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indirectly as shown by accounts payable or other forms of credit, or if the business of the corporation is in any way financed by or through any of the owners or stockholders, these facts will be deemed evidence that the use of capital is necessary. If a substantial amount of capital is used to finance or carry the accounts of clients or customers, it will be inferred that because of competition or other reasons such practice is necessary in order to secure or hold business which otherwise would be lost, and that the corporation is not a personal service corporation. If a corporation engaged in an agency, brokerage or commission business regularly employs a substantial amount of capital to lend to principals, to buy and carry goods on its own account, or to buy and carry odd lots in order that it may render more satisfactory service to its principals or customers, it is not a personal service corporation. In general the larger the amount of the capital actually used the stronger is the evidence that capital is necessary and is a material income-producing factor and that the corporation is not a personal service corporation. (Art. 1532.)

Generally speaking, the test is not the small amount of capital employed, but the nature of the business as indicated by the kind of services rendered, rather than by the extent to which capital is required. If capital is employed, but is not needed for the conduct of the business, the size of the capital alone would not prevent a corporation from being classed as a personal service corporation.

To constitute a "personal service corporation" no definite percentage of stock need be held by those conducting the business.

REGULATION. No.definite percentage of stock or interest in the corporation which must be held by those engaged in the active conduct of its affairs in order that they may be deemed to be the principal owners or stockholders can be prescribed as a conclusive test, as other facts may affect any presumption so established. No corporation or its owners or stockholders shall, however, make a return in the first instance on the basis of its being a personal service corporation unless at least 80 per cent of its stock is held by those regiilarly engaged in the active conduct of its affairs. (Art. 1529.)

The regulations do not require that at least 80 per cent of the stock of the corporation must be held by those regularly engaged in the active conduct of its affairs, but do stipulate that unless 80 per cent of the stock is so held the corporation must first make the corporation return and subsequently make application for the privilege of being classed as a personal service corporation.

The Secretary of the Treasury in his Notes on the Revenue Act of 1918 suggests (page 7) that the fourth paragraph of section 200 be amended to read as follows:

The term “personal corporation” means a corporation (1) whose principal stockholders (a) regularly devote their chief time and attention to the active conduct of the affairs of the corporation, and (b) own not less than 85 per centum of the capital stock of the corporation and (2) in which the number of stockholders not regularly devoting their chief time and attention to the active conduct of its affairs does not exceed ten.

Change of ownership does not take a corporation out of the personal service class.

REGULATION. The fact that the owners or stockholders of the corporation may change during the course of the taxable year does not take a corporation which is normally in the personal service class out of that class. Frequent changes in the ownership of any substantial interest or number of shares are, however, evidence bearing on the question as to whether the principal owners or stockholders are actively engaged in the conduct of the affairs of the corporation. The incapacity, retirement or death of a principal owner or stockholder who has been actively engaged in the conduct of its affairs will not be deemed to make any change in the status of the corporation during a reasonable time thereafter. (Art. 1530.)

Manner of taxing stockholders of a "personal service corporation."REGULATIONS.

An individual stockholder of a personal service corporation is . . . . subject to tax much like a member of a partnership upon his distributive share of the net income of the corporation. The net income of a personal service corporation, as in the case of a partnership, shall be computed in the same manner and on the same basis as the net income of an individual, except that the deduction of contributions or gifts is not permitted. . . . . A corporation which is taxable under section 303 is not a personal service corporation and its stockholders are taxed like stockholders in an ordinary corporation.31 (Art. 328.)

"See page 523.

A stockholder of a personal service corporation is required to include in his gross income for the taxable year (a) any dividends paid by the corporation in such year out of earnings or profits accumulated since February 28, 1913, and before January 1, 1918; (b) his share of any distribution made by the corporation in such year out of earnings or profits accumulated since December 31, 1917, and since the close of its taxable year ending with or during his next preceding taxable year; and (c) his distributive share of the undistributed net income of the corporation for its taxable year ending with or during his taxable year, provided he was at the close of its taxable year a stockholder in the corporation notwithstanding he might since have ceased to be a stockholder. .... In the case of personal service corporations with taxable years other than the calendar year, however, such distributive shares or distributions may be subject to different rates of tax.32 (Art. 330.)

CREDITS ALLOWED STOCKHOLDERS OF PERSONAL SERVICE CORPORATION.

REGULATION. A stockholder of a personal service corporation is entitled to credit for the purpose of the normal tax only for amounts received in distribution of earnings or profits of the corporation accumulated since February 28, 1913, and prior to January 1, 1918. .... In addition to the credits ordinarily allowed to an individual a stockholder of a personal service corporation is entitled to the following credits: (a) a credit against net income for the purpose of the normal tax only of his proportionate share of such dividends from a corporation subject to tax and of such interest not entirely exempt from tax upon obligations of the United States and bonds of the War Finance Corporation as are received by the personal service corporation, and (6) a credit against income tax of the stockholder's proportionate share of income, war profits and excess profits taxes of the personal service corporation paid or accrued during the taxable year to a foreign country upon income derived from sources therein, or to any possession of the United States, subject to the limitations of section 222 of the statute. .... (Art. 331.)

Foreign corporations cannot be classed as personal service corporations.—Even though a foreign corporation doing business in the United States derives all its income from the activities of its principal owners, it cannot be classed as a personal service corporation. The 8 per cent excess profits tax rate no longer applies, so that prima facie such foreign cor

*See Chapter VI, “Rates and Computation of tax," page 152.

poration is subject to the graduated excess profits tax rates, but it can apply for relief under the appropriate sections of the 1918 law. 33

“Trading" corporations cannot qualify as personal service corporations.-When 50 per cent of the gross income of a corporation consists of "gains, profits or income derived from trading as a principal” such corporation cannot qualify as a personal service corporation.$4

Many close corporations carry on extensive business with little invested capital of their own. In some cases the funds necessary to carry on the business are derived from borrowed money and in other cases the trading is done as broker or agent. The reference in the law is to the activities of the principal owners. If the principal owners are not engaged in "trading" as "principals,” the limitation does not apply. This probably will be interpreted to include as personal service corporations certain types of brokerage and commission houses which do not take title to the property they sell and do not have a substantial amount of invested capital. In general, trading is any kind of commercial activity wherein buying and selling of commodities are concerned. Selling the product of one's brains or skill, or selling one's services would appear not to be "trading" in the strict sense of the section. Selling anything else would seem to be trading.

Corporations with large government contracts may not qualify.-When 50 per cent or more of the gross income of a corporation is derived from “gains, profits, commissions or other income derived from a government contractor contracts made between April 6, 1917, and November II, 1918,” it cannot qualify as a personal service corporation." This would include engineering and other corporations whose activities were devoted to government work during 1918.30

"Sections 327 and 328.
“Section 200.
**Section 200.
“For definition of government contract, see section 1.

Corporations which do not distribute earnings may be classed as personal service corporations.—The attempt to impose in the 191837 law a penalty tax on the undistributed profits of all corporations was very properly defeated.

But corporations which do not reinvest their earnings in, nor hold them for the need of, the business may in certain circumstances have to face the charge that the failure to distribute is intended to prevent the imposition of the surtax on stockholders. If and when "the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business" the stockholders will be taxed in the same manner as the stockholders of a personal service corporation.38 As this would mean, first, that the corporation would be subject to excess profits tax, and, second, that the stockholders would be subject to the normal income tax and surtax on the entire balance of the net income of the corporation, it is not likely that any corporation would voluntarily submit to the tax.39

Computation of tax when corporation is partly a personal service corporation.-Section 303 provides that if at least 30 per cent of the net income of a corporation is derived from a business, which if constituting its sole business would bring it within the class of personal service corporations, the tax upon that part of the income shall be computed separately. Such a corporation is subject to the excess profits tax. It should be noted on this point, however, that in computing the tax there must be ascribed to the personal service part of the business the same amount of capital which is normally required by corporations which have been deemed to be personal service corporations not subject to the excess profits tax.

Status of stockholders in personal service corporation.The surplus accumulated prior to December 31, 1917, by a

s See Chapter XXXII for discussion of the 1917 law,
** Section 220.
*See Chapter XXXII.

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