UC-NRLF 773 TAX TAXES JOSEPH J. I SCOTT Former Collector of Internal Revenue at San Francisco, Cal. An Authoritative Analysis, Simplification and Illustration of the Exacting and Perplexing Requirements of the United States Tax Laws. Press of KOHNKE PRINTING COMPANY 233 Pine Street San Francisco, California Copyright 1917 by JOSEPH J. SCOTT GIFT FOREWORD This book is intended for reference. It has been written and ar- ranged for the use of the taxpayer who must comply with the exact- ing requirements of the Federal Revenue laws but who has not had opportunity to follow the official interpretation and administration of their many intricate and involved provisions. t It is suggested that the index be consulted for reference to the subject regarding which information is desired; in this way an answer may be found immediately to the question in the taxpayer's mind, without unnecessary reading. Toward the back of the book will be found the text of the laws, which also can be consulted, according to the direction of the index, when the taxpayer would see whether in his own opinion instructions are in compliance with the law. For the reason that "net income", as ascertained under the pro- visions of the Act of September 8, 1916 the general Income Tax Law, is taken as the basis of computation, not only of the combined Income Taxes, but also of the Excess Profits Tax, it has been deemed advisa- ble to go very thoroughly into the requirements of that Act. The Act of September 8, 1916, as amended, has become, by a wide margin, the most important of Federal tax laws. It is the funda- mental statute. With respect to it the War Income Tax law is supple- mentary, and the Excess Profits Tax law occupies a position of re- lationship due to the fact that "net income," as ascertained for Income Tax purposes, is one of the controlling factors of the computation of the Excess Profits Tax. The instructions given in this book are based upon an experience of four years in administering Federal Tax laws, as Collector of In- ternal Revenue at San Francisco, Cal. That experience included the inauguration of taxation of income under the old law of 1913 and con- tinued through the handling of thousands of individual and corpora- tion assessments under both the law of 1913 and the Act of September 8, 1916. Supporting the instructions and advice given in succeeding chap- ters are not only the regulations and practice of the Treasury Depart- M699156 nient and the decisions of the Federal courts but also experience in dealing with actual conditions when general rules did not seem to ap- ply and the problems that arose could be solved only by extensive offi- cial correspondence. The taxpayer is entitled to know his rights. In this book an effort is made to tell him what they are and how to claim them. But the taxpayer, judging by the experience of the writer, desires 'to meet his obligations as well as to be able to assert his rights ; hence, he is told not only what he can do but also what he must do. The Income Tax, the Excess Profits Tax, the Capital Stock Tax, the Estate Tax, the new Stamp Tax. and the several other taxes, as increased or originally imposed by the provisions of the War Revenue Act are covered in appropriate chapters, as indicated by the Table of Contents. ' No instruction has been given that is not within the law. Au- thority can be cited on every point. The full text of official regula- tions has been omitted, in most cases, for the reason that, in general, the text of such regulations is little less involved and confusing than that of the laws they are intended to interpret. JOSKIMI J. SCOTT. TABLE OF CONTENTS INCOME TAX INTRODUCTORY Chap. I Page 9 COMPUTATION OF TAX Chap. II Page 11 ON INDIVIDUAL INCOME Chap. Ill Page 19 INDIVIDUAL INCOME SUBJECT TO , Chap. IV Page 22 INCOME EXEMPT FROM TAX Chap. V Page 39 DEDUCTIONS OF INDIVIDUALS Chap. VI Page 43 CREDITS OF INDIVIDUALS Chap. VII Page 57 FILING OF INDIVIDUAL RETURN Chap. VIM Page 61 NON-RESIDENT ALIENS Chap. IX Page 66 PARTNERSHIPS Chap. X Page 71 DEDUCTION OF TAX AND INFORMATION AT SOURCE Chap. XI Page 75 ESTATES AND FIDUCIARIES Chap. XII Page 87 CORPORATIONS SUBJECT TO Chap. XIII Page 90 CORPORATIONS EXEMPT Chap. XIV Page 99 CORPORATIONS, GROSS INCOME OF Chap. XV Page 104 DEDUCTIONS OF CORPORATIONS Chap. XVI Page 116 DEPRECIATION OF PROPERTY Chap. XVII Page 139 DEPLETION OF DEPOSITS Chap. "XVIII Page 149 FILING OF CORPORATION RETURN Chap. XIX Page 158 MISCELLANEOUS PROVISIONS Chap. XX Page 166 ASSESSMENT AND PAYMENT OF TAX Chap. XXI Page 196 PENALTIES, ETC Chap. XXII Page 201 CLAIMS Chap. XXIII Page 205 WAR INCOME TAX Chap. XXIV Page 209 ILLUSTRATIVE CASES (INCOME TAX) Chap. XXV Page 215 EXCESS PROFITS TAX Chap. XXVI Page 235 I LLUSTR ATI VE CASES Page 251 CAPITAL STOCK TAX Chap. XXVII Page 256 ESTATE TAX Chap. XXVIII Page 265 STAMP TAXES Chap. XXIX Page 270 TAX ON INSURANCE POLICIES Chap. XXX Page 277 TAX ON TRANSPORTATION, ETC Chap. XXXI Page 279 TAX ON ADMISSIONS AND DUES Chap. XXXII Page 283 TAX ON MISCELLANEOUS ARTICLES Chap. XXXIII Page 286 TAX ON LIQUORS, ETC Chap. XXXIV Page 291 TAX ON SOFT DRINKS Chap. XXXV Page 294 TAX ON TOBACCO, ETC Chap. XXXVI Page 296 OCCUPATIONAL TAXES Chap. XXXVII Page 298 COURT DECISIONS Chap. XXXVIII Page 300 TEXT OF LAWS INCOME TAX (Act of Sept. 8, 1916, as amended) Appendix Page 1 WAR INCOME TAX (Act of Oct. 3, 1917) Appendix Page 23 EXCESS PROFITS TAX Appendix Page 25 TAX ON BEVERAGES Appendix Page 31 TAX ON TOBACCO, ETC. Appendix Page 36 TAX ON TRANSPORTATION, ETC Appendix Page 37 TAXES ON MISCELLANEOUS ARTICLES Appendix Page 40 TAX ON ADMISSIONS AND DUES Appendix Page 42 STAMP TAXES Appendix Page 43 ESTATE TAX Appendix Page 48 ADMINISTRATIVE PROVISIONS Appendix Paqe 48 INDEX Following Appendix THE INCOME TAX CHAPTER I THE INCOME TAX There are now in effect two Federal Income Tax laws. One is the Act of September 8, 1916 and the other the Act of October 3, 1917. The former imposes the regular or ordinary income tax and the latter the War income tax. The Act of October 3, 1917 is supplementary to the Act of Sep- tember 8, 1916. One of its provisions is that it shall be administered according to the method by which taxes are assessed under the Act of September 8, 1916. It imposes new taxes upon individuals and cor- porations but in its enforcement the Government will rely upon the system inaugurated under the old law, and both new and old laws will be administered together. In any study of the practice and policy adopted by the Govern- ment in the taxation of income the primary consideration is, there- fore, an understanding of what has been done under the Act of Sep- tember 8, 1916. There are a few points of difference between the two laws, but very few. The personal exemption is lowered by the Act of October 3, 1917, and the War income tax is made applicable, as far as individuals are concerned, only to those persons who are citizens or residents of the United States. More persons are subjected to the additional, or super, tax, and corporations are given certain privileges with respect to assessment of the War income tax that they do not enjoy under the assessment of the Regular or ordinary income tax. But the differences will be explained and taken care of in the com- putation. The important consideration now is that the administration of the Act of September 8, 1916 must be understood if either an indi- vidual or a corporation expects to be able to take advantage of the rights allowed by law and to meet the obligations imposed. For this reason Income Tax instructions will be based almost en- tirely upon practice under the Act of September 8, 1916, which is still the principal income tax law with the War income tax serving, as it 10 THE INCOME TAX were, only to bring more persons under this system of taxation and make the incomes of those who have not heretofore enjoyed exemp- tion bear a far heavier part of the country's tax burden. It is thought that the question of one's income tax liability (a.s either individual or corporation) can be ascertained by consulting the appropriate chapters, paragraphs or parts of the general income tax instructions that follow. Wherein any of such instructions do not apply to the War Income Tax is explained in the chapter on "War In- come Tax." Only one return will be required of any individual or corporation lor the assessment of income tax under both laws. The computation must, therefore, take cognizance of the rates imposed by both laws. And in order that the general scheme of computation of tax liability, according to the schedules of both laws, may be understood at the outset, a condensed version of it is given and illustrated in the next succeeding chapter. THE INCOME TAX II CHAPTER II THE INCOME TAX COMPUTATION OF INCOME TAX UNDER BOTH LAWS. There follow condensed instructions for computing both an indi- vidual and a corporation income tax under the rates of both Income Tax laws now in effect (Act of September 8, 1916 and Act of October 3, 1917.) All of the points in this chapter are explained in more detail elsewhere in this book under appropriate headings. It is not expected that instructions relative to the treatment of net income can be fol- lowed until the meaning of "net income," according to the law and regulations and Treasury Department practice, is understood until the taxpayer will have submitted his own particular case to the defini- tions, explanations and illustrations given in succeeding chapters. But in order that the taxpayer may have in mind from the outset an administration of the two income tax laws together the combined computation is outlined here. Reference should be made bac'k to this chapter as other chapters or paragraphs are consulted. 1. WHAT IS MEANT BY "NET INCOME." The first thing to be understood is what is meant by "net income," as the phrase is used in the law. Many persons have their own ideas regarding that part of income which is "net," but these ideas will have to be laid aside if they do not agree with the significance of the term as used in the statute. The net income of either an individual or a corporation is the difference between total gross income and the aggregate of certain specified deductions. ]? THE INCOME TAX The net income of an individual is the difference between total gross income and the aggregate of deductions allowed for business expenses, taxes, interest, bad debts, losses and certain gifts to charita- ble, religious or educational organizations. Net income is ascertained before account is taken of any other credit allowed in the subsequent computation of tax. The net income of a corporation is, likewise, the difference be- tween total gross income and the aggregate of allowable deductions such deductions, in the case of a corporation, being for ordinary and necessary business operating expenses, losses, interest, and taxes. The result at this point is net income, within the meaning of the law, before account is taken of any other credit that may be considered later in computing tax liability. 2. THOSE WHO MUST FILE RETURNS. Under the operation of both laws a return must be filed by (a) Every individual who is a citizen or resident of the United States, and who, if single, has a net income of $1,000 or more, or, if married, a net income of $2,000 or more, for the Calendar year. (b) Every alien who is not a resident of the United States and who has a net income from sources within the United States amounting to $3,000 or more for the Calendar year. (c) Every domestic corporation, whatever the amount of its income, and even though it have none, except those of a character specifically exempted. (See "Corporations Exempt.") (d) Every foreign corporation (subject to same exemption as to character) of its income from sources within the United States. (e) Certain estates, as explained in appropriate paragraphs. (See index). 3. ONE RETURN UNDER BOTH LAWS. Only one return of income will be required by the Government from either an individual or a corporation. Upon the basis of net in- come shown by this one return total tax liability will be ascertained according to the rates imposed by both the old law (Act of September 8, 1916) and the new law (Act of October 3, 1917.) THE INCOME TAX 13 4. COMPUTATION OF INDIVIDUAL TAX. The income tax liability of an individual who is a citizen or resi- dent of the United States will be ascertained, in general, as follows : (1) Determine Net Income. Determine net income by subtracting from gross income the total of allowable deductions. By "deductions" are not meant the credits allowed for dividends, income taxed at the source, the specific exemp- tion and the amount of Excess Profits tax assessed for the same year. By "deductions" are meant only the allowances for business expenses, taxes, interest, losses, bad debts, depreciation, depletion and gifts to certain organizations. (2) Credit for Excess Profits Tax. Credit net income, ascertained as just explained, with the amount of Excess Profits Tax assessed for the same year. The result, at this point, is the only basis of assessment of any income tax. (3) Get Normal Tax Basis. Ascertain basis of computation of the normal tax by taking credit for that part of net income represented by dividends from corpora- tions, if any. Dividends in the hands of an individual are not subject to the normal tax. (4) Ascertain Exemption. Next ascertain the specific exemption allowed under both the new law and the old law $1,000 for a single person and $2,000 for a married person or the head of a family, with an additional allowance of $200 for each dependent child, under the new law ; and $3,000 for a single person and $4,000 for a married person or the head of a family, with an additional allowance of $200 for each dependent child, under the old law. (5) Compute Normal Tax. Next compute normal tax as follows : (a) At the new law rate of 2 per cent on the amount in excess of $1,000 and not in excess of 1.4} THE INCOME TAX $3,000 in the case of a single person, and on the amount in excess of $2,000 and not in excess of $4,000 in the case of a married person or the head of a family; (b) at the rate of 4 per cent (combining the 2 per cent rate of the old law and the 2 per cent rate of the new law) on the amount in excess of $3,000 in the case of a single person and on the amount in excess of $4,000 in the case of a married person or the head of a family. Should a married person or the head of a family be entitled to the additional exemption of $200 for each dependent child, the amount of income subject to tax only at the 2 per cent rate of the new law would be the amount in excess of ($2,000 plus the addi- tional exemption for dependent children) and not in excess of ($4,OC* plus the additional exemption for dependent children) and tax would he imposed at the rate of 4 per cent (combined rates) only on net in- come in excess of ($4,000 plus the additional exemption for dependent children.) For instance : a married person with one dependent child would be taxed at the rate of 2 per cent on net income between $2,200 and $4,200 and at the rate of 4 per cent on net income in excess of $4,200, and so on with the amount determining the tax rate increased by $200 for each dependent child. (6) Deduct Normal Tax Withheld. Having ascertained total normal tax liability, the" individual is en- titled to deduct from the amount of such liability any amount of nor- mal tax which has been withheld at the source, and the remainder is the amount of normal tax still due the Government. (7) Get Additional Tax Basis. Ascertain the basis of computation of additional tax by reverting to the amount of net income before dividends were deducted. While dividends in the hands of the individual are not subject to normal tax, they are subject to additional tax. Therefore, go back to the result that was obtained w r hen steps No. 1 and No. 2, above, had been taken. If the amount of net income, as ascertained at the end of step X<>. 2, is not in excess of $5,000 no additional tax is due ; if it is in excess of $5,000, additional tax liability may be ascertained by considering the ascending rate scales of both the old and the new laws. The addi- tional tax rates of the new law alone apply if net income does not ex- ceed $20,000 and the combined additional tax rates if net income does exceed $20,000. THE INCOME TAX '15 The following table shows the application of each rate scale and of the two .combined : Net Income In Excess of Old Law New Law . Com- bined 5,000 and not in excess of $ 7,500 0% 1% \% 7,500 " " " 10,000 " " " 10,000 12.500 2 3 Z 3 12,500 " " " 15,000 4 4 15.000 " " " 20,000 5 5 20.000 " " " 40,000 1 7 8 40,000 " " " 60,000 " " " 60,000 80,000 2 3 io 14 12 17 80,000 " " " 100,000 4 18 22 100,000 " " " 150,000 5 22 27 150.000 " " " 200,000 " " " 200,000 250,000 6 7 25 30 31 37 250.000 " " " 300,000 " " " 300,000 500,000 8 9 34 37 42 46 500,000 " " " 750.000 " " " 750,000 " 1,000,000 10 10 40 45 50 : 55 1,000,000 " " " " 1,500,000 11 50 61 1.500,000 " " " All in excess of... " 2,000.000 ...2.000.000 12 13 50 50 62 63 5 EXAMPLES OF INDIVIDUAL TAX COMPUTATION. Xote preceding instructions as applied in the following illustra- tions : No. 1 John Smith ic single with a net income of less than $1,000. Me is not required even to file a return. No. 2 William Jones is married with a net income of less than $1,000. He is not required even to file a return. 16 THE INCOME TAX No. 3 Peter Brown is single, with no one dependent on him for support and with a net income of $1,500. He is required to file a return and pay a tax of 2 per cent on $500. No. 4 Arthur Burns is single, with a net income of $1,500, but his aged mother is dependent on him for support. He is the head of a family. He should file return but in it claim exemption of $2,000 and thus have no tax to pay. No. 5 William Tupper is married and lives with his wife and six-year-old son. His net income is $6,000. His exemption under the new law is ($2,000 plus $200) and under the old law is ($4,000 plus $200). He is taxed at the rate of 2 per cent on the $2,000 between the new law exemption of $2,200 and the old law exemption of $4,200 ; and at the rate of 4 per cent on the $1,800 in excess of $4,200. But he is also subject to additional tax under the new law, which is figured at the rate of 1 per cent on the amount of $1,000, which is in excess of $5,000, but not in excess of $7,500. None of his income consists of dividends ; no Excess Profits Tax has been assessed for the same year, and none of his income has been taxed at the source. In such circumstances, Tupper's total tax liability is $40 plus $72 plus $10 or $122. No. 6 John Morrison is a widower supporting two daughters, aged 6 and 9, respectively. He is a lawyer by profession. His net income is $52,000. It is all from the practice of his profession except the amount of $800, representing a dividend on oil stock. The amount of his Excess Profits Tax for the same year figures (for the purpose of this example) $3,680. His exemption under the new law is $2,400 and under the old law $4,400. After deducting from his net income of $52,000, the amount of his Excess Profits Tax, which is $3,680, there is a remainder of THE INCOME TAX 17 $48,320 on which income tax must be paid. However, from such re- mainder should be deducted the $800 dividend in order to ascertain normal tax liability. This having been done, Morrison finds that he has $47,520 on which to compute his normal tax and he proceeds to do so as follows : 2 per cent on the amount of $2,000 between $2,400 and $4,400 ; and 4 per cent on all of the $47,520 above $4,400. In other words, 2 per cent of $2,000 and 4 per cent of $43,120, which results in normal tax liability of $1764.80. Then Morrison turns to the additional tax computation. He goes back to the amount obtained when he deducted from his net income the amount of his Excess Profits Tax. On such amount, $48,320, he figures his additional tax, as follows : On the $2,500 between $5,000 and $7,500 at 1 per cent, $25. On the $2,500 between $7,500 and $10,000 at 2 per cent, $50. On the $2,500 between $10,000 and $12,500 at 3 per cent, $75. On the $2,500 between $12,500 and $15,000 at 4 per cent, $100. On the $5,000 between $15,000 and $20,000 at 5 per cent, $250. On the $20,000 between $20,000 and $40,000 at 8 per cent, $1,600. On $8,320 (over $40,000 but not over $60,000) at 12 per cent, $998.40. The above computation gives a total additional tax liability of $3098.40. The addition of this amount to the normal tax of $1,764.80 shows Morrison's total income tax liability in such circumstances to be $4,863.20. 6. COMPUTATION OF CORPORATION TAX. The income tax liability of a domestic corporation under both the old and the new laws will be ascertained, in general, as follows : (1) Determine Net Income. Determine net income by subtracting from gross income the total of allowable deductions. By "deductions" are not meant the credit allowed under the new law (but not under the old) for dividends re- ceived from another corporation and that given under both laws for the amount of Excess Profits Tax assessed for the same year. By "deductions" are meant only the allowances for actual and necessary business operating expenses, losses, depreciation, depletion, interest, and taxes. 18 THE INCOME TAX (2) Credit for Excess Profits Tax. Credit net income, ascertained as just explained, with the amount of Excess Profits Tax assessed for the same year. The result, at this point, is the only basis of assessment of any income tax. (3) Compute Tax Under Old Law. On the amount of net income shown when Steps No. 1 and No. 2. just above, have been taken, compute tax at the rate of 2 per cent on the entire amount of net income thus shown, without any credit for dividends received from another corporation. (4) Compute Tax Under New Law. From the amount of net income shown when Steps No. 1 and No. 2, just above, have been taken, deduct the amount of income repre- sented by dividends from another corporation. On the remainder compute tax at the rate of 4 per cent. (5) Total Tax Liability. Ascertain total tax liability for the year by adding the amount due at the old rate and the amount due at the rate imposed by the new law. THE* INCOME TAX 19 CHAPTER III THE INCOME TAX OLD LAW ACT OF SEPT. 8, 1916 TAX ON INDIVIDUAL INCOME 7. WHO ARE LIABLE. There are three classes of individuals liable to income tax. (a) A citizen of the United States is subject to the require- ments of the law, whether Or not he is a resident of the United States, and must pay tax upon his entire net income, less any specific exemptions and deductions allowed by the law. (b) An alien residing in the United States is under exactly the same liability as a citizen of the country. (c) An alien who does not reside in the United States, but with interests in this country, is subject to the law with re- spect to his income from all sources within the United States. 8. NO RELIEF FROM TAX. No person, liable under the income-tax law of the United States can claim exemption from tax by reason of payment of an income tax in another country. This ruling applies to both citizens of the United States and aliens, resident and non-resident. It also follows that liability to the federal income tax is ift no way affected by payment of an income tax imposed by any state. 9. PARTNERS ONLY AS INDIVIDUALS. Members of partnerships are liable for income tax only in tlu'ir individual capacity. Each is required to take into account his share 20 THE INCOME TAX of the earnings of the partnership in which he is interested in deter- mining the question of his own individual liability. This question will be gone into fully, however, under the heading of "Partnerships." 10. RATES OF TAX ACT OF SEPT. 8, 1916. The income tax, in the aggregate, consists of a tax levied at a flat rate upon entire net income, known as the Normal tax, and a tax levied on total net income, according to an ascending scale of assess- ment, when net income is in excess of $20,000 for the taxable year known as the Additional Tax. Note Often this additional tax is referred to as the "sur-tax" or "super-tax." In any event the meaning of the prefix should be obvious. 11. NORMAL TAX RATE ACT OF SEPT. 8, 1916. The Normal Tax rate is 2 per cent. 12. ADDITIONAL TAX RATES ACT OF SEPT. 8, 1916. The Additional tax rate is imposed according to the following scale : 1 per cent upon the amount by which total net income ex- ceeds $20,000 and does not exceed $40,000, 2 per cent upon the amount by which total net income ex- ceeds $40,000 and does not exceed $60,000, 3 per cent upon the amount by which total net income ex- ceeds $60,000 and does not exceed $80,000, 4 per cent upon the amount by which total net income ex- ceeds $80,000 and does not exceed $100,000. 5 per cent upon the amount by which total net income ex- ceeds $100,000 and does not exceed $150,000, 6 per cent upon the amount by which total net income ex- ceeds $150,000 and does not exceed $200,000, 7 per cent upon the amount by which total net income ex- ceeds $200,000 and does not exceed $250,000, 8 per cent upon the amount by which total net income ex- ceeds $250,000 and does not exceed $300,000, 9 per cent upon the amount by which total net income ex- ceeds $300,000 and does not exceed $500,000, 10 per cent upon the amount by which total net income ex- ceeds $500,000 and does not exceed $1,000,000, 11 per cent upon the amount by which total net income ex- ceeds $1,000,000 and does not exceed $1,500,000, THE INCOME TAX 21 12 per cent upon the amount by which total net income ex- ceeds $1,500,000 and does not exceed $2,000,000, 13 per cent upon the amount by which total net income ex- ceeds $2,000,000. 22 THE INCOME TAX CHAPTER IV THE INCOME TAX INCOME SUBJECT TO TAX INDIVIDUALS 13. INCOME FROM ALL SOURCES. The statute makes entire net income, from all sources during the taxable year (which, in the case of individuals, is the calendar year) taxable with respect to the liability of citizens and resident aliens, and entire net income received from all sources within the Unit- ed States, with respect to the liability of non-resident aliens. At the same time, however, the statute specifically exempts from tax, and even from the computation for tax, income from certain sources. But, in the main, all net income is taxable, provided it is received by the individual in sufficient quantity to exceed the exemption allowed every person. The exceptions will be taken up later. According to the law the net income of a taxable person shall include gains, profits and income derived from (a) salaries, wages, or compensation for personal service of what- ever kind and in whatever form paid, (b) or from professions, vocations, businesses, trade, commerce, or sales, or dealings in property, whether real or personal, grow- ing out of the ownership or use of or interest in real or personal property, (c) also from interest, rent, dividends, securities, or the trans- action of any business carried on for gain or profit, (d) or gains, or profits and income derived from any source what- ever. THE INCOME TAX 23 It is obvious from the above that Congress intended to close every possible avenue of escape from tax liability. The language of the law is so comprehensive and sweeping that no other conclusion can be drawn. Naturally, then the rulings of the Treasury Depart- ment, opinions of the Attorney-General and decisions of the United States Courts show little patience with technicalities but insist that the fundamental purpose of the law be faithfully followed by sub- mission to taxation of all net income except that from the few sources specifically exempted . And, yet, innumerable problems have arisen and many finely drawn decisions have had to be issued. Close distinctions between income and capital transactions have had to be made. 14. ONLY INCOME "RECEIVED." Under the first income tax law (Act of October 3, 1913) income "accrued", as well as income "received," had to be included in a return and became subject to tax. This requirement gave rise to a great deal of confusion and inexcusable inequity. With >such a provision in the statute it was impossible to administer the act fairly. But this condition was remedied by the Act of September 8, 1916 and only income "received" now need be included in a return for a particular taxable year. 15. PROFESSIONAL FEES AND SALARIES. It is a matter of quite common occurrence that compensation for personal service is not paid within the year during which it is earned, that is within the calendar year for which the individual is re- quired to file a return. For instance, service rendered during the year 1916 may not have been paid for until sometime in the year 1917. At first the Government requirement was that the individual, in filing return for the year during which the service was rendered include in the retirn for that year the charge for the service, even though payment had not been made. Now, however, the person in receipt of compensation for personal service, in making return of income accounts for only the amounts received during the year. A salary or fee, earned in 1917, but not paid until 'Sometime in 1918, need not be accounted for in the return for 1917, but can.be included in the return for 1918. Such is the present ruling of the Treasury Department, and it is especially applicable to the accounting diffi- culties of lawyers, physicians and engineers, as well as to any salaried person in receipt of a bonus, in addition to his salary, such bonus being generally determinable only after the close of the year in which earned. 24 THE INCOME TAX 16. BONUS TAXABLE. In some cases, of course, a bonus is clearly a gratuity ; but, in general, a bonus to an employee represents additional compensation for service rendered by him and is based upon that service. When a special payment is made as extra compensation in pursuance of a contract express or implied, it becomes income to the employee and is subject to tax. It cannot be regarded as a gift and is not there- fore in such circumstances, exempt from tax, as would be a payment clearly a gift. 17. LIVING QUARTERS. When an individual is furnished living quarters in addition to salary the actual rental value of such quarters is regarded as addi- tional compensation subject to the income tax. This ruling applies to quarters for either the individual or the individual's family, or both; and it is necessary that the rental value of the quarters be ascertained with all possible accuracy. When such value has been ascertained the amount for the year should be added to the com- pensation for the year and this should be included in the return for the year. In the case of Government officers this requirement is extended to cover commutation of quarters and the money equivalent of quarters furnished in kind. In this respect the ruling is that, when quarters are furnished in kind, of a less number of rooms than the number allowed by law, the money equivalent only of the number of rooms actually assigned shall be included in income for taxation. When quarters are furnished in kind of a greater number of rooms than the number allowed by law, the money equivalent only of the number of rooms allowed by law shall be returned. 18. HEAT AND LIGHT ALLOWANCE. Likewise, amounts received by an officer for heat and light must be returned for tax ; or, if the officer occupies public quarters, the money equivalent of the heat and light furnished him, as fixed by the Government must be returned, it being the contention of the Treasury Department that by such amount is his compensation increased. 19. MILEAGE. The difference between the amount received as mileage and the amount of actual expense of travel must be returned for tax. The Treasury Department's ruling on this point affects, in general, only officers and employees of the Government. THE INCOME TAX 25 20. COMMISSIONS. Payments received by a taxable person in the form of com- missions are income subject to tax and must be returned by the sales- man for the year in which received. 21. RENEWAL PREMIUM COMMISSIONS. Commissions on renewal premiums for insurance are taxable income for the year in which received, without respect to the date of issue of the policy. This means that commissions received on renewal premiums for insurance written prior to the incidence of the income tax must be included in the individual's return. 22. CLERGYMEN'S FEES. A close definition has been drawn by the Treasury Depart- ment with respect to the so-called offerings and fees received by clergymen. It is held that such offerings, received on Easter, for instance, or for funerals, masses, marriages, baptisms and the other services rendered by a clergyman, are income sublet to tax. A Christmas gift to a clergyman, however, even though in the form of money, is not taxable income to him. 23. TRUSTEE'S COMPENSATION. A trustee of an estate must return for tax the amount he receives for his services, and in the year he receives it. The sig- nificance of this ruling by the Treasury Department will be appreci- ated when it is understood that in the ruling it is also held that if no determination was made with respect to the trustee's compensation over a period of years until the trust was terminated, the amount finally allowed must be returned in full for the year in which paid. The amount cannot be prorated over the period during which the trustee served. All is subject to tax for the year in which received. 24. RENT. Rent should be returned as income subject to tax for the year in which received. For instance, a landlord may not have received his rent for the month of December, 1916, until early in January, 1917. While the payment actually was for the use of the property in the year 1916, it was not received until the year 1917, and, therefore, should be included in the landlord's return for 1917, instead of in his return for 1916. Board, lodging or other consideration received in lieu of cash rent is income subject to tax and its equivalent must be included in the recipient's return. 26 THE INCOME TAX 25. DIVIDENDS CASH AND STOCK. Dividends are income to the recipient and must be included in the individual's return. Moreover, dividends are income, whether paid in cash or in stock. The stock dividend must be included to the amount of the earnings or profits of the distributing corporation. 26. DIVIDENDS HOW TAXABLE. While a dividend must be included by the individual in his return of gross income, the amount of it is allowed as a credit against net income for the purpose of the normal tax. The amount of the dividend is not allowed as a credit for the purpose of the additional tax, however. It is subject to the additional tax and enters in full into the computation, according to the ascending scale of assessment. 27. VALUE OF STOCK DIVIDEND. A stock dividend should be returned by the shareholder re- ceiving it at the amount it represents in the distribution made by the corporation which has paid it. In a case where a corporation has issued 1000 shares of stock of the par value of $100 and distributes 500 additional shares in payment of a dividend declared from net earnings, profits or surplus amounting to $50,000, an individual who holds ten shares of the original stock and receives five shares of the new stock as his pro rata share of the dividend, should, on account of their receipt, include the amount of $500 in his personal return. 28. DIVIDENDS PAID IN SCRIP. A dividend paid in scrip is returnable by the shareholder who receives it the same as a cash dividend, at the amount at which the distribution is made by the corporation paying the dividend. Pay- ment in scrip is held to be equivalent to payment in cash, and any amount of interest subsequently paid on the scrip must be accounted for as a separate item of income. 29. DIVIDENDS FROM FOREIGN CORPORATIONS. When a dividend is paid by a fo.eign corporation which derives its entire income from the business done in the United States and pays a tax upon its net income, such dividend is to be treated in the same manner by its recipient as a dividend from a domestic corporation. THE MCOME TAX 27 30. BANK TAX A DIVIDEND. When a bank pays for its stockholders a tax assessed against them, in proportion to their respective holdings of its shares, the action of the bank is regarded merely as an accommodation to the stockholders. The amount of the tax thus paid is allowed as a de- duction, not in the return of income filed by the bank, but in the returns filed by the stockholders, according to the number of shares held by each. However, the individual stockholder must , at the same time, regard the amount of tax paid upon his shares as an additional dividend and must take the amount into account in preparing his return of income. Banks generally notify their stockholders of the amount of such payments. If such, notice is not received, inquiry should be made of the bank of which the taxpayer is a stockholder. 31. PROFITS OF LIMITED PARTNERSHIP. The profits of those limited partnerships which make retirns and pay tax in the same manner as corporations are to be treated the same as dividends by individuals receiving them. That is, they should be entered in the individual's return as dividends. Hence, they would ,not be subject to the normal tax in the hands of the individual but would enter into the computation for the additional tax. 32. INTEREST. Interest on notes, ordinary mortgages, and corporate obligations, is returnable as income subject to tax for the year in which it is re- ceived, without regard to the time of accrual. In the main the re- quirement of the Treasury Department is only that interest received be returned. Interest on bank accounts should be included in the return for the year in which credited. Exceptions to the general rules, referred to here, will be taken up in the discussion of other subjects as those subjects may call for con- sideration of the question of interest. 33. BUSINESS AND TRADE. The gross income of every business or trade, engaged in for gain or p-ofit, must be included by the individual conducting it. Against this gross income may be entered, and from it deducted for the pur- pose of the income tax, the legitimate expenses incurred in the con- duct of the business; On this point the language of the statute is dear. - 28 THE INCOME TAX Just how expenses can be deducted is explained in the consider- ation of "Deductions," and how the income of various kinds of business should be ascertained in accordance with the law and regula- tions is shown in the specialized treatment given such subjects. 34. SALE OF PROPERTY. In the language of the law there must be returned for tax the income derived from all "sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in real or personal property.'' It is the gain derived from transactions in property, real or per- sonal, that is liable to tax the gain derived from transactions fhat have been completed with respect to the particular property con- cerned, whether that property be real estate, corporate securities, or property in some other form. The whole theory of the administration of the law is that the transaction must have been completed and the gain, if any, must have been actually realized. In other words, the property must have been disposed of by the taxpayer. [Likewise and conversely any loss sustained in such a transaction must be just as definite before it can be claimed as an offset against income, but this will be explained under the heading "Losses."] The present law provides an entirely new method of ascertaining gain derived from the sale of property. In respect to property ac- quired before March 1, 1913, the incidence of the income tax, the statute provides that the fair market price or value as of March 1, 1913, shall be taken as a starting point or basis for determining the amount of gain. Under the first law (Act of October 3, 1913) the original cost price (however far back) was taken as the starting point, the gain was distributed over the years the property was held and the pro-rata belonging to the period beginning March 1, 1913, was regarded as returnable income. In the case of sale or disposition of property acquired on or after March 1, 1913 the cost is taken as the starting point and gain is as- certained by determining- the difference between cost and selling price. It is very important that these two methods of reckoning gain be kept distinct in the taxpayer's mind that with respect to property acquired prior to March 1, 1913 and that with respect to property acquired on or after March 1, 1913. For the former there is the most THE INCOME TAX 29 definite and specific provision in the statute itself ; for the latter reg- ulations have been made by the Treasury Department. 35. GAIN IN REAL PROPERTY. With respect to real estate the amendment of the law has worked important changes. When, under the old provision it was necessary in computing gain derived from a sale of real estate to go back to original cost, in all cases, and then work out the problem by proration, it was impossible to ascertain the gain belonging to the period covered by the income tax law. For instance, an individual may have acquired 1000 acres of des- ert land in the year 1900 for $20 an acre. After holding the land in an unproductive state a number of years, he discovered in July 1912 that it was oil-bearing. Immediately this discovery became known, he was offered $1,000,000 for the property. But he did not sell at that time. Again, in January, 1913, he was offered $1,750,000, but he held the land until July 1916 and then sold it for $2,000,000. Under the old system of proration the individual's income tax would have been computed about as follows : Selling price $2,000,000 Original Cost $20,000 Carrying charges 30,000 (Taxes, Development, etc.) $50,000 Total cost . 50,000 Gain in 16 years $1,950,000 One year's prorata of gain 121,875 Four years' pro-rata 487,500 (1913-1914-1915-1916) Subject to tax 487,500 Under the new system the computation, in the rough, would take about the following form : Selling price $2,000,000 Fair market value of land as of March 1, 1913, determined by bona fide offer in January, 1913 1,750,000 Gain, subject to tax $250,000 30 THE INCOME TAX 36. GAIN IN PERSONAL PROPERTY. In a similar way the gain in a sale of securities, stocks or bonds, or other form of personal property, would be computed, according- to the old and the new methods. Sometimes the new method made imperative by the Act of Sep- tember 8, 1916, works in favor of the taxpayer, and at other times in favor of the Government. In the example just given, it works in favor of the taxpayer. But change the example. Suppose, for instance, that the individual, after having received the first offer of $1,000,000 for his land, held it and sold it in July, 1916, for $2,000,000 ; but did not, subsequent to July, 1912, and prior to March 1, 1913, receive a second bona fide offer. In such a case it might have been necessary to take the offer of $1,000,000 in July, 1912, as indicating with the nearest possible ap- proximation the fair market value as of March 1, 1913, in the absence of other data or the known value of adjacent lands to the contrary. And, in such circumstances the computation of gain would have shown $1,000,000 instead of $250,000. 37. FAIR MARKET VALUE. The fixing of fair market price or value as of March 1, 1913, becomes, of necessity, very difficult in many instances. The govern- ment insists upon a conclusive showing; and, likewise, the question is of such importance to the taxpayer that he should make sure of evidence w r hich the Internal Revenue officers must accept. With respect to real estate, in the absence of definite and bona fide offers, the selling price or market value of adjacent lands of similar character in regard to formation and productiveness is given great weight. Also assessments made by local officials, with due con- sideration for the particular local percentage of assessment, fre- quently help. And, in the case of lands passing through probate pro- ceedings, the appraisement of such lands by the court of jurisdiction. All these factors, or anv of them, can be considered. While they are '.I;..!.!'. not invariably accepted by the Government, they do offer valuable and generally acceptable support when it is necessary to fix an arbi- trary fair market value as of March 1, 1913, in the absence of more specific information regarding fair market price or value as of that date. In the matter of computing gain on the sale of personal property, such as corporate stock, acquired prior to March 1. 1913, very little difficulty is experienced with respect to stocks listed on an exchange, THE INCOME TAX 31 or quite generally dealt in. The varying daily market prices of such issues can be readily ascertained. However, taking cognizance of the, fact that in many cases there is on the one day both an opening and a closing price, the Treasury Department has held that the fair mar- ket price or value as of March 1, 1913, is the fair market price of value as of that entire day, which, in the case of variation between an opening and a closing price for the day, would mean the average price for the day. Even this, however, would be conditioned upon showing that the exchange quotation actually represented the fair market price or value of the stock. In the case of securities that are not commonly or frequently dealt in, great difficulty is experienced in ascertaining fair market price or value as of March 1, 1913. The Treasury Department has not laid down a -rule that can be invariably followed, and the result is that each case must be considered by itself according to the data available. Private sales of such securities, or the market price of other securities with assets of about the same value and productive- ness back of them, or appraisal by a court, can be taken into con- sideration, even though not always controlling. Thus, at best, in many cases, the computation becomes an approximation. 38. SALE OF SECURITIES LEFT BY DECEDENT. In this connection an interesting point arises with respect to the sale of inherited securities by a beneficiary under a w r ill. If, for instance, a beneficiary under a will receives certain secur- ities which have been appraised as of date of the decedent's death, at $100 a share, and subsequently sells them at $125 a share, he must include the increase in value in his return of income. In this con- nection it is essential that the taxpayer not confuse the increase of value after the securities have come into the possession of the bene- ficiary with the value of them at the time of the inheritance. The latter value, fixed by appraisal, in this example, at $100 a share, rep- resents the inheritance proper and, as such, is not subject to income tax ; but the gain, amounting to $25 a share, is a profit derived by the beneficiary from property received by inheritance and is, therefore, income which must be returned for tax by him. In other words the gain realized after the securities have come into the possession of the beneficiary is not a part of the inheritance. 39. SECURITIES SOLD BY ESTATE. If securities belonging to an estate are sold prior to the settle- ment of the estate by the executors or administrators, any gain de- 32 THE INCOME TAX rived, if any, is computed exactly as in the case of an individual, is considered income accruing to the estate and is, therefore, subject to tax. 40. IDENTITY OF STOCK UNCERTAIN. When various parcels of stock of the same issue are bought and sold at different dates the rule is that wherever possible, the shares sold shall be identified by the numbers of the certificates covering them. When stock is sold, and its identity cannot be determined, the Government requires that it be charged against the stock first pur- chased. If the purchase occurred on or after March 1, 1913, the entire amount of difference should be returned for tax. 41. GAIN FROM SALE OF RIGHTS. In the enforcement of the law there have arisen many unusual cases of income to be classified and defined. One of these is that accruing to an individual who holds stock in a corporation by reason of the sale of his rights to subscribe to new stock in the corporation. Basing its ruling upon the requirement of the law that income from all sources be returned for tax, the Treasury Department has held that such income must be included in the individual's return. 42. ACCIDENT INSURANCE. Accident insurance gives rise to another form of income. Money received by the person insured by an accident policy on account of an accident sustained is taxable income and must be returned by the in- sured person. However, upon the death of the person insured, when the proceeds of the. policy are paid to the individual beneficiary named in the policy, the amount paid is treated like the proceeds of a life in- surance policy and is not subject to tax. 43. DAMAGES. And, likewise, any amount received as "damages" or compensa- tion for injury or suffering, as the result of a suit or other proceeding, is income returnable by the person receiving the payment. However, should the amount received be in the form of reimbursement for ex- penses incurred by the recipient as the result of an accident, it is not subject to tax. 44. ALIMONY AND SEPARATE MAINTENANCE. An amount paid as alimony or for separate maintenance is tax- able income to the person receiving it. The woman must include THE INCOME TAX 33 the amount in her return if she has sufficient income, including the amount received, to make her liable to file a return. On the other hand, however, such a payment is regarded as a personal expenditure on the part of the man paying it and, as such, is not allowable as a deduction in his return. 45. FARMER'S INCOME. By reason of the fact that, generally speaking, he does not keep his accounts in very good order, the farmer has trouble ascertaining his income tax liability. Some simple form of accounting should be instituted by every farmer. It need not be elaborate even though his business be quite extensive. But some system is one of his most urgent needs if he is to be prepared to take advantage in full of those deductions to which the law says he is entitled. Without a system of accounting, the farmer finds himself at the end of the year with practically nothing but the stubs of his check- book to help him meet the perplexing requirements of the income tax law. And the inevitable result is that he has lost track of in- numerable expenditures that would be allowable as deductions could he state them in detail. Moreover, he is in no position to take ac- count of the depreciation of his equipment, an item which, in many another business, is most carefully guarded. In brief, the farmer not only cannot state his gross income for the year correctly, but is also unable to claim the rights to which he is entitled. As in the case of any other business, that of the farmer also re- quires individual consideration with respect to this preparation of his return of income. The Treasury Department has, however, laid down several general rules of guidance which are outlined here. 46. INCOME WHEN PRODUCTS ARE SOLD. All income derived from the sale or exchange of farm products should be included in the return of income for the year in which the products are actually marketed and sold. This rule covers not only that which is produced by the farmer making the return on his own place, but also any other farm products which are purchased and re- sold by him. For example : The returns from hay, cut in the spring of 1917 but held by the farmer in stack or warehouse until the year 1918 for sale, belong to the farmer's income for 1918. Grain, harvested in the summer of 1917 but held for sale until the spring of 1918, con- 34 THE INCOME TAX tributes to the farmer's income for 1918. And the same with all other products that can be held for marketing with the prospect of or hope for more favorable prices. 47. RENTS IN CROP SHARES. Likewise, rents received in crop-shares are to be included in the return of income for the year in which such crop-shares are reduced to money or a money equivalent. For example : A entered into a contract with B by the terms of which B agreed to produce during the year 1915 a crop of barley on A's land and deliver to A a third of the barley in sack, as rent. B sold his two-thirds share of the barley immediately after harvest ; A held his one-third share until the following spring and then sold it. B should have returned the proceeds of his share as income for the year 1915 and A the proceeds of his share as income for the year 1916, notwithstanding that the barley was all produced at the same time. 48. COST OF CROPS. But, while the proceeds from the sale of farm products should be included in the return of income for the year in which sold, the cost of production is allowable as a deduction for expense in the re- turn for the year in which incurred. In other words, the cost of operating a farm during the year 1917 should be deducted as expense in the return for 1917, even though the crop produced is held for sale beyond the end of the year 1917. 49. COST OF LIVESTOCK. When livestock is purchased for resale by a farmer, its cost is an allowable deduction as an item of expense of operation ; but when livestock is purchased for breeding or working purposes, the cost is not an allowable deduction as an expense in the farmer's return of in- come. In the latter case the expenditure is regarded as an investment of capital. . For example : A buys a number of calves and steers to feed and fatten for market, and the cost of the stock can be deducted by him as an item of expense. But when A buys a number of cows and mares for breeding purposes, and a work team of mules, his expendi- ture for them cannot be deducted in his return. 50. LOSS OF LIVESTOCK. A\ here livestock has been purchased by the farmer for any pur- pose and later dies from disease or injury, or is killed by order of THE INCOME TAX 35 public authorities, the cost can be deducted as a loss by the farmer in his return of income, provided (in the case of animals purchased for marketing) the cost has not already been deducted as an item of ex- pense, and less (in the case of animals purchased for breeding and working purposes) any amount claimed as a deduction on account of depreciation. If a fanner, who has deducted as a loss the cost of animals killed by order of public authorities, is later reimbursed by the State, or the United States, in whole or in part, on account of stock killed, he is required to report the amount of such reimbursement as income for the year in which received. The same rule also holds true with re- spect to reimbursement for other property destroyed, when deduc- tion has been claimed as a loss on account of such destruction. 51. COST OF FARM EQUIPMENT. The cost of farm machinery is not an allowable deduction as an item of expense. Such an expenditure is regarded as a capital invest- ment. However, the cost of the ordinary tools used on the farm is re- garded as an item of expense and may be so deducted. By farm machinery is meant such equipment as wagons, harvest- ers, mowers, tractors, and the like. By farm tools are meant articles such as axes, she vels, simple plows and harrows and similar equipment. 52. DEPRECIATION ON THE FARM. The farmer may in his return of income, also claim as a deduction on account of the exhaustion, wear and tear of his property, arising out of its use in his business, a reasonable allowance for depreciation. This applies to farm buildings (other than a dwelling on the farm occupied by the owner). It can be claimed on all buildings and structures used in connection with the business of farming barns, sheds, fences, drying-sheds, quarters of employees and the like. It applies also to farm machinery and to livestock purchased for breeding and working purposes. It does not apply to livestock purchased for resale, the cost of which can be deducted as an item of expense. 53. EXCEPTIONS TO GENERAL RULES. In general, the rules, given above are to be followed by the farmer. However, there is a provision in the Income Tax law ( Sub- division G of Section 8) which allows an individual keeping accounts 36 THE INCOME TAX upon any basis other than that of actual receipts and disbursements to make his return upon the basis upon which his accounts are kept, provided his method reflects his income. Hence, the farmer, who keeps books, according to some approved method of accounting, which clearly show his net income for the year, may prepare his re- turn from his books, even though his system may not follow strictly the rules outlined hereinbefore. In the event, however, that a farmer departs from the rules and follows his own system, he must have his accounts in condition for examination by field officers of the Internal Revenue Service. 54. FARMING FOR FUN. The rules hereinbefore explained are applicable to farming as a business, for profit. A person who cultivates a farm for recreation or pleasure, and not according to the principles of commercial farm- ing, is not regarded as a "farmer." The result, in his case, is gen- erally a loss from year to year, and, if the expenses of cultivation are in excess of the receipts from the farm, the entire venture may be ignored in the preparation of his return of income. The receipts need not be included in his return and the expenses of cultivation, being regarded as personal expenditures for pleasure, cannot be de- ducted from income derived from other sources. 55. INCOME DERIVED FROM GIFT. While the law provides that "the value of property acquired by gift, bequest, devise, or descent," is not income subject to tax, it must be clearly understood that any gains or profits derived from such property, after the property has been thus acquired, are subject to tax. For example : A inherits industrial bonds valued at $100,000 paying interest at the rate of 6 per cent per annum. The value of the bonds is not taxable income to A but the interest received by A after his acquisition of the bonds must be returned by him. 56. PENSIONS. Pensions paid by the United States Government are subject to the income tax. Likewise pensions paid, by private corporations to retired em- ployees are subject to tax if the person receiving them has sufficient income, including the amount thus received, to make him liable. 57. INCOME FROM PARTNERSHIP. While a partnership is not subject to income tax, each individual partner is required to include in his personal return as a part of his THE INCOME TAX 37 gross income his share of the net earnings of the partnership. How- ever, the members of a partnership which deals in State, municipal or other similar bonds, the interest on which is not subject to income tax, can exclude from their distributive interests in the partnership's earnings their proportionate shares of the interest received by the partnership on all such bonds. 58. INCOME FROM EXPORT BUSINESS. It has now been determined that income derived from an export business is clearly subject to tax. Legal attack was made on the re- quirement that income from such business be returned for taxation, the contention being that such an interpretation of the law was un- constitutional on the ground that to tax the income from export busi- ness is to tax the articles exported. In the case of Wm. E. Peck & Co. vs. John Z. Lowe Jr., collector (234 Fed. 125) decision is given in favor of the Government, and the income from such business is sub- ject to tax. 59. ROYALTIES, PATENTS, COPYRIGHTS. A payment in the form of a royalty on a patent is returnable by its recipient. A payment in absolute purchase of a patent right, as a result of which title to the patent passes, is returnable by the recipient as in- come to the amount by which such payment exceeds the aggregate amount expended in perfecting the invention and obtaining the patent. Quite similarly would be treated income derived in the form of royalties on publications or from the disposition of a copyright. The consideration of royalties from mines and oil and gas wells will be taken up in connection with the treatment of income from natural deposits in the earth. 60. MATURED BUILDING AND LOAN SHARES. When a certificate in a Building and Loan Association is ma- tured and payment on account of such maturity is made by the asso- ciation to the holder of the certificate, if the amount paid is in excess of the aggregate of the deposits made by the holder of the certificate to bring the certificate to maturity, the amount of such excess should be returned by the certificate holder for the year during which the certificate is matured. 61. TAXABLE INSURANCE INCOME. While the law exempts from tax the proceeds of life insurance policies paid to individual beneficiaries upon the death of the insured, 38 THE INCOME TAX and the amount received by the insured, as a return of premiums paid by him under a life insurance endowment, or annuity contract, either during the term or at the maturity of the term mentioned in the con- tract or upon the surrender of the contract, still there are certain gains from insurance policies or contracts that are regarded as tax- able income. When the amount paid to the insured under a life insurance, en- dowment, or annuity contract, either upon the maturity or surrender of the contract, exceeds the sum paid by the insured pursuant to the contract, the amount of the excess is held to be income subject to tax and should be returned by its recipient. Also dividends received by the insured from a paid-up policy are held taxable income to the insured and must be treated the same as dividends from a corporation's earnings in his individual return of income. THE INCOME TAX 39 CHAPTER V THE INCOME TAX INCOME EXEMPT FROM TAX Under the specific mandate of the statute certain income is ex- empt from the provisions of the law. Such income is clearly defined and is exempt not only from tax but also from any other provision of the law. In other words, with respect to income which comes within the exemptions named in the statute, the recipient has no duty to perform to the Government. He is not even required to report any such income and no amount, thus received, need be considered by him in determining his liability to make a return. 62. DEFINITION OF EXEMPT INCOME. Section 4 of the Income Tax Law, Act of Sept. 8, 1916, peads as follows : The following income shall be exempt from the pro- visions of this title: The proceeds of life insurance policies paid to individual beneficiaries upon the death of the insured; The amount received by the insured, as a return of pre- mium or premiums paid by him under life insurance, endow- ment or annuity contracts, either during the term or at the maturity of the term mentioned in the contract or upon sur- render of the contract; The value of property acquired by gift, bequest, devise or descent (but the income from such property shall be in- cluded as income) ; Interest upon the obligations of a State or any political subdivision thereof or upon the obligations of the United States (but, in the case of obligations of the United States 40 THE INCOME TAX issued after September 1, 1917, only if and to the extent provided in connection with the issue thereof) or its pos- sessions or securities issued under the provisions of the Fed- eral Farm Loan Act of July 17, 1916; The compensation of the present President of the United States during the term for which he has been elected and the judges of the supreme and inferior courts of the United States now in office, And the compensation of all officers and employees of a State, or any political subdivision thereof, except when such compensation is paid by the United States Government. 63. PROCEEDS OF INSURANCE POLICIES. In making up his return of income the taxpayer can ignore income derived from insurance policies or contracts as such income comes within the meaning of the law. He should not include any amount thus received in his statement of gross income. He can be guided by the following general definitions of exempt insurance in- come : (a) Proceeds of life insurance policies paid upon the death of the person insured to an individual beneficiary. (b) Amount paid under a life insurance, endowment, or annuity contract to the person making the contract (the in- sured) either upon the maturity or surrender of the contract ; provided, such payment does not exceed the sum paid on the contract by the insured. When there is such an excess, the amount of it becomes taxable income in the hands of its re- cipient, the insured. (c) Dividends paid on life insurance policies that have not matured, whether such dividends are drawn in cash by the insured or applied to the reduction of the annual premium due. (Dividends from paid-up policies are, however, con- sidered taxable income.) (d) Amount paid on life insurance policy to beneficiary in annuities or installments. 64. GIFTS, BEQUEST, ETC. The law provides that the value of property acquired by gift, be- quest, devise, or descent does not represent taxable income to the recipient, but it does definitely provide that any income from such property, after the property has come into the hands of the recipient, is taxable and must be returned by him. THE INCOME TAX 41 Distinction must therefore, be drawn between the value of the property at the time it comes into the possession of the person who benefits by the gift or bequest, and the subsequent income from the property. A bonus received by an employee, as additional compensation for services rendered, is not a gift, if paid by the employer pursuant to a contract, express or implied, or pursuant to a fixed policy or practice. In such circumstances, the amount of the bonus is regarded as a part of the wage of the employee. Payment of the bonus in a case of this kind, however, would have to be conditioned upon the services rendered by the employee and not upon the earnings of the employer. Where the salary of an employee is paid for a limited period after his death to his widow, or other dependents, in recognition of the services rendered by the deceased employee, no services being rendered by the widow or other dependents, the payment is regarded as a gift and is not subject to tax. 65. INTEREST ON U. S. AND STATE BONDS. Income in the form of interest on bonds or obligations of the following general classifications is exempt and need not be included in a return : (a) Bonds or obligations of the United States or its possessions (except as to the limitation with respect to ob- ligations issued after September 1, 1917, as hereinafter ex- plained). (b) Federal Farm Loan bonds, issued under authority of the Federal Farm Loan Act of July 17, 1916. (c) Bonds of any State. (d) Bonds of any political subdivision of a State. [Note important : The exception noted above in (a), with respect to interest on bonds or obligations of the United States issued after September 1, 1917, has reference to a provision in the Act of September 24, 1917 to the effect that if the aggregate principal of the bonds and certificates issued by its authority and owned by one individual, partnership, cor- poration or association, does not exceed $5,000, the interest on them is exempt from income tax. If the aggregate principal of a single holding does exceed $5,000, then the interest on the principal in excess of $5,000 is subject to the graduated additional income tax. But only an individual is liable to the graduated additional income tax ; hence only an individual is concerned with the amount of investment in such 42 THE INCOME TAX securities when income tax liability with respect to the interest is incurred. The Liberty Loan Bonds of the Second Series were issued subject to this provision. The Liberty Loan Bonds of the First Series are not subject to the provision, they having been issued prior to Sep- tember 1, 1917. All interest on the bonds of the First Series is exempt from income tax.] 66. WHAT "POLITICAL SUBDIVISION" COVERS. Referring to sub-paragraph (d) of the preceding general para- graph, the full scope of the meaning of the phrase "political sub- division of a state" should be understood. The Treasury Department has ruled, upon the advice of the Attorney-General of the United States, that it comprehends the bonds issued by (a) Municipalities (b) Counties (c) School Districts (d) Irrigation Districts (e) Reclamation Districts (f) Levee Districts (g) Street Assessment Districts. Interest on all such bonds is not to be considered for income-tax purposes. However, a mortgage assumed by a municipality in the purchase of a public utility, at the time of purchase subject to mortgage, does not become an obligation of the municipality within the meaning of the exempting provisions of the law with respect to interest. 67. STATE, COUNTY, MUNICIPAL EMPLOYEES. The exemption with respect to the compensation of officers and employees of a State, or political subdivison of a State is applicable to the salaries not only of all elected and appointed officers and em- ployees of a State, county or municipality but also to the salaries of public-school teachers, members of the faculty and employees of a State University or other institution of learning, managers, super- intendents and employees of all State, county and municipal institu- tions, and even special compensation paid by a State, or any political subdivision of a State, for professional services, whether such pay- ment be denominated salary or special fee. However, a payment made by a State or political subdivision of a State to a contractor engaged in the construction of a public work pursuant to the terms of a contract is not exempt. THE INCOME TAX 43 CHAPTER VI THE INCOME TAX DEDUCTIONS ALLOWED INDIVIDUALS [The deductions explained in this chapter are those allowed citizens or residents. For deductions allowed non-resident aliens read chapter on "Non-Resident Aliens."] Unless the individual, on the one hand, knows his rights of de- duction and, on the other, understands the technical limitations es- tablished by the Treasury Department, he is sure to be in trouble all the time, both before and after the filing of his return. He may, in the first place, overestimate his rights, upon the meager information avail- able to him, and decide, without consulting authority, not to file a return. Then comes a day of reckoning. The field officers of the Internal Revenue Service, following leads from their innumerable sources of information, check him up and call for an explanation. Or, the individual may, in an excess of caution, neglect to charge against his gross income for the year deductions to which he is legit- imately entitled. He may be wary of insisting upon the credits the law allows him lest he make a mistake. Government officers do not, as a rule, call him in and advise him that he has overstated his tax- able income. In haphazard fashion he makes up his return and sub- mits thousands of dollars to assessment that the law does not con- template taxing. He pays dearly for his failure to assert his rights. It, therefore, behooves every individual to look closely into his rights of deduction before filing his return. In this chapter such rights of deduction will be outlined. It will be necessary, however, to supplement the information given in this chapter by consulting that given elsewhere in the book under headings applicable to the questions involved. 44 THE INCOME TAX 68. EXPENSE OF BUSINESS. The deduction for expense is limited to the expenditures in the conduct of the business of the individual during the year for which the return is made. There may be one business, or more than one ; if the necessary expense of operation for the year has actually been paid, the amount may be deducted. This expense may comprise many items, as will hereinafter be explained, but the first essential is that it be strictly the year's operating expenditure in connection with the individual's business. 69. NO PERSONAL EXPENSE. No amount representing the personal, living or family expenses of the taxpayer can be deducted in his return. On this point the Gov- ernment is very strict and a great deal of the trouble in which tax- payers have become involved has been due to their failure to obey the requirement, generally through lack of understanding of some of the Government's finely drawn distinctions between business and per- sonal expense. However, with respect to the general exclusion of personal, living or family expenses the language of the law is clear, even though individuals may differ regarding the distinctions im- posed by regulations and decisions. 70. NO PARTNERSHIP EXPENSE. A business expense incurred by a partnership is not allowable as a deduction in the return of an individual partner for the reason that such partner is required in his statement of gross income from all sources to include only his share of the net earnings of the partner- ship. The business expenses of the partnership have, therefore, been taken care of in determining the partnership's net earnings, and are not a proper charge against the gross income of the individual partner. 71. NO COST OF MERCHANDISE. Cost of merchandise, when considered in connection with a mer- cantile business, should not be deducted as an item of expense. Gross income from a mercantile business the amount reported in the re- turn is ascertained by opening and closing inventories, hence cost of merchandise is accounted for in ascertaining the amount of gross in- come from the mercantile business and would not, therefore, be properly chargeable again in the individual's return. 72. NO PERMANENT IMPROVEMENT. And a question that has given rise to no end of controversy is that relative to expenditures for improvements and betterments. The THE INCOME TAX 45 law and Treasury Department regulations do not allow such an ex- penditure as a deduction from gross income. An expense of this na- ture is regarded as a capital investment. In many instances, how- ever, it has been difficult to draw the line between business expense amd expenditure for a permanent improvement or betterment. So many and varied problems have arisen that each case must be con- sidered upon its own merits. Always, however, the theory should be followed that an expense tending to increase the value of a property goes into an improvement or betterment, and is not deductible. Such would be the cost of new buildings, or of additions to old buildings, and the remodeling of old buildings and installation of modern equip- ment and conveniences. In this last respect, however, the cost of re pairing and rennovating a business building, as such expenditure is necessary to keep the building a producing property, is an allowable deduction as a business expense. Other paragraphs on special subjects should be consulted for in- formation as to the treatment of expenses in connection with them. 73. EXPENSES ON RENTED PROPERTY. In his return the individual is required to report his gross re- ceipts from rents. Deduction may be claimed on account of any ex- pense incurred in the maintenance of the property, or its use, for rental purposes, including amounts paid for repairs, insurance, fuel, light and water, janitor and elevator service. The deduction for such expense of maintenance must, however, be claimed against total gross income from all sources. Experience has shown that many landlords have first deducted from gross rental receipts the expense of main- tenance and have then included in their returns the net income from rent. This is not allowed under the regulations of the Treasury De- partment. 74. ASSESSMENTS ON STOCK. Assessments paid by an individual on stock do not constitute a deductible expense any more than does an original investment in stock. Such payments are regarded as strictly capital transactions as additional investments of capital in the stock of the corporation. In New York City there arose an interesting case in this connec- tion. A corporation, whose stock had been fully paid and was non- assessable, found a deficit at the close of the year, which the stock- holders made good by agreeing to the payment of voluntary assess- ments. The Treasury Department held, by letter, that the payment 46 THE INCOME TAX of such "voluntary assessment" by the stockholders was, to all in- tents and purposes, additional payment for the stock of the corpora- tion and, therefore, a capital expenditure. The stockholder could not deduct the amount paid in rendering his individual return. It follows, of course, (as will be explained in another paragraph) that when such a payment is not allowable as a deduction to the stockholder, it is not income to the corporation receiving it. 75. PREMIUM ON BOND. A premium paid on a fidelity bond by an employee (when he is required to furnish bond,) or on the faithful performance, labor and material or other surety bonds given by contractors or others in con- nection with business transactions, is a business expense allowable as a deduction. Under this rule would come the premiums on the bonds required by the Government from distillers, wine-makers, liquor deal- ers, brewers and cigar and tobacco manufacturers, covering both the manufacture and movement of their products. 76. COMMISSIONS AND FEES. Commissions and fees, required to be paid in the transaction of business are items of business expense allowable as deductions ; ex- amples of such items being commissions paid real estate agents and salesmen and fees paid for professional services rendered in connec- tion with the business of the taxpayer. 77. INSURANCE PREMIUMS. The cost of insurance on property which is not occupied by the owner as a dwelling is allowable as a deduction. The rule is that the cost of all business insurance is a legitimate business expense and the amount of the premium paid during the year may be deducted. This may be the premium on fire insurance, burglary or general liability insurance, workmen's compensation insurance, or other form of in- surance required in connection with the taxpayer's Business. It covers also insurance on merchandise, stock, crops and business equipment of any kind, as well as insurance on buildings. Premiums paid on life insurance policies by the insured can not be deducted in his return. They are regarded as personal expenses. 78. FARMER'S DEDUCTIONS. A farmer, of course, is entitled to every deduction, as business expense, allowable in any other kind of business, provided such ex- pense be necessary in the operation of his farm. However, there are THE INCOME TAX 47 certain additional items of expense peculiar to the business of farm- ing that may be mentioned. For example, the farmer may deduct the cost of (a) Stock and crops bought for resale. (b) Seed. (c) Farming tools (but not machinery.) (d) Feed for stock. (e) Fertilizer. (f) Tree or vine spray. (g) Crop insurance. 79. ALIMONY. Any amount paid as alimony is not allowable as a deduction in the return of the person paying it, the expenditure being regarded as a personal expense. However, the person receiving alimony must ac- count for it as taxable income. Likewise, many expenditures, while personal expenses and there- fore not allowable deductions to those paying the money, must be returned as taxable income by recipients of them. 80. INTEREST PAID. In the language of the law the individual (citizen or resident of the United States) can deduct from gross income for the taxable year All interest paid within the year on his indebtedness ex- cept indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under this title. The exception noted in the paragraph above is an amendment carried by the War Revenue Act and refers, of course, to indebted- ness incurred for the pmpose of purchasing securities such as United States, State, County, Municipal, School, Street Improvement, Irri- gation District, Farm Loan, and other bonds of a public character, the interest upon which is not subject to income tax. Any amount of interest deducted must have been paid on the personal indebtedness of the individual during the year for which the return is made. 81. TAXES PAID. In the Income Tax law, as amended by the War Revenue Act, the provision for deduction on account of taxes reads as follows : Taxes paid within the year imposed by the authority of 48 THE INCOME TAX the United States (except income and excess profits taxes) or of its Territories, or possessions ; or any foreign country, or by the authority of any State, county, school district, or munici- pality, or other taxing subdivision of any State, not including those assessed against local benefits. The amendment carried by the War Revenue Act is the exception of Federal income and excess profits taxes. The amount of these taxes paid during the year for which return is filed cannot be deducted from gross income in filing a return. However, in assessing income tax, there will be allowed a credit against the net income shown in the return of the excess profits tax assessed for the same tax year. The limitation written into the law does not refer to the income tax im- posed by any State. Such a tax is obviously still allowable as a de- duction in the return for the year in which it has actually been paid. 82.TAXES AGAINST LOCAL BENEFITS. The other limitation in the law with respect to deduction on ac- count of taxes paid is that covering "taxes assessed against local benefits." By such taxes are meant payments made pursuant to assessment levied by a special district an assessment confined in its application to property within a certain limited area and resulting in a local bet- terment of that property. A case in point is the cost of street im- provement or sidewalk construction within a specified district of a city. The district covered by the assessment may be small in relation to the size of the city (such is generally the case with respect to a street or sidewalk assessment), or it may be more extensive and af- fect property within a much greater area as in the case of so well known an improvement as the Twin Peaks Tunnel in San Francisco. A tax of this kind is not allowable as a deduction. And the Treasury Department has ruled that the limitation has reference also to an irrigation, reclamation, or drainage district assessment where local improvement is again the purpose of the ex- penditure. The municipality seems to be the smallest taxing unit acceptable to the Government as capable of imposing a tax sufficiently general in application to be allowable as a deduction. 83. STATE INHERITANCE TAX. A collateral inheritance tax, levied under the laws of a State and made a charge against the corpus of the estate, has been held by the Treasury Department to constitute such an item of expenditure as cannot be allowed as a deduction in computing the income tax liability of either the beneficiary of the inheritance or the estate. THE INCOME TAX 49 84. TAXES PAID BY A BANK. A great deal of confusion has arisen over the payment to the State directly by a bank of taxes assessed against the stockholders of the bank in proportion to the number of shares of stock held by each. Such a tax, the Treasury Department holds, is in reality paid by the bank in behalf of its stockholders. It becomes, therefore, a proper deduction for each stockholder to claim, according to his in- terest ; but cannot be claimed as a deduction by the bank. As herein- before explained, however, the stockholder must at the same time account for the amount of the tax upon his shares as an additional dividend from those chares. 85.^-CUSTOMS DUTIES. Import duties are also deductible taxes in the return of an indi- vidual required to pay them. In the case of a person engaged in the importation of merchandise as a business the amount of customs charges may be added to the cost of the merchandise, if preferable, or may be treated as a payment of tax. In any case it is allowable as a deduction. 86. TAXES MUST BE PAID. To be allowable as a deduction, however, the tax must actually have been paid within the year for which the return of income is ren- dered. Where an annual local assessment becomes due in two in- stallments, in different calendar years, it follows that the amount claimed as a deduction by an individual in his return for the first cal- endar year is frequently the sum of the second installment of the local assessment for the year before (paid in the year for which the return is rendered) and the first installment of the local assessment for the year for which the return is rendered. 87. FOREIGN TAXES. There is no limitation with respect to a tax paid to a foreign government. The entire amount of the tax paid within the year may be deducted. This also includes any foreign income tax even though the United States income tax is not allowable as a deduction. However, a foreign tax payment is deductible only in the return of a citizen or resident of the United States. It cannot be charged against his income from sources within the United States by a non- resident alien. 50 THE INCOME TAX 88. LICENSE AND STAMP TAXES. Local license taxes, State excise or franchise taxes and the Fed- eral license, stamp and occupational taxes are all proper deductions. In this connection may be mentioned such expenditures as those made by various kinds of business for municipal or county licenses, those payments to the State for licenses and franchises and those payments to the Government either in the purchase of Internal Revenue stamps or for the privilege of conducting business. The exception with re- spect to the Federal Income and Excess Profits taxes should, however, be kept in mind. 89. LOSSES DEDUCTIBLE. The allowance for losses and the Treasury Department's strict ruling on every point that has arisen has caused more confusion and brought more controversy between government officials and tax- payers than any other feature of the Income Tax law. Properly this allowance for losses may be divided into three distinct provisions as follows : (a) Losses arising from fires, storms, or shipwreck, or other casualty, and from theft, when such losses are not com- pensated for by insurance or otherwise. (b) Losses sustained in the business or trade of the in- dividual who makes the return. (c) Losses sustained in transactions that have been entered into for profit but are not connected directly with the business or trade of the individual who makes the return. Before attention is given to each of the above kinds of losses, certain general restrictions imposed by the Government in its inter- pretation of the law should be emphasized. 90. LOSS MUST BE ABSOLUTE. A loss to be allowable as a charge against gross income must have been actually sustained and ascertained during the year for which the return is filed. The Government insists upon an exact definition of the words "actually sustained during the year," appear- ing in the law. The loss must be absolute and must result from a transaction which has been completed. It must be the outcome of dealing in property, real or personal, which has been closed and does not offer further opportunity for either additional loss or recovery from loss. Where an investment has been continued by the taxpayer and his loss is represented only by a decrease in the value of the THE INCOME TAX 51 property he holds there has not been sustained a loss which can be allowed as a deduction, according to the Treasury Department's ruling. In other words, the uncertainty of fluctuation in value cannot be considered; the transaction must have been closed and the loss must have been thus determined during the year for which the return is made. 91. LOSS FROM CASUALTY. To revert to the classification of losses under three general defi- nitions, consider, first, the loss from fire, storm, shipwreck, or other casualty, or from theft, when such loss is not compensated for by insurance, or otherwise. If the insurance is insufficient, the loss in excess of the amount of insurance received may be claimed as a deduction. Cost should be taken as the basis of computation in such a case. If the insurance received is full compensation for the property destroyed, or lost, no deduction on account of the casualty can be claimed, and no account need be rendered of the receipt of the insurance in making a return of income. 92. LOSS IN BUSINESS OR TRADE. But with respect to a loss sustained in business or trade the Treasury Department has applied the strictest kind of interpretation to the language of the law. First, there is the loss incurred in the taxpayer's business or trade during the year. Then, there is the loss incurred in transactions entered into for profit by the taxpayer but not connected with his business or trade. The experience of the writer in administering the Income Tax law is that the public has never become reconciled to the Treasury Department's interpretation of the Act in this respect. In a way, the decisions of the department are conflicting, as will be pointed out; at least they are sufficiently indefinite to leave doubt in the mind of the taxpayer. A loss incurred in the taxpayer's business or trade is deductible in full. A loss incurred in transactions entered into for profit by the taxpayer, but not connected with his business or trade, is deductible only to an amount not exceeding profits from other transactions of a similar kind during the year. 93. WHAT IS A MAN'S BUSINESS? And so it has become necessary for the Treasury Department to attempt to say what is an individual's business or trade and when a transaction is not connected with that business or trade. 52 THE INCOME TAX Says the Department in Treasury Decision 2090: The term "in trade," as used in the law is held to mean the trade or trades in which the person making the return is engaged; that is, in which he has invested money otherwise than for the purpose of being employed in isolated transac- tions, and to which he devotes at least a part of his time and attention. A person may engage in more than one trade and deduct losses in all of them, provided, that in each trade the above requirements are met. As to losses on stocks, grain, cotton, etc., if these are incurred by a person engaged in trade to which the buying or selling of stocks, etc., are incident as a part of the business, as by a member of a stock, grain, or cotton exchange, such losses may be deducted. A person can be engaged in more than one business, but it must be clearly shown in such cases that he is actually a dealer, or trader, or manufacturer, or whatever the occupation may be, and is actually engaged in one or more lines of recognized businesses. The Government insists that the above requirements be met be- fore the full amount of a loss may be allowed as a deduction. The result is controversy without end. Before the Income Tax law was amended and re-enacted by the Act of September 8, 1916, no amount of loss sustained in a transaction not connected with the business or trade of the individual was deductible, according to the ruling in Treasury Decision 2090, and before that in Treasury Decision 2005. With the law in its present form, and the ruling still the same, only so much of such loss may be deducted as the amount of the loss does not exceed a profit from a similar transaction. If there has been no profit during the year, no loss, however great, may be deducted. The condition of confusion is one that requires tha c each taxpayer do his best to comply with the Treasury ruling. Each case, each loss, must be considered on its own merits. The difficulty comes, however, from the application of the Treas- ury ruling. The Department has plainly stated that an individual may be engaged in more than one trade or business ; and yet in prac- tice it has repeatedly denied individuals this privilege in connection with allowance for losses. A case in point is refusal to allow a banker and investor to de- duct in full his losses in stocks and the promotion of manufacturing ventures, when, as a matter of fact, he gives as rrmch time to his stock investments and industrial promotions as to his banking activ- ities. He happens, however, to have the title of bank president. THE INCOME TAX 53 Another case is the disallowance of the full amount of losses claimed by an investor in connection with real estate investments, the Treasury Department holding that only a person whose business is that of a real estate dealer may deduct in full his losses from real estate transactions. The Treasury Department has also taken the position in its in- structions to field investigating officers that only a person whose busi- ness is that of a licensed and recognized broker, and who buys and sells securities for others as well as for himself, has a right to deduct the full amount of any loss sustained in handling stocks and bonds. These references to the position of the Treasury Department are made merely in illustration. Obviously, under the original Income Tax Law, the Act of October 3, 1913, the Treasury Dej artment sought merely by regulation to prevent deduction of speculative losses. Then in the Act of September 8, 1916, Congress, in part, acceded to the stand taken by the Treasury, and wrote in the fifth paragraph of sub- division (a) of Section 5 (note text of law). This amendment pro- vides for allowance of a speculative loss only in a year when the tax- payer has enjoyed a speculative profit, and, even then, never to an amount in excess of the profit. An example : A lawyer invests in two issues of stock and sells both during the year. In one transaction he loses $10,000 but in the other makes a profit of $5,000. He can claim deduction for a loss of only $5,000, and at the same time must include his profit of $5,000, in the latter transaction, in his statement of gross income. Another example : The lawyer loses in both transactions, selling one lot of stock for $10,000 less than cost and the other for $5,000 less. He has made no profit in a similar transaction during the year, and so cannot claim as a deduction any part of his total loss of $15,000. 94. TAXPAYER'S COURSE. It is suggested that the individual adopt the following course: 1. Deduct in full every business or trade loss sustained during the year if transactions of the general character of that in connection with which the losses have been incurred have engaged a part of his time and attention in the ordi- nary course of affairs from year to year and are not to him merely isolated and speculative ventures. 2. In connection with the explanation of the loss deduc- tion which he is required to make, attach a rider to his return calling attention to the fact that he is engaged in 54 THE INCOME TAX more than one trade or business, and furnishing evidence of the fact. 3. Fall back upon the provisions of the fifth paragraph of subdivision (a) of Section 5 of the law only in the case of a transaction strictly speculative and isolated, with respect to its character, from the course of his ordinary business affairs. The individual will be within his rights if he follows the sug- gestion just made. He knows whether he is engaged in one business, or more than one business, and it is his right to make his claim for deduction on account of losses accordingly. By doing so he risks no penalty but may save hundreds (or possibly thousands) of dollars in taxes that he does not legitimately owe and should not be assessed. 95. HOW TO ASCERTAIN LOSS. In the event a loss is deductible it must be ascertained according to one of two general methods. 1. When sustained from the sale or other disposition of property, real, personal or mixed, acquired before March 1, 1913, the amount of loss must be determined upon the basis of the fair market price or value of the property as of March 1, 1913. 2. When sustained from the sale or other disposition of property acquired on or subsequent to March 1, 1913, the amount of loss must be determined upon the basis of the cost of the property. In this connection it is suggested that the reader note the ex- planation given with respect to method of ascertaining gain from the sale or disposition of property, real or personal. 96. VALUE AS OF MARCH 1, 1913. The fair market price or value of real property as of March 1, 1913 can be ascertained by considering any bona fide offer made im- mediately prior to that date, or the selling price at about that time of similar property, or in some other way suggested in the paragraph on "Gain from Real Property." Sometimes the individual must fall back upon such bases as local assessment and court appraisement for a working foundation. The method must be varied to fit each indi- vidual case ; it is impossible to lay down a general rule. And in some respects so it is in regard to the fair market price or value of personal property, particularly securities, as of March 1, THE INCOME TAX 55 1913. There is, however, to be considered the fact that in the case of many such securities as stocks and bonds there is available record of the price at which they were selling on the market on March 1, 1913 ; hence in any such case the determination of a basis of loss computation is comparatively simple. 97. COST ON OR AFTER MARCH 1, 1913. The cost of property acquired on or after March 1, 1913 (as a basis of ascertaining loss or gain) is held by the Treasury Depart- ment to be the actual price paid for it, plus any expense incident to purchase and sale, and the cost of improvement, if any. Special assessments, which have added to the value of the property and have not been allowed as deductions on account of taxes, also become a part of the cost of the property, in the case of real estate. Such assessments are those for street and sidewalk improvement, local sewerage, and the construction of irrigation and reclamation works. 98. BAD DEBTS. Deduction for bad debts is allowed only when the debt due the taxpayer has been actually ascertained to be worthless and has been charged off within the year for which the return is made. It is not sufficient that the taxpayer merely regard a debt as worthless. He must have made some effort to collect and must have then charged off the amount due him as an absolute loss in his own system of accounting. The insistence of the ruling is that there be no guessing as to the worthlessness of the debt. The fact of loss must be established to make the amount due an allowable charge against gross income. 99. DEPRECIATION DUE TO EXHAUSTION, WEAR AND TEAR. The Federal Income Tax law provides for the deduction of a "reasonable allowance" for the exhaustion, wear and tear of physical property used in the business of the taxpayer. Such "reasonable allowance" may be claimed in a return of income, provided the fact that it is "reasonable," within the meaning of the Treasury Depart- ment regulations, can be established. ^ However, for the reason that the subject is one of such great im- portance and for the further reason that both individuals and corpora- tions must follow the same rules, it has been deemed advisable to dis- 56 THE INCOME TAX cuss the question fully with detailed illustrations, in a separate chap- ter under the heading, "Depreciation of Physical Property." The reader is, therefore, referred to the special chapter on the subject. 100. DEPLETION OF OIL, GAS AND ORE DEPOSITS. Also, the taxpayer is allowed to deduct a "reasonable allowance'" for reduction in flow of oil and gas from wells, and for depletion of ore deposits in mines. But, as in the case of depreciation of physical property, this sub- ject is one with which both individuals and corporations are con- cerned and can be done justice only in a separate chapter where it can be gone into in full detail. And so the reader is referred to such special chapter under the heading, "Depletion of Natural Deposits." 101. GIFTS TO CHARITIES, ETC. An individual is also allowed as a deduction contributions or gifts made during the year covered by his return to charitable and other organizations of certain classes, but the deduction on this account can not be excess of 15 per cent of what his net income would be if this particular deduction were not allowed. In order for such a contribu- tion or gift to be allowable as a deduction, the organization to which it is made must have been formed and be operated exclusively for re- ligious, charitable, scientific, or educational purposes, or it may be a society for the prevention of cruelty to children or animals, provided no part of its net income inures to the benefit of any private individual. THE INCOME TAX 57 CHAPTER VII THE INCOME TAX CREDITS IN COMPUTATION OF INDIVIDUAL TAX. (The credits referred to in this chapter are those allowed citizens or residents of the United States.) 102. CREDITS ALLOWED. Even after the individual has stated in full his gross income (ex- cluding, of course, income exempt from tax) and has claimed the de- duction to which he is entitled, there are certain credits he is allowed in the computation to determine his tax liability. 103. CREDIT FOR EXCESS PROFITS TAX. The law provides that in assessing income tax the net income shown by a return shall be credited with the amount of any excess profits tax assessed for the same tax year. The amount of the excess profits tax is not allowed as a part of the general deduction for taxes in ascertaining net income (net income being gross income less de- ductions), but when net income has been ascertained it can be credited with the amount of excess profits tax assessed for the same tax year. Thus the amount of net income shown by the return less the excess profits tax, if any, assessed for the same tax year is the basis of in- come tax assessment. There are, however, certain other credits to be considered in the computation of normal tax liability. They are ex- plained in the paragraphs immediately following. 104. CREDIT FOR DIVIDENDS. The law provides that "for the purpose of the normal tax only, the income embraced in a personal return shall be credited with the 58 THE INCOME TAX amount received as dividends upon the stock or from the net earn- ings of any corporation, joint-stock company or association, or insurance company, which is taxable upon its net income." The amount received as dividends must be stated as a part of gross income but after net income has been ascertained by subtract- ing the total amount of deductions from gross income and after proper credit has been taken for excess profits tax, if any, the amount of dividends may be deducted in the computation of normal tax lia- bility. However, as noted above, (in the case of a net income running into figures to make it subject to the additional tax) the determina- tion of additional tax liability is entirely another consideration, and into such computation the amount of dividends must enter. On this latter point the law reads as follows : "For the purpose of the additional tax there shall be in- cluded as income the income derived from dividends on the capital stock or from the net earnings of any corporation, joint-stock company or association, or insurance company." 105. SPECIFIC EXEMPTION. Credit is also allowed for what is known as the "specific ex- emption," with respect to the net income of every individual (citizen or resident). This specific exemption under the old law (Act of Sept. 8, 1916) is as follows : (a) A single person who is not the head of a family is al- lowed $3000. (b) A single person who is the head of a family is allowed $4000 and an additional $200 for each dependent child. (c) A married man living with his wife, or a married woman living with her husband, is allowed $4000 and an additional $200 for each dependent child. 106. HEAD OF FAMILY. The Treasury Department has defined "the head of a family" as follows : "A person who actually supports and maintains one or more individuals who are closely connected with him by blood relationship, relationship by marriage or by adoption and whose right to exercise family control and provide for these dependent individuals is based upon some moral or legal obligation." THE INCOME TAX 59 The law specifies that a "dependent child" must be under eighteen years of age or incapable of self-support because mentally or phys- ically defective. Thus an unmarried person may be the head of a family, as in the case of a son with aged parents or younger brothers and sisters (de- pendent children) dependent upon him for support. Or a widow with dependent children would meet the requirement of the Department. However, a widow or a widower, with no dependents, is entitled to only the exemption of $3000 allowed a single person who cannot qualify as the head of a family. And the married or single status of a person must be determined as of the last day of the year for which the return is filed. Should a man's wife die prior to the end of the year, even though she had lived the greater part of the year, his status, in the computation of income tax for the entire year, would be that of a single person and he would be allowed an exemption of only $3000 unless he could qualify as the head of a family or had been married again prior to the end of the year. 107. HUSBAND AND WIFE. The law provides that only one deduction of $4000 (as an exemp- tion) can be made from the aggregate income of both husband and wife when living together, and that the additional exemption of $200 for each dependent child shall operate only in the case of one parent in the same family. If husband and wife file separate returns, either may claim the full amount of the exemption or they may prorate the amount between themselves. 108. CREDIT FOR DEDUCTION AT SOURCE. The total normal tax liability having been ascertained by taking credit according to the preceding paragraphs of this chapter, the in- dividual has the right to credit such total normal tax liability with the amount of normal tax, if any, which has been deducted at the source. When this credit has been taken, the result should be the amount of normal tax due the government. 109. ADDITIONAL TAX DIFFERENT. Of the credits mentioned in this chapter only one is allowable o gainst net income for the purpose of ascertaining additional tax lia- bility. That is the credit for amount of excess profits tax assessed for 60 THE INCOME TAX the same tax year. Only by such amount can the net income shown by a return be reduced before the additional tax is computed. The amount represented by dividends can be deducted from net income and the specific exemption claimed only in the computation for the normal tax. It also follows that the amount of normal tax withheld at the source is not to be considered in the computation for the additional tax. THE INCOME TAX 61 CHAPTER VIII THE INCOME TAX FILING OF INDIVIDUAL RETURN 110. PERIOD COVERED. The individual return of income is based upon the calendar year beginning January 1 and ending December 31. In this the language of the law is specific. The individual is not allowed the privilege of filing a return according to a fiscal year, as is the corporation. The Government recognizes just the one income-tax period with respect to the individual and that is the Calendar year. 111. WHEN TO BE FILED. The individual return of income must be filed on or before the first day of March for the preceding Calendar year. This means that a return for the year 1917 must be filed on or before March 1, 1918. There are two distinct penalties provided for neglect or refusal to file a return within the time prescribed by law. One takes the form of an addition of 50 per cent of the amount of tax shown to be due. The other is what is known as the specific penalty and consists of a fine of not less than $20 nor more than $1000. With respect to either of these penalties, however, the taxpayer should read the appropriate paragraphs in the chapter on "Penalties, Offer in Compromise and Prosecution." 112. BY WHOM TO BE FILED. In view of the fact that the two income tax laws (Act of Septem- ber 8, 1916 and Act of October 3, 1917) are to be administered to- gether, the question of liability to file a return for the year 1917 and subsequent years must be determined by the provisions of the act by which the amount of net income necessarv to create such liabilitv has 62 THE INCOME TAX been reduced. That act is the Act of October 3, 1917. Under it a re- turn must be filed by every individual, who is a citizen or resident of the United States, according to the following circumstances : (a) A single person with a net income for the year of $1,000 or more. (b) A married person, living with wife or husband, with a net in- come for the year of $2,000 or more. A non-resident alien, not being subject to the War income tax, imposed by the Act of October 3, 1917, still has his liability to file a return fixed by the provisions of the Act of September 8, 1916, alone, and these provisions are that every non-resident alien with a net in- come from sources within the United States of $3,000 or more is re- quired to file a return. A point in this connection deserving emphasis is that liability to file a return is not the same as liability to tax. It is important that the distinction be understood. Under the law a single person with a net income of exactly $1,000, or a married person with a net income of exactly $2,000, is required to file a return ; yet neither would have any tax to pay. Penalty could be imposed, however, for failure to file. Many returns are filed on which no tax is assessed. 113. HOW FILED. The filing of a return means the delivery of the return to the Collector of Internal Revenue. And tbis must be accomplished on or before the first day of March. Filing with a Deputy Collector is regarded the same as filing with the Collector. If a return is mailed it should in every instance be forwarded under either a registry or special delivery stamp, so that the taxpayer may obtain a receipt showing the time of the arrival of the return in the hands of the Collector. Mailing a return on or before the first day of March is not re- garded as compliance with the law unless sufficient time is allowed for the return to reach the Collector, in the ordinary course of the mail, within the time prescribed. These points are not trivial ; indeed, their importance cannot be too strongly emphasized, for many a pen- alty has been imposed in the face of proof that the return was mailed on or before the first day of March but not in time to reach the Col- lector's office before the expiration of the time limit. 114. RECEIPT FOR RETURN. The taxpayer is entitled to a receipt from the Collector for the filing of a return. He should ask for this receipt, whether he file in THE INCOME TAX t 63 person or by mail. The receipt is not ordinarily issued, but the Treas- ury Department has provided a form and instructed Collectors to issue a receipt whenever one is requested. The suggestion is, there- fore, made that the taxpayer ask for a receipt for his own protection. Experience has shown that in the rush of work during the filing per- iod returns are misplaced or lost after they have been regularly filed. 115. WHERE FILED. The return should be filed with the Collector of the district in which the individual resides. The law provides that it be filed in the district where the individual has his legal residence or principal place of business, but the Treasury Department has directed that residence determines the place of filing. 116. FORM TO BE USED. The return must be made on a form to be obtained from the Col- lector of Internal Revenue, at his headquarters, or from one of his deputies at a branch office. This form can be obtained by writing and asking for the form for individual return. [Prior to recent amend- ment of the law this form was No. 1040. Presumably the same desig- nation will apply when the revised forms are issued.] The return must show all income received during the preceding calendar year (except income which is exempt from tax), all deduc- tions (with proper explanations) and the specific exemption which the individual claims. All information called for by the return must be given in the spaces provided for it. The name and address must be plainly written on the first page. And in every instance the return must be made under oath. It may be sworn to before any officer qualified to administer an oath, or be- fore the Collector or one of his deputies. 117. EXTENSION OF TIME. In certain cases it is possible to obtain an extension of time for filing. In cases of sickness or absence the Collector has authority to grant an extension not to exceed thirty days from March 1. When this extension is desired application must be made in writing to the Collector and reason given. It is useless to apply to the Collector for an extension for any other reason than sickness or absence, as the law limits his authority. However, a person residing or traveling abroad and unable to file his return on or before March 1, can obtain a further extension of time from the Commissioner of Internal Rev- enue, provided his case is meritorious. If this further extension is 04 THE INCOME TAX required written application should be made to the Collector with the request that he transmit the application to the Commissioner, whose office is in Washington, D. C. When a return is filed, after an extension of time has been ob- tained, notation of the extension should be made on the top margin and, if possible, a copy of the letter granting the extension should be attached; otherwise the person filing the return will be regarded as delinquent and will be liable to penalty. 118. KEEP COPY OF RETURN. Each individual should retain for his files a copy of his return. If an extra copy of the official form can be obtained, the retained copy should be kept on it ; otherwise a form for the retained copy should be improvised. This is important to the taxpayer in the event he should later be investigated by a field officer. 119. AGENT OR GUARDIAN MAY FILE. When by reason of minority, insanity, absence, sickness or other disability one is unable to make his own return, his guardian or duly authorized agent must act for him and comply in full with the law and be subject to the same penalties as his principal. The Treasury Department has held, however, that a person acting merely under a power of attorney for the management of property, where no legal trust has been created, does not have to assume the responsibility of making an income tax return for his principal. 120. NOTICE TO DELINQUENTS. After the returns filed on or before March 1 have been properly recorded the Collector of Internal Revenue is required to notify every delinquent of whom he has knowledge and who has not filed that a return is expected within ten days. With this notice he is supposed to reach not only those who have filed returns in previous years but also those concerning whose affairs he has been able to obtain suffi- cient information to lead him to believe that they are liable to file re- turns. Immediate attention must be paid to such notice whenever it is received. If a person's income has fallen below that of previous years, a letter of explanation should be written. If the recipient of the notice has not received the income which the Collector suspects him of having received, he should write in full. 121. COLLECTOR CAN MAKE RETURN. The law gives the Collector authority to call witnesses and ex- amine accounts in case of neglect or refusal to file a return. He can, THE INCOME TAX 65 indeed, make the return himself and such return would be acceptable as a basis of assessment of tax. [See similar paragraph in instruc- tions given corporations.] 122. CORRECTION OF A RETURN. Whenever a return is received back from a Collector with in- structions to alter it, the directions of the Collector should be studied with care. The taxpayer is not obliged to follow arbitrary instruc- tions or comply with a peremptory demand with respect to any de- duction he has claimed, for instance, unless such instructions or de- mand are accompanied by an explanation of the law and regulations. In other words, before he is obliged to alter his return or prepare a new one, the taxpayer has the right to be shown the mistake in his original return. He has the right to present his side of the case and should do so. And when he prepares the corrected or amended re- turn he should mark it "Amended" and, in forwarding it to the Col- lector, attach to it the original incorrect return. This is necessary in order that he be given credit for having filed a return within the time prescribed by law. 123. FRAUDULENT RETURN. For the filing of a false or fraudulent return with intent to evade tax the law provides two distinct penalties. One is an increase of 100 per cent in the amount of tax found to be due, and the other is a fine not exceeding $2000 or imprisonment not exceeding one year, or both. 124. ON BASIS OTHER THAN RECEIPTS. While the law primarily requires that a return be based upon income received and deductions actually paid out during the year for which the return is made, it does contain an important exception in this respect with reference to an individual in the following language : "An individual keeping accounts upon any basis other than that of actual receipts and disbursements, unless such other basis does not clearly reflect his income, may, subject to regulations made by the Commissioner of Internal Rev- enue, with the approval of the Secretary of the Treasury, make his return upon the basis upon which his accounts are kept, in which case the tax shall be computed upon his in- come as so returned." [See similar paragraph in instructions given corporations.] 66 THE INCOME TAX CHAPTER IX THE INCOME TAX NON-RESIDENT ALIEN INDIVIDUALS 125. EXTENT OF TAX LIABILITY. A non-resident alien individual must pay income tax on all in- come from sources within the United States, except specifically ex- empted income. A resident alien that is, an alien residing in the United States must pay tax on income from all sources, both within and without the United States, except specifically exempted income, the same as an American citizen ; but a non-resident alien is liable only to the extent of his net income from the United States. 126. NOT LIABLE TO WAR INCOME TAX. A non-resident alien is, however, liable only under the old law (the Act of September 8, 1916.) His net income from sources within the United States is not subject to the extra rates imposed by the Act of October 3, 1917. 127^-WHAT CONSTITUTES RESIDENCE. It becomes necessary, therefore, to obtain an exact understand- ing of what the law means by the adjectives, "Resident" and "Non- resident." In Treasury Decision 2242 the Department has held that "residence" is "that place w r here a man has his true, fixed and perma- nent home and principal establishment, and to which whenever he is absent, he has the intention of returning; and indicates permanency of occupation as distinct from lodging or boarding, or temporary occupation. For the purpose of the income tax, it is held tha f where for business purposes or otherwise, an alien is permanently located in the United States ; has there his principal business establishment and is there permanently occupied or employed, even though his domicile THE INCOME TAX 67 may be without the United States, he will be held to be within the definition of 'every person residing in the United States, though not a citizen thereof.' " In application of the above ruling the Department has held that "aliens who are physically present in the United States, but only tem- porarily resident or employed therein (as for a season or similarly definite term, and with the expectation or intention of leaving the United States upon the termination of employment or accomplish- ment of the purpose which necessitated presence in the United States), are within the class of 'Persons residing elsewhere' " that is, are non-resident aliens. An alien who has come to the United States with the intention of becoming a permanent resident is, under the general interpretation of the law, a resident alien. An American woman who marries a foreigner assumes the nationality of her husband and is, for the purposes of the income tax, a resident or a non-resident alien according to his status with respect to residence. 128. NO SPECIFIC EXEMPTION ALLOWED. A non-resident alien is not allowed the specific personal exemp- tion enjoyed by citizens and residents of the United States. By this exemption is meant the allowance of $3,000 or $4,000, according to single or married status. And, likewise, the specific exemption of $3,000, given to (a) estates of deceased citizens or residents of the United States during the period of administration or settlement, and to (b) trust or other estates of citizens or residents of the United States, the. income of which is not distributed annually or regularly, is not allowed to similar estates of non-resident aliens. 129. NET INCOME OF NON-RESIDENT ALIEN. The net income of a non-resident alien is ascertained by taking from gross income from sources within the United States the deduct- tions allowed by law. 130. DEDUCTIONS LIMITED. These deductions are limited, however, to expenditures or losses immediately connected with or related to the sources within the Un : ted States from which the non-resident alien reports his income. 68 THE INCOME TAX The reader is referred to definitions of deductions in instructions given citizens and residents for detailed information. Certain specific limitations may, however, be noted here as follows : 1. Expenses only of business or trade carried on in United States. 2. Interest that proportion of all interest which gross income from United States bears to gross income from all sources (less in- terest on indebtedness incurred to buy bonds the interest on which is exempt from income tax.) 3. Taxes paid in the United States, except those assessed against local benefits ; (Taxes imposed by a foreign government are not de- ductible by a non-resident alien) ; except also United States Income and excess profits taxes. 4. Losses in trade in United States. 5. Losses (speculative) not exceeding profits from similar tran- sactions in United States. 6. Bad debts arising from business conducted in the United States. 7. Depreciation of business property and depletion of natural de- posits only in the United States. 131. CREDITS FOR NORMAL TAX. As in the case of a citizen or resident of the United States, a non- resident alien is allowed credits against net income of the amounts representing dividends from taxable corporations and income taxed at the source, in the computation for the normal tax. These credits are not allowed, however, in assessing the additional tax. 132. BOTH NORMAL AND ADDITIONAL TAX. A non-resident alien is subject to both the normal and the addi- tional tax under the rates of the Act of September 8, 1916, according to the amount of his income. However, were his entire income from corporation dividends, and in excess of $20,000 for the year, he would (under the Income Tax law of September 8, 1916, as amended) be subject only to the graduated additional tax. 133. MUST MAKE RETURN. In order to receive the benefit of deductions and credits, the law requires that a non-resident alien shall make an accurate return of all income, except exempt income, from sources within the United States, THE INCOME TAX 69 including dividends. If he fails to file such a return, the Collector of Internal Revenue must proceed to collect the tax due on his income and may take and sell any of his property to satisfy the Government's claim. 134. WHERE TO FILE RETURN. A non-resident alien is directed to file his return of income in the district in which he carries on his principal business within the United vStates. However, if he has no such principal business, and in all cases of doubt, he may and should file with the Collector at Baltimore, Md., in whose district Washington, D. C. is situated. 135. AGENT CAN MAKE RETURN. The return of a non-resident alien can be made by a resident agent in the United States. In fact, the Department in formal Treas- ury Decisions and extensive correspondence has insisted that in all cases where resident agents are responsible for the American in- terests of their principals to the extent of being in charge of any prop- erty owned, or business carried on, such resident agents must make the ieturns. The resident agent can act in full for his non-resident alien principal, can swear to the return and pay the tax assessed. Moreover, such resident agent may be either an individual or a cor- poration. If a corporation acts as resident agent, such corporation can sign, by one of its responsible officers, the individual return made in behalf of its non-resident alien principal. The return herein referred to (which is to be made by agent for principal) is the return of annual net income required of the non-resi- dent alien individual, and not the withholding agent's return required in the case of deduction of tax at the source. 136. TRUSTEE OR EXECUTOR TO MAKE RETURN. A trustee, executor, administrator, or any person acting in a fidu- ciary capacity can make the. individual return for a non-resident alien beneficiary. This has reference to a return similar to that which would be made by an agent and not to the return required to be filed for the estate of a deceased person during the period of administra- tion, or to the return required of any other estate the income of which is not annually or regularly distributed, or to the withholding agent's return required of a fiduciary when such fiduciary comes under the provisions of the law relative to deduction of the normal tax at the source. 70 THE INCOME TAX 137. DEDUCTION OF TAX AT SOURCE. All the income of a non-resident alien individual from the United States is subject to deduction of the normal tax at the source except income from dividends on the stock of a corporation subject to income tax. Such is the requirement of the law of September 8, 1916, as amended by the War Revenue Act of October 3, 1917. All persons, corporations or partnerships having control of the payment of any in- come except corporation dividends to a non-resident alien must de- duct the normal tax, as prescribed by law, and make return and pay- ment of such tax to the Collector of Internal Revenue. [This is more fully explained in the special chapter on ["Deduction of Tax and In- formation at Source."] 138. FOREIGN DIVIDENDS. A non-resident alien is not required to include in his return of in- come any amount received as dividends on the stock of foreign cor- porations, whether such dividends are payable either in the United States or abroad. Particular attention is called to this, lest the re- quirement that all dividends be included in a return be misunderstood as far as its application to non-resident alien individuals is concerned. THE INCOME TAX 71 CHAPTER X THE INCOME TAX PARTNERSHIPS 139. NOT SUBJECT TO INCOME TAX. A partnership, as such, is not subject to income tax except a limited partnership which has been held by the Treasury Department to be an "association," within the meaning of the law, liable to make return and pay tax. An ordinary partnership has no income-tax lia- bility. The individual members of a partnership must, however, in- clude in the gross income stated in their individual returns their re- spective shares of the net earnings of the partnership, whether such earnings have been distributed or not. 140. INCOME FROM A PARTNERSHIP. The requirement that each individual member of a partnership account for his share of its net earnings as a part of his gross income, whether he has actually received such share by way of distribution or not, has necessitated careful definition of income from a partnership. The Department holds that income from a partnership accrues to the individual partner at the time his distributive interest has been as- certained and is reducible to possession. In his own return for the calendar year the individual partner must include income accruing from the business of the partnership for its business year as such in- come is shown by the books of the partnership, whether or not dis- tribution has been made to the partners. The net earnings of the partnership thus to be accounted for by the individual members are the net earnings for the business year of the partnership ending in the calendar year for which the individuals make their return. For example: The partnership of "A & B" closed its books on September 30, 1917. In their personal returns for the calendar year ending December 31, 1917, A and B, as individuals, must include their 72 THE INCOME TAX respective shares of the net earnings of the partnership, as shown by the books on September 30, whether or not such net earnings have actually been distributed. If the partnership's business year should close the last day of De- cember, then the partners would include in their returns for the year ending the last day of December their respective shares of the net earnings as shown by the partnership's books on that date. It follows, of course, that if the net earnings of a partnership are not actually distributed during the year for which the individual part- ners account for them in their personal returns, such net earnings, when actually paid to the partners, need not again be included as in- come received. 141. CREDITS AGAINST PARTNERSHIP EARNINGS. As the individual partner is required to include in his statement of gross income his share of a partnership's net earnings, he would, in many cases, be subjected to both normal and additional tax on his share of that part of the partnership's income represented by interest on those certain bonds (enumerated hereinbefore) the interest on which is exempt from tax; and he would be subjected to normal tax on his share of that part of the partnership's income represented by dividends from corporations, but for credits specifically provided for in the law as follows : That from the net distributive interests on which the individual members shall be liable for tax, normal and additional, there shall be excluded their proportionate shares received from interest on the obli- gations of a State or any political or taxing subdivision thereof, and upon the obligations of the United States (if and to the extent that it is provided in the Act authorizing the issue of such obligations of the United States that they are exempt from taxation) and its possessions, And that for the purpose of computing the normal tax there shall be allowed a credit ***** f O r their proportionate share of the profits derived from dividends. 142. RETURN MAY BE REQUIRED. While a partnership is not liable to income tax and does not, in the ordinary course of its business, have to file a return, the statute gives both the Commissioner of Internal Revenue and a district Col- lector of Internal Revenue authority to call for a return. At any time either the Commissioner or a Collector may request a partnership to file a return, and such request must be complied with. Moreover, such return, when filed, must give a complete statement of the gross income of the partnership, and of the deductions and credits to which it is entitled, and the name and address of each individual partner in terested in the net earnings of the partnership. THE INCOME TAX 73 Since the partnership, as such, is not subject to income tax, this return, when called for, is for the information of the officials of the Government and not for assessment of tax against the partnership. As a matter of fact, the purpose in calling for it would be to obtain data desired in checking the personal returns of the individual part- ners. The return should not be filed unless called for by either the Com- missioner or a Collector. 143. CAN FIX A FISCAL YEAR. A partnership can designate a fiscal year of its own, and make re- turn upon such basis, if called upon to make return. It has the same rights in this respect as a corporation. 144. WHEN TAX RATE CHANGES. If the fiscal year of a partnership should at any time comprehend parts of two calendar years for which there are different rates of tax. then each partner's share of its net earnings must be apportioned for taxation under the two rates, according to that portion of the partner- ship's fiscal year falling within each of the two calendar years. 145. PARTNERSHIP MUST WITHHOLD TAX AND GIVE INFORMATION AT SOURCE. Under the income tax law of 1916, as amended by the War Rev- enue Act of October 3, 1917, a partnership is under the same require- ments as a withholding agent with respect to deduction of the normal tax at the source as are corporations and individuals. These require- ments have been greatly reduced from those that were in the law prior to amendment on October 3, 1917. If a partnership engages in the business of making collection of foreign payments of interest or dividends, it must obtain a license and submit to the same regulations as are imposed upon corporations and individuals. With respect to information at the source, regarding payments to others, the partnership stands exactly as does the corporation or in- dividual. It is subject to the same general requirements and liable to the same general penalties for refusal or neglect to obey the law. [See chapter on "Deduction of Tax and Information at Source."] 146. CANNOT DEDUCT INSURANCE PREMIUMS. In computing its net earnings, in order that the individual part- ners may account for their respective shares in their personal returns, a partnership is not allowed to deduct from gross income premiums 74 THE INCOME TAX paid on policies insuring the lives of individuals, (members or em- ployees) in favor of the business. This prohibition was written into the law by the Act of October 3, 1917. Prior to such amendment the ruling was that while the annual premium could not be deducted, as paid from year to year, the aggre- gate of premiums paid could be deducted from the proceeds of the policy in ascertaining the amount of such proceeds to be included as income. THE INCOME TAX 75 CHAPTER XI THE INCOME TAX DEDUCTION OF TAX AND INFORMATION AT SOURCE. 147. LAW RADICALLY CHANGED. The requirements of the Income Tax law with respect to the de- duction and withholding of the normal income tax at the source were radically changed by amendments carried by the Act of October 3, 1917. Certain of the deduction-at-the-source features have been re- tained and for others have been substituted requirements that infor- mation be furnished from the source without deduction of the tax. 148. INCOME OF CITIZENS OR RESIDENTS OF UNITED STATES. All of the requirements relative to the deduction of the normal tax from the income of individuals who are citizens or residents of the United States have been repealed with the exception of that re- lating to interest on bonds containing the so-called "tax-free" coven- ant. Only in this one respect is a corporation or its paying agent .re- quired to deduct the normal tax, and then only at the rate of 2 per cent. The individual can, however, claim exemption for deduction at the source, in which case no tax is to be deducted. In collecting his interest the bondholder must fill out an ownership certificate. In this certificate he can either claim exemption from deduction of tax at the source, or not claim exemption. If he does not claim exemption, the corporation must pay the normal tax upon the interest. In either case original tax liability remains with the bondholder the recipient of the interest. This liability is not transferred from bondholder to corporation by the "tax-free" covenant in the bond. 76 THE INCOME TAX If the bondholder claims exemption in filing his certificate of ownership at the time he collects his interest, when the time comes to file his return of annual income with the Government he must enter the amount of interest received as income which has not been subjected to tax at the source. If the bondholder does not claim exemption in filing his certificate of ownership at the time he collects his interest, when the time comes to file his return of annual income with the Government he must enter the amount of interest received as income which has been sub- jected to tax at the source. It is of the utmost importance that the two preceding paragraphs be understood by every individual holder of "tax-free" industrial bonds. Endless confusion has resulted from a clash between the withholding provisions of the Federal law and the "tax-free" coven- ant in such bonds. To illustrate : John Smith owns $20,000 (par value) of the Western Railway Company's bonds paying 5 per cent interest. The interest is pay-- able quarterly. There is a clause in the bonds by which the railway company agrees to pay the interest without deduction for taxes. What happens if Smith, desiring to pass liability for the tax to the railway company, decides that the way to do so is to claim exemption when he fills out the ownership certificate required when he collects his interest? Having claimed exemption in collecting a year's interest, he de- cides that he is no longer liable to tax on the interest and when he makes up his return of income he enters the amount of interest as having been taxed at the source. This is not what should be done but it is what generally has been done by the individual during the past (our years. The mistake made by Smith may not be noticed in the local In- ternal Revenue office during the rush of the filing period, but eventual- ly it will be discovered in the Department at Washington where all ownership certificates are filed and assembled, and Smith will be assessed and required to pay the tax on the interest. When he pro- tests that the bonds are "tax-free," he will be told that the Govern- ment is not concerned with the "tax-free" covenant, that the liability is his and that in claiming exemption at the time he filled out owner- ship certificates he specifically released the railway company from lia- bility to pay the tax to the Government under the provisions of the Income Tax law. THE INCOME TAX 77 On the other hand, if at the time he collects his interest and fills out the requisite ownership certificates, Smith does not claim exemp- tion, the railway company is under obligation to pay the tax to the Government. Smith, then, can enter the amount as having been taxed at the source when he files his return of income. He can make this kind of entry and benefit by the credit represented by it even though he has received his interest in full, which generally has happened in the case of interest payments on "tax-free" bonds, whether the bond- holder has or has not claimed exempt ion. The form of ownership certificate used by the bondholder i.-, what determines the liability of the bond-issuing corporation as far as the Government is concerned. The Government requires that the corporation make return and pay the normal tax in the case of every interest payment for which a certificate claiming exemption cannot be furnished. But with respect to interest payments for which it has received ownership certificates claiming exemption, the corporation is required merely to deposit the certificates with the Collector for transmission to Washington and is not required to pay tax at the source. 149. INCOME OF NON-RESIDENT ALIEN INDIVIDUALS. All of the income of non-resident alien individuals, from sources within the United States, is still subject to the deduction of the nor- mal tax at the source with the exception of dividends from domestic corporations. All persons, corporations, partnerships and associations, having control, receipt, custody, disposal or payment of income of any kind, except dividends, from the United States to foreigners residing under other flags must deduct the normal tax of 2 per cent and make return and payment to the Collector of Internal Revenue. Moreover, a non- resident alien, not being entitled to the specific exemption allowed other individuals, can not claim exemption from deduction, at the source. ) 50. INCOME OF FOREIGN CORPORATION FROM UNITED STATES. The income of a foreign corporation from sources wthin the United States is subject to deduction of tax at the sourci in two re- spects, provided such corporation is not engaged in business or trade in the United States and does not have an office or place of business in this country. 78 THE INCOME TAX 1. The income derived by such a corporation from dividends on the stock of a domestic corporation is subject to deduction of tax at the source to the amount of 2 per cent. 2. The income derived by such a corporation from interest on American corporation bonds is subject to deduction of tax at the source to the amount of 6 per cent. 151. FOREIGN PARTNERSHIP NOT SUBJECT TO DEDUCTION AT SOURCE. Payments of domestic corporation dividends or bond interest, or of income in any other form, to a foreign partnership is not subject to deduction of tax at the source. True,, Subdivision (e) of Section 13 6i the Act of September 8, 1916, as amended by the Act of October 3, 1917, states that the withholding-at-the-source requirement with re- spect to bond interest "shall be made applicable to the tax imposed by subdivision (a) of Section 10 (of the Act of September 8, 1916) upon incomes derived from interest upon bonds and mortgages or deeds of trust or similar obligations of domestic or other resident corporations, joint-stock companies, or associations, and insurance companies, by non-resident alien firms, copartnerships, companies, corporations, joint-stock companies or associations, and insurance companies, not engaged in business or trade within the United States and not having any office or place of business therein." But Subdivision (a) of Section 10, above referred to, does not im- pose an income tax upon the income of foreign partnerships ; there- fore, no tax is to be. deducted when payments are made to them. The Department has so held. 152. DOMESTIC CORPORATIONS AND PARTNERSHIPS NOT SUBJECT TO DEDUCTION AT SOURCE. The income of a domestic corporation or partnership is not sub- ject to deduction of the tax at the source upon income paid in any form. It has in the past been held necessary, however, for such or- ganizations to file ownership certificates when presenting bond coupons or interest orders for collection. Under the law as amended they will still have to do so with respect to coupons and interest orders for interest payments upon "tax-free" bonds. 153. WHO IS "WITHHOLDING AGENT"? The regulations of the Treasury Department and the official in- come tax forms contain many references to "withholding agents." THE INCOME TAX 79 The withholding agent is the source of the income. In the case of bond interest payments the withholding agent is the interest-paying corporation or its regularly designated paying agent. In the case of payment of salaries, rent, etc., the withholding agent would be the employer, lessee, etc., making such payments to a non-resident alien. In the case of dividend payments by a domestic corporation to a foreign corporation having no office or place of business in the United States, the withholding agent would be the domestic corporation. A withholding agent can be an individual, a corporation, a part- nership or any kind of association or organization. 154. REFUND OF TAX WITHHELD IN 1917 AUTHORIZED. All amounts of tax withheld at the source during 1917 from the income of individuals who are citizens or residents of the United States, with the exception of that withheld from interest payments on "tax-free" bonds, must be returned to the owners. This covers amounts withheld from salaries, rents, ordinary note interest, and any other form of income of an individual citizen or resident of the coun- try which was formerly subject to deduction of tax at the source. Employers, lessees and others who withheld the tax from payments made during the year 1917, are authorized and directed by law to pay back the amounts. The Government will expect the individuals re- ceiving the income to include all such income in their returns as not having been taxed at the source. 155. DUTIES OF THOSE WHO DEDUCT TAX UNDER AMENDED LAW. Those persons, corporations or partnerships (a) making payments of any kind, except domestic corpora- tion dividends, to a non-resident alien individual ; (b) or making payments of "tax-free" corporation bond in- terest to an individual citizen or resident of the United States, when ihe certificate of ownership filed does not claim exemption; (c) or making payments of domestic corporation dividends and any domestic corporation bond interest (whether bonds are "tax- free" or not) to a foreign corporation not engaged in business or trade in the United States and not having an office or place of business in this country, 80 THE INCOME TAX will be required to make return and pay the tax deducted to the Collector of Internal Revenue of the district in which such "with- holding agent" has his or its principal place of business. In the case of payment of bond interest they must require the til- ing of ownership certificates in one of the several forms provided, and they must make both monthly and annual returns to the Collector. In regard to other payments annual returns will be filed. For neglect or refusal to file such a return of tax deducted and withheld at the source the person, corporation or partnership under liability to do so is subject to fine and to an increase of the amount of tax by 50 per cent. Every person, corporation or partnership making any payment subject to deduction of the tax at the source, as hereinbefore ex- plained, should write to the Collector of Internal Revenue, state the kind of payments made, and request the forwarding of official f