Distributions by limited partnerships.-All divisions of profits by limited partnerships which are of the corporation type should be treated by the partners as dividends. The normal tax will have been paid, so that in 1919 the recipients will receive credit of 8 per cent on such distributions in calculating their normal tax.

Undivided profits will not be subject to the surtax on the returns of partners of the limited partnership as is the case with ordinary partnerships, but limited partnerships of the corporation type are subject to the excess profits tax.

Personal Service Corporations Grouped with
Partnerships

In an attempt to put partnerships and corporations on a more equal footing the 1918 law established a class of "personal service corporations" which are to be considered partnerships for income tax purposes. They are specifically exempt from the corporation income and excess profits tax.29

LAW. Section 218. (e) Personal service corporations shall not be subject to taxation under this title, but the individual stockholders thereof shall be taxed in the same manner as the members of partnerships. All the provisions of this title relating to partnerships and the members thereof shall so far as practicable apply to personal service corporations and the stockholders thereof: Provided, That for the purpose of this subdivision amounts distributed by a personal service corporation during its taxable year shall be accounted for by the distributees; and any portion of the net income remaining undistributed at the close of its taxable year shall be accounted for by the stockholders of such corporation at the close of its taxable year in proportion to their respective shares.

"Personal service corporation" defined.

LAW. Section 200. . . 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

"Law, section 231 (14). (See page 57.)

foreign corporation, nor any corporation 50 per centum or more of whose gross income consists either (1) of gains, profits 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 following illustrations used by Mr. Kitchin may be considered an authoritative expression of the intention of Congress.

30

An insurance agency that writes insurance on commissions and requires no capital; a corporation of architects, which requires no capital; a lawyers' guaranty title company that looks up titles and requires no capital; any company where the earnings may be ascribed primarily to personal services and in which capital is not a material income-producing factor. . . . . where it (capital) is not actually required-where the business does not require them to have capital.

The regulations of the Treasury have deviated somewhat from this expression of legislative intent. It was to be expected from this expression that the controlling test would be found in an answer to the question: "Is capital (invested or borrowed) a material income-producing factor?" No rule can be laid down which can be used as an infallible answer to the question. Each taxpayer who believes that he may claim the benefit of the section is entitled to have his claim considered on its merits.

REGULATION. The term "personal service corporation" means a corporation, not expressly excluded, the income of which is derived from a profession or business (a) which consists principally of rendering personal service, (b) the earnings of which are to be ascribed primarily to the activities of the principal owners or stockholders, and (c) in which the employment of capital is not necessary or is only incidental. No definite and conclusive tests can be prescribed by which it can be finally determined in advance of an examination of the corporation's return whether or not it is a personal service. corporation. In the following articles are laid down the general principles under which such determination will be made. . . . . (Art. 1523.)

Congressional Record, September 18, 1918, page 11329, but this was said before the provision was inserted eliminating "traders" from the scope of the definition.

I. What constitutes rendering of personal service?-
SERVICES MUST BE RENDERED PRINCIPALLY BY THE

(a)

STOCKHOLDERS.

REGULATION. In order that a corporation may be deemed to be a personal service corporation its earnings must be derived principally from compensation for personal services rendered by the corporation to the persons with whom it does business. Merchandising or trading either directly or indirectly in commodities or the services of others is not rendering personal service. Conducting an auction, agency, brokerage, or commission business strictly on the basis of a fee or commission is rendering personal service. If, however, the corporation assumes any such risks as those of market fluctuations, bad debts, failure to accept shipments, etc., or if it guarantees the accounts of the purchaser or is in any way responsible to the seller for the payment of the purchase price, the transaction is one of merchandising or trading and this is true even though the goods are shipped directly from the producer to the consumer and are never actually in the possession of the corporation. The fact that earnings of the corporation are termed commissions or fees is not controlling. The fact that a commission or fee is based on a difference in the prices at which the seller sells and the buyer buys raises a presumption that the transaction is one of merchandising or trading, and it will be so considered in the absence of satisfactory evidence to the contrary. (Art. 1525.)

It will be noted that any agency or brokerage business conducted strictly on the basis of fees or commissions is deemed to be rendering personal service, but that any trading in commodities or the services of others is not rendering personal service. This is hardly consistent, because many businesses use the services of employees, in which case there is a trading in such services. The official illustration in Chapter V, Excess Profits Tax Procedure, deals with a corporation which renders engineering services and assumes an income of $60,000 therefrom. It may reasonably be assumed that the fees paid for services are for the services of others than the principal stockholders. If the use of capital is the fundamental test there is practically no more capital required to pay the salaries of employees than for the salaries or living. expenses of the principal stockholders. The language of the

statute would seem to be broad enough to include as personal service corporations those which trade in the services of others.

(b) THE BUSINESS MUST BE CONDUCTED PRINCIPALLY

BY THE STOCKHOLDERS.—

REGULATION. In determining whether a corporation is a personal service corporation, no weight can be given to the fact that it renders personal services unless (a) the principal owners or stockholders are regularly engaged in the active conduct of its affairs and are engaged in such a manner that the earnings are to be ascribed primarily to their activities, and (b) its affairs are conducted principally by such owners or stockholders. (Art. 1527.)

2. To what extent must the earnings be derived from services rendered by the stockholders?—

(a) A NON-PERSONAL SERVICE ELEMENT MAY BE PRESENT

IF IT IS NEGLIGIBLE.

REGULATION. It frequently happens that corporations are engaged in two or more professions or businesses which are more or less related, one of which does not consist of rendering personal service. Thus an engineering concern may also engage in contracting, which amounts to trading in materials and labor, a brokerage concern may guarantee some of its accounts, a photographer may sell pictures, frames, art goods and supplies, or a dealer in a commodity may furnish expert advice or services with respect to its installation, use, etc. In such case the corporation is not a personal service corporation unless the non-personal service element is negligible or merely incidental and no appreciable part of its earnings. are to be ascribed to such sources. ... (Art. 1526.)

An advertising agency which is incorporated, the principal owners of which are personally engaged in the business, although capital is employed to carry the accounts of customers, would probably be classed as a personal service corporation. In such a case capital would be no more than incidental and would not be a material income-producing factor.

(b) EARNINGS ARE NOT DERIVED FROM PERSONAL SER

VICES IF THE PRINCIPAL DUTIES OF THE STOCKHOLDERS ARE TO SUPERVISE A FORCE OF EMPLOYEES.

REGULATION. Where the principal owners or stockholders do not render the principal part of the services, but merely supervise

or direct a force of employees, the corporation is not a personal service corporation. If employees contribute substantially to the services rendered by a corporation, it 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 principal owners or stockholders and such fact is evidenced in some definite manner in the normal course of the profession or business. The fact that the principal owners or stockholders 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, the principal owners or stockholders of which do not devote personal attention to the management or supervision of its affairs, does not of itself constitute the corporation a personal service corporation. (Art. 1528.)

3. To what extent may capital be used to conduct the business?

(a) CAPITAL MUST NOT BE A MATERIAL INCOME-PRODUC

ING FACTOR.—

REGULATION. In determining whether a corporation is a personal service corporation, no weight can be given to the fact that the invested capital of the corporation for the purpose of the war profits and excess profits tax or the actual investment of the principal owners or stockholders is comparatively small. The test established by the statute with respect to capital is entirely different. That test is the nature of the profession or business as indicated (a) by the kind of services it renders and (b) the extent to which capital is required to carry on such profession or business. If the use of capital is necessary or more than incidental, capital is a material income-producing factor and the corporation is not a personal service corporation. No corporation is a personal service corporation if it carries on business of a kind which ordinarily requires the use of capital, irrespective of whether the owners or stockholders have actually invested a substantial amount of capital. (Art. 1531.)

(b) THERE MUST NOT BE A SUBSTANTIAL AMOUNT OF

CAPITAL EMPLOYED, WHETHER SECURED DIRECTLY OR INDIRECTLY.

REGULATION. The term "capital" as used in section 200 of the statute . . . . means not only capital actually invested by the owners or stockholders, but also capital secured in other ways. Thus if capital is borrowed either directly as shown by bonds, debentures, certificates of indebtedness, notes, bills payable or other paper, or