Parker v. Commissioner

• Decision Date: 30 October 1985
• Docket Number: Docket No. 24368-81.
• Citation: 1985 TC Memo 545,50 TCM (CCH) 1349
• Parties: James J. Parker and Rosemarie Parker v. Commissioner.
• Court: U.S. Tax Court

50 T.C.M. (CCH) 1349 (1985)

T.C. Memo. 1985-545.

James J. Parker and Rosemarie Parker v. Commissioner.

Docket No. 24368-81.

United States Tax Court.

Filed October 30, 1985.

Charles W. Johnson, 530 South Fourth St., Las Vegas, Nev. for the petitioners. Ronald D. Dalrymple, for the respondent.

Memorandum Findings of Fact and Opinion

SHIELDS, Judge:

Respondent determined deficiencies in income tax due from petitioners for the years 1977 and 1978 in the respective amounts of $60,557 and $21,505. The only issue is whether the net profits of petitioners for 1977 and 1978 constitute "personal service income" within the meaning of section 1348.¹

Findings of Fact

Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by reference.

At the time of the filing of their petition, James J. Parker and Rosemarie Parker resided in Las Vegas, Nevada. They filed joint income tax returns for the calendar years 1977 and 1978 with the Internal Revenue Service at Ogden, Utah. All references herein to petitioner in the singular shall refer to James J. Parker.

During the years 1977 and 1978, petitioner owned and operated a sole proprietorship in Las Vegas, which assembled dollar slot machines that were placed in the Lady Luck Casino (Lady Luck) and the Golden Gate Casino (Golden Gate).

Petitioner's dollar slot machine was unique for its time. All of its internal parts were designed by petitioner. Many of the parts were made by him but a majority of the parts were manufactured by a machine shop pursuant to his specifications. Furthermore, the cabinets housing the slots including the etched glass exteriors were made to his order by independent contractors.

With the various parts petitioner assembled the finished machines and placed them in Lady Luck and Golden Gate under two different agreements. Those placed in Lady Luck were subject to a written lease agreement under which petitioner received $100 per week per machine. Those placed in Golden Gate were subject to a verbal participation agreement under which the proceeds from the machines were divided 60 percent to Golden Gate and 40 percent to petitioner. Under both agreements, petitioner was required to service and maintain the machines in good working condition and to meet this obligation, he employed servicemen and maintained an inventory of parts as well as spare machines. Under the agreement with Golden Gate, petitioner was also required to provide 40 percent of the initial bank from which payouts were made. The initial bank was $500 per machine.

The slot machines placed by petitioner in Lady Luck and Golden Gate had a total cost basis of $198,454 in 1977 and $238,982 in 1978 and had an adjusted basis of $190,667 and $163,196 at the end of 1977 and 1978, respectively.

For the years 1977 and 1978, petitioner had gross receipts of $619,092 and $524,525 from the machines and claimed and was allowed by respondent business expenses totaling $172,829 and $191,544 for a net profit of $446,263 in 1977 and $332,981 in 1978. The business expenses included the cost of servicing the machines which totaled $65,280 in 1977 and $96,153 in 1978, plus replacement parts and supplies in the respective amounts of $40,924 and $31,693.

On their income tax returns, petitioners claimed that the entire net profit for each year was personal service net income within the meaning of section 1348 and therefore subject to a maximum tax rate of 50 percent. In his notice of deficiency, respondent determined that the amount of net profit subject to the maximum tax rate of 50 percent was limited to 30 percent of the net profit because capital was a material income-producing factor in the business of petitioners.

Opinion

Petitioners contend that their entire net earnings for 1977 and 1978 constituted "personal service income" within the meaning of section 1348² as in effect during 1977 and 1978. On such issue, petitioners have the burden of proof. Welch v. Helvering 3 USTC ¶ 1164, 290 U. S. 111 (1933); Rule 142(a). As then in effect, section 1348(a) prescribed a 50 percent maximum tax rate with respect to "personal service income." Section 1348(b)(1)(A) defined the term "personal service income" to include any income which was "earned income" within the meaning of section 401(c)(2)(C) or section 911(b).

Section 401(c)(2)(C) as it was in effect in 1977 and 1978 defined the term "earned income" to include "net earnings derived from the sale or other disposition of, the transfer of any interest in, or the licensing of the use of property (other than good will) by an individual whose personal efforts created such property." (Emphasis added.) Section 401(c)(2)(C) was intended to encompass the income of a self-employed individual which directly resulted from the individual's efforts; for example, the income of a writer, an artist or an inventor. See S. Rept. 1707, 89th Cong., 2d Sess. (1966), 1966-2 C. B. 1059, 1103 (1966). However, if property is not created solely from an individual's efforts but is created solely, or in part, from the efforts of his employees, then the individual's net profits from the property are not "earned income" within section 401(c)(2)(C). See Van Kalker v. Commissioner Dec. 40,328, 81 T. C. 91, 93 n. 3 (1983), revd. on other grounds ___ F. 2d ___ (7th Cir. 1984, 54 AFTR 2d 5671, 84-2 USTC ¶ 9727); Van Dyke v. United States, an unreported case (Ct. Cl. Trial Div. 1982), 49 AFTR 2d 82-556, 82-1 USTC ¶ 9156, affd 83-1 USTC ¶ 9127 696 F. 2d 957 (Fed. Cir. 1982).

In this case, petitioner's gross receipts came from the use of the completed slot machines, not from the sale or other disposition of, the transfer, or licensing of his plans or designs for the machines. In this connection it should be noted that the cabinet housings, the etched glass exteriors and a majority of the internal parts of the slot machines were made by independent contractors. Consequently, while the design of the machines and the assembly of the components into the completed machines were the direct result of petitioner's personal efforts, it cannot be said that petitioner's "personal efforts created" the machines. In this regard, we are unable to distinguish between property created through the joint efforts of an individual and employees under his supervision from property created through the joint efforts of an individual and independent contractors who are making component parts pursuant to his specifications. We conclude, therefore, that petitioner's net profits are not "earned income" under section 401(c) (2)(C).

Petitioners also rely on the definition of "earned income" as set forth in section 911(b) which states:

For purposes of this section, the term "earned income" means wages, salaries, or professional fees and other amounts received as compensation for personal services actually rendered ***. 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.

Section 911(b) was amplified by section 1.1348-3(a)(3)(ii), Income Tax Regs., as follows:

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. Thus, the practice of his profession by a doctor, dentist, lawyer, architect, or accountant will not, as such be treated as a trade or business in which capital is a material income-producing factor even though the practitioner may have a substantial capital investment in professional equipment or in the physical plant constituting the office from which he conducts his practice since his capital investment is regarded as only incidental to his professional practice. Emphasis added.

The above regulation has received judicial approval on several occasions. See Moore v. Commissioner Dec. 35,823, 71 T. C. 533 (1979) and Bruno v. Commissioner Dec. 35,529, 71 T. C. 191 (1978). See also Holland v. Commissioner Dec. 35,426, 70 T. C. 1046 (1978), affd. 622 F. 2d 95 (4th Cir. 1980); Rousku v. Commissioner Dec. 30,839, 56 T. C. 548 (1971). It is also well settled that in applying the section and the regulation, the question of whether capital is a "material income-producing factor" is a factual inquiry which must be determined from all of the facts and circumstances of the particular case. Bruno v. Commissioner, supra; Rousku v. Commissioner, 56 T. C. at 550.

Petitioner's proprietorship obviously employed a significant amount of capital. His cost basis in the slot machines was $198,454 in 1977 and $238,982 in 1978. We have repeatedly held that a taxpayer's investment in equipment and other business assets is an element to be considered in determining whether capital is a material income-producing factor in a trade or business. Gaudern v. Commissioner Dec. 38,504, 77 T. C. 1305 (1981); Moore v. Commissioner Dec. 35,823, 71 T. C. 533 (1979); Rousku v. Commissioner Dec. 30,839, 56 T. C. 548 (1971); Fairfax Mutual Wood Products Co. v. Commissioner Dec. 14,881, 5 T. C. 1279 (1945). During 1977 and 1978 petitioner also expended $40,924 and $31,693 for replacement parts and supplies for the machines and $65,280 and $96,153 to service them.³ Such...