Kalker v. Comm'r of Internal Revenue
| Decision Date | 04 August 1983 |
| Docket Number | Docket No. 5554–81. |
| Citation | 81 T.C. No. 8,81 T.C. 91 |
| Parties | JOHN E. VAN KALKER, JR. and CAROL VAN KALKER, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner owned and operated an ornamental iron business as a sole proprietor. Pursuant to orders solicited by petitioner, petitioner's employees fabricated ornamental iron railings and other iron products out of an inventory of crude iron rods, using equipment and machinery. Petitioner then installed the finished products.
Held: Capital was a material income-producing factor in such business within the meaning of sec. 1348, I.R.C. 1954. John M. Van Der Aa and Russell T. Paarlberg, for the petitioners.
Ronald A. Stein, for the respondent.
Respondent determined a $14,578 deficiency in petitioners' 1978 Federal income tax. The only issue is whether capital is a material income-producing factor in petitioners' ornamental iron business.
Some of the facts are stipulated and found accordingly.
Petitioners John E. Van Kalker, Jr. and Carol Van Kalker, resided in South Holland, Illinois, when they filed their petition herein.
For the past 23 years, John E. Van Kalker, Jr. (hereinafter petitioner), has been a sole proprietor in the business of fabricating and installing wrought iron railings. Under the name “Van's Ornamental Iron Co.,” petitioner operates the business out of a structure the size of a four-car garage adjacent to his home. This structure was built years ago by petitioner's father to repair farming equipment when the area was still a farming community. Since there was little money in farming when petitioner finished high school, he used the structure to start his ornamental iron business.
The ironwork is used primarily for railings around decks and for staircases; it is also used for fences, gates, and arches. Each railing or product is custom made by petitioner. It is separately measured, fabricated, and installed. Petitioner visits the location, discusses designs and plans with the customer, and takes measurements. The specifications and measurements are then given to an employee who, in the normal case, prepares the desired product. The employee removes iron rods from stock and cuts, bends, welds, and paints them. The ironwork is then taken to the location wherein petitioner himself installs the finished product.
In the beginning, petitioner made his own tools which included a simple welder, a saw, and an old stoker. In the first 5 years, he employed one or two people. The business grew until its peak year 1978, the taxable year in issue, when petitioner employed six or seven people. As of 1978, equipment used in the business included two metal cutters, four welders, and an assortment of handmade tools. A stock of unworked iron rods and bars was also kept on the premises.
Petitioner sold a majority of his railings to individual homeowners; the rest were sold to building contractors for newly constructed homes. Petitioner's sales were generally made within a 40-mile radius of his home located 20 miles south of Chicago. Petitioner depended on word-of-mouth for advertising.
As of 1978, the bases of the following depreciable assets used in petitioner's business were as follows:
+---------------------------------------------------------+
¦ ¦ ¦Depreciation allowed ¦
+-----------------------+----------+----------------------¦
¦ ¦Adjusted ¦or allowable in ¦
+-----------------------+----------+----------------------¦
¦ ¦basis ¦prior years ¦
+-----------------------+----------+----------------------¦
¦ ¦ ¦ ¦
+-----------------------+----------+----------------------¦
¦Trucks and automobiles ¦$24,953 ¦$7,104 ¦
+-----------------------+----------+----------------------¦
¦Machinery and equipment¦19,040 ¦12,105 ¦
+-----------------------+----------+----------------------¦
¦Furniture and fixtures ¦2,728 ¦758 ¦
+-----------------------+----------+----------------------¦
¦Total ¦46,721 ¦19,967 ¦
+---------------------------------------------------------+
Petitioner had $476,178 in gross receipts from sales in 1978. His cost of goods sold plus materials and supplies was $113,010.1 The cost of labor was $105,125.
Petitioner's 1978 net profit from his business was $196,046. On their 1978 Federal income tax return, petitioners treated the entire $196,046 net profit as personal service income within the meaning of section 1348, 2 thus qualifying for the 50-percent maximum tax rate. In his notice of deficiency, respondent determined capital was a material income-producing factor in the business; thus, respondent limited the amount subject to the maximum tax to 30 percent of the net profit.
OPINIONIn 1978, petitioner had net earnings of $196,046 from a business in which he engaged in the fabrication and sale of ornamental ironworks. He contends that capital was not a “material income-producing factor” in his business, within the meaning of section 1348, with the result that the entire amount of his net earnings is “personal service income” qualifying for the maximum tax rate limitations in effect in 1978. Respondent, on the other hand, argues that capital was a material factor in the production of petitioner's income so that not more than 30 percent of his net profits from the business is considered earned income, qualifying for the maximum tax rate limitation. In the light of all the facts, we think respondent has the better side of the argument.
Section 1348(a), in the form in which it was in effect in 1978, prescribed a 50-percent maximum tax rate limitation with respect to “personal service taxable income.” Section 1348(b)(1)(A) defined the term “personal service income” to include any income which is “earned income” within the meaning of section 401(c)(2)(C)3 or section 911(b). Section 911(b), 4 as it was in effect in 1978, defined the term “earned income” to mean “wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered”; with regard to self-employed persons, section 911(b) contains the following provision:
In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income.
The congressional objective in incorporating by reference this trade-or-business language into section 1348 was to extend the benefits of the maximum tax limitations to the portion of an individual's net profits which represented a reasonable allowance for compensation for the personal services actually rendered by him.5 At the same time, the objective was to deny those limitations to income derived by a taxpayer materially from assets or capital used in a trade or business. Just as amounts in excess of reasonable compensation paid to an employee-shareholder as salary may be treated as dividend income,6 which in 1978 could be taxed up to a 70-percent rate, the amounts above the level of reasonable compensation for the services rendered by a self-employed individual were intended to be treated as attributable to capital, taxable without regard to the section 1348 limitations.7
To aid in determining whether capital is material to the production of the income, the regulations set forth guidelines drawn mainly from the decided cases interpreting other Code sections or provisions of prior law involving the issue of capital as a material income-producing factor. See, e. g., Rousku v. Commissioner, 56 T.C. 548, 551 (1971). Sec. 1.1348–3(a)(3)(ii), Income Tax Regs., provides as follows:
(ii) Whether capital is a material income-producing factor must be determined by reference to all the facts of each case. Capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business, as reflected, for example, by a substantial investment in inventories, plant, machinery, or other equipment. In general, capital is not a material income-producing factor where gross income of the business consists principally of fees, commissions, or other compensation for personal services performed by an individual. * * * [8]
Under this test, capital was a material factor in earning a substantial portion of the gross income of petitioner's business. The earnings did not consist “principally of fees, commissions, or other compensation,” sec. 1.1348–3(a)(3)(ii), Income Tax Regs., but were realized from manufacturing and sales operations.
Petitioner's manufacturing activities, involving the fabrication of ornamental ironworks, employed a significant amount of capital which was material to the production of the business' income. In addition to the capital required to meet operating expenses,9 capital was used to buy an inventory of iron rods and other materials and supplies at a total cost of $113,010. Although the inventories on hand at the beginning and at the end of the year were approximately $10,000 and $11,000, respectively, petitioner made purchases of $96,024 worth of raw materials during the year, equal to 20 percent of the gross receipts ($476,178). The total amount spent on the inventory of raw materials is a far more important figure than the opening and closing amounts. Significantly, the regulation ( sec. 1.1348–3(a)(3)(ii), Income Tax Regs.) refers to the “employment” of capital, not merely its possession. And the courts have said that “it is not the presence of capital, but its use in...
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...deemed to be an income-producing factor in the business.‘ 696 F.2d at962. In Van Kalker v. Commissioner, 804 F.2d 967 (CA7 1984), revg. 81 T.C. 91 (1983), the taxpayer was in the business of fabricating wrought iron railings. The taxpayer's equipment consisted of two metal cutters, four wel......
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Parker v. C.I.R., 86-7045
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