Brewer, discussed fully the matter of making returns with the local collector and his subordinates and was told to file the income tax return and to attach thereto a statement explaining the operation of the business and *29 the basis for the corporation's claim. A statement, entitled "Schedule explaining absence of excess profits tax return," was attached to the return. It contained an explanation of the manner in which petitioner conducted its business, a list of the stockholders and the number of shares owned by each, and a statement to the effect that petitioner considered itself a personal service corporation and that, although its profits had not been distributed, the stockholders had included their share of the profits of the corporation in their individual returns and had paid the tax thereon. We do not think that we are warranted in holding that a corporation claiming the benefits of section 725, supra, does so at its peril. An election, in good faith, based upon an analysis of its own business should not, we think, open the way to the imposition of the penalty if such election be an erroneous one. Petitioner did not willfully neglect to file an excess profits tax return, but advisedly refrained from filing in a reasonable belief that none was required of it. It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable*30 care. Such errors are corrected by the assessment of the deficiency of tax and its collection with interest for the delay. Spies v. United States, 317 U.S. 492. The imposition of the delinquency penalty under section 291 (a) is not justified. Decision will be entered under Rule 50. Footnotes 1. SEC. 725. PERSONAL SERVICE CORPORATIONS. (a) Definition. -- As used in this subchapter, the term "personal service corporation" means 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; but does not include any foreign corporation, nor any corporation 50 per centum or more of whose gross income consists of gains, profits, or income derived from trading as a principal. For the purposes of this subsection, an individual shall be considered as owning, at any time, the stock owned at such time by his spouse or minor child or by any guardian or trustee representing them. * * * *↩ 2. Conference Committee Report, H. R. 3002, 76th Cong., 2d sess. (C. B. 1940-2, pp. 548, 557).↩