FEDERAL INCOME TAX PROBLEMS FACTS: PROBLEM 1 Illustrating Personal Service Corporations The Architectural Service Co. Inc., organized under the laws of the State of Illinois, is composed of five architects each of whom is actively engaged in the business. It has a paid-in capital of $500.00. The company specializes in planning industrial buildings and its sole income for the taxable year 1921 was as follows: Commissions and consultation fees Total $75,581.96 There is a small office force, but the earnings are due primarily to the activities of the five stockholders. The company has never been involved in a government contract, nor has it ever traded as a principal. QUESTION (A): Is the Architectural Service Co. Inc., a "personal-service corporation," and if so, how is it to be taxed for the year 1921, ANSWER: It is a personal-service corporation because its earnings are due primarily to the activities of its stockholders, and not to its capital invested, nor is its income derived from Government contracts made between April 6, 1917, and November 11, 1918, nor does the company engage in trading. For the taxable year 1 1921 it is not subject to income and profits taxes, but its earnings for the year are taxable in the hands of the stockholders (whether distributed or not) as if it were a partnership. REFERENCES: Sec. 200 (5): "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 incomeproducing 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, 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." Sec. 218 (d): "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 title1 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. . . ." Sec. 231: "That the following organizations shall be exempt from taxation under this title 1-.. (14) Personal service corporations. This subdivision shall not be in effect after December 31, 1921." QUESTION (B): Assuming the same facts as above, except that the taxable year was 1922, how should the company be taxed? ANSWER: In 1922 personal-service corporations are subject to the same taxes and rates as other taxable corporations. The rate in 1922 is 12% of the net income in excess of the credits allowed under section 236. REFERENCE: See Problem 171 for illustration of taxation at 1922 rates. 1 Refers to Title II, covering income tax. PROBLEM 2 Illustrating Taxability as Personal Service Corporation- FACTS: The Swedish Match Export Co., organized under the laws of Sweden, and licensed to do business in the State of New York, is selling agent in America for a certain brand of safety matches. There are five stockholders, two of whom are in charge of the Stockholm office, and three are active in the New York office. The company merely acts as intermediary between manufacturer and purchaser and assumes no obligations to either. Its sole income is derived from the commissions earned in placing the orders, and collecting the agreed sales price. The facts above stated apply for the calendar year 1921. The Swedish Match Export Co. files its returns on the calendar-year basis. QUESTION: Is the Swedish Match Export Co. to be taxed as a "personal service corporation" for the calendar year 1921? ANSWER: No; even though its earnings were solely the result of the activities of the stockholders, and capital was not an incomeproducing factor, and the company did not derive its income from trading as a principal, it would not be taxed as a personal-service corporation because it is a foreign corporation. REFERENCE: Sec. 200 (5). (Quoted under Problem 1.) See Problem 1. PROBLEM 3 Illustrating Taxability of Dividends Distributed By a Personal Service Corporation Out of Earnings Accumulated Prior to March 1, 1913; Subsequent to Feb. 28, 1913, but Prior to January 1, 1918; Subsequent to December 31, 1917, but prior to FACTS: January 1, 1922; Subsequent to December 31, 1921 The Andrews Audit Company, a personal-service corporation, on February 1, 1922 distributes as a dividend its entire surplus which was accumulated as follows: January 1, 1910, to Feb. 28, 1913 March 1, 1913, to Dec. 31, 1917 January 1, 1918, to Dec. 31, 1921 $ 50,000 130,000 270,000 5,000 QUESTION: What portion of this dividend is taxable? ANSWER: The $130,000 and the $5,000 are taxable. The $50,000 accumulated prior to March 1, 1913 and the $270,000 representing the accumulation of earnings of a personal-service corporation in the period from Jan. 1, 1918, to Dec. 31, 1921, inclusive, are upon distribution exempt from tax. REFERENCE: ... Sec. 201 (a): "The term 'dividend' when used in this title 1 means any distribution except a distribution made by a personal service corporation out of earnings or profits accumulated since December 31, 1917, and prior to January 1, 1922. (b) For the purposes of this Act every distribution is made out of earnings or profits, and from the most recently accumulated earnings or profits, to the extent of such earnings or profits accumulated since February 28, 1913; but any earnings or profits accumulated or increase in value of property accrued prior to March 1, 1913, may be distributed exempt from the tax, after the earnings and profits accumulated since February 28, 1913, have been distributed." 1 Refers to Title II, covering income tax. FACTS: PROBLEM 4 Illustrating Taxability of Dividends Paid in The Bellwood Corporation declared a dividend of $150,000 payable in Liberty Bonds having a par value of that amount. The market value of the bonds on the date the dividend was payable was $140,000. On the same date the company had a surplus of $300,000, all earned since 1913. QUESTION: At what amount must the stockholders report the dividends as income? ANSWER: Dividends subject to tax, received in the form of property of any kind, should be taken into income at the fair market value of such property as of the date receivable. REFERENCE: Art. 1547, Regulations 62: "Dividends paid in securities or other property (other than its own stock) in which the earnings of a corporation have been invested, are income to the recipients to the amount of the market value of such property when receivable by the stockholders. . . PROBLEM 5 Illustrating Taxability of Cash Dividends Declared Payable Out of Depletion Reserve FACTS: The Evans Engineering Corporation on December 15, 1921, declared a cash dividend of $188,000 payable Dec. 31, 1921, $160,000 to be paid out of the company's depletion reserve. The balance sheet of the company on December 31, 1921, appeared as follows: |